Essay About Nike’S Cost And Joanna Use

Nike’s Cost of Capital
_________________________________________________________________________________Recommendation: Based on the following assumptions, estimate of Nike’s cost of capital is 8.95% with an intrinsic value of $61.83/share with a buy recommendation.Single or Multiple Cost of CapitalJoanna is correct in using a single cost of capital as oppose to multiple cost of capital as risk profile of multiple revenue streams is similar.  On the other hand, risk profile of Cole Haan line may defer, except, the impact on valuation would be immaterial, as such, single cost of capital assumption validates.Methodology of Calculating the Cost of Capital (WACC)Based on exhibit 1, market value of equity is 11,503 (90%) and value of debt is 1,296 (10%). Based on MV weighted cost of capital is 8.95%.  Joanna is using book value compared to market value for equity and debt. As such MV of equity is essentially number of shares outstanding (271.5) multiplied by share price of $42.09.MV was used to reflect current and forward looking pricing the market is assigning.Calculation of cost of debt of 7.16% is illustrated in exhibit 2 (MV of Debt is provided in the case). 40 semi-annual periods were used as 5 years have elapsed already.Statutory tax rate of 35% plus mid-point of 2.5%-3.5% being used for taxes. International tax rate ignored – Nike has world-wide operations (Not presented in the case)Beta (Exhibit 3) provides systematic exposure of a security that cannot be diversified away. As such, recent beta of 0.69 has been used to derive cost of equity as it reflects current and going forward systematic exposures. Calculation of cost of equity is derived based off CAPM. Risk free rate of 5.39% has been used as DCF valuation is only 10 years out. Applying a 20 year risk free rate results in a higher risk premium and an under-valuation of equity. Joanna use of 20 year risk free rate also violates the matching principle.Nike has outstanding perpetual preferred shares in the amount of $0.3m and does not have any plans to issue any further preferred shares.  The $0.3m outstanding is not part of financial strategy going forward and is relatively low, as such, can be ignored in WACC calculation.Geometric return has also been used to reflect accurate market risk premium. Use of arithmetic return results in higher weighting to outlier’s fluctuations and assumes each return is independent.Cost of EquityDDMAs highlighted in exhibit 4, forward dividend of 0.51 was used, results in a cost of equity of 6.70%Due to dividend growth does reflect growth rate of earnings as reflected in exhibit 5, as such, growth rate of 5.5% dividend was used.Advantages:Value derived strictly through firm’s dividend policy and not dependent on market conditionsApplicable to mature firms with steady dividend payout policyDisadvantages:Best suited for companies that pay dividends based on a stable dividend payout history and want to maintain in the future. Nike did not issue a dividend since after June 30, 2001; it is not an effective tool to calculate cost of equityNot effective for firms in distressSensitive to cost of equity minus dividend growthNot applicable to firms that do not pay a dividendAssumes 100% of earnings are paid out as dividendsECMEPS forecast of 2.32 ’02 was used with a current price of $42.09, results in cap rate of 5.51%Advantages:Used as a compliment to detailed analysisDisadvantagesSensitivity to cap rate (cost of equity) can lead to inaccurate conclusionInaccurate forward earnings estimate can also lead to inaccurate conclusionsNike’s earnings are predicted to grow at an aggressive rate in the long-term. However, ECM model only considers earnings for next year and therefore is not an accurate discount rate calculation model for Nike in the long-term.CAPMBeta of 0.69 was used to reflect current and going forward systematic exposureBased on risk free rate of 5.39% and market risk premium of 5.90%, results in cost of equity of 9.5%Advantages:Incorporates systematic exposure of a security through betaAssumes investors only rewarded for systematic risk as unsystematic risk will be diversifiedDisadvantages:Risk free rate can be volatileOnly considers single market factor and ignores other factors highlighted in Fama-French model for exampleAssumptions of borrowing and lending in real world not applicable in real worldDifficulty in estimating beta, can also be vary as time elapses ValuationValuation details are highlighted in Exhibit 7Upon adjusting WACC to 8.95% from 12% and by using market value instead of book value for equity and debt, results in a valuation of $61.83 per share.  As such, compared to current price of Nike of $42.09, Nike is currently undervalued and should be purchased. Nike will be targeting mid-priced segment of athletic shoes market – a segment that had been overlooked over the past years while focusing on expense control.Appendix[pic 1][pic 2][pic 3][pic 4][pic 5][pic 6][pic 7][pic 8]