Nike Wacc Case Study

Financial Management Agenda 1. What is the WACC and why is it historic to estimate a firms embody of majuscule? Do you agree with Joanna Cohens WACC tally? why or why non? 2. If you do non agree with Cohens analysis, calculate your own WACC for Nike and release your assumptions. 3. Calculate the cost of virtue development CAPM, the dividend discount model, and the earnings upper-case letterization ratio. What atomic number 18 the advantages and disadvantages of apiece mode? 4. What should Kimi ford recommend regarding an investing in Nike? 2 subject field Overview Nike, Inc. NorthPoint Group Investment Decision Current share damage of USD 42. 09 ? Declining grocery store share for the dot 1997-2000 ? St calculategy for revitalizing the company down the stairs reflexion ? Plan to boost revenue and optimize costs ? Highly experient management team ? Mutual fund management firm ? violence on large-cap value stocks ? Has been outperforming the grocery for the pas t 18 months ? Kimi hybridizing portfolio manager seeking to identify undervalued stocks, consistent with the funds coronation st gradegy ? Stock valuation found on portent forthcoming cash f unkepts all over a ten year period ? discounting the UFCFF utilise a predetermined WACC value ? reason the discount factor base on the CAPM draw near ? Considering sensitivity analysis 3 Understanding the WACC ? The weight Average speak to of Capital is the interest locate (minimal return) at which investor-supplied capital (equity and interest bearing loans) has been provided. Therefore, it is the weighted intermediate minimum expectation, which shareholders and creditors require for their individual investments do with the company under carryation. The WACC strikes both, the cost of equity and the cost of debt. polar sources of funds have different costs and therefore, depending on the capital social organization of the organization, the weightings of debt and equity are c alculated and assigned. ? The WACC is calculated use the following compare WACC = E/(D+E) x Ke + D/(D+E) x Kd (1-t) ? The minimum required return on shareholders investment. ? CAPM method has been widely used in calculating the cost of equity. ? Ke = Rf + b. (Rm Rf) ? chance level and volatility are calculated based on historic data. monetary value of Equity Cost of Debt ? The interest rate at which a company can acquire in the altogether debt. ? Any fixed rate on outstanding debt are non relevant, since the investors are concerned with what it forget cost the company to generate cash from any future investments, which would give at market rates rather than historical ones. ? subsequently assess cost of debt = (1-t)Kd, since interest is tax deductible. 4 Critique of Joannas Calculations Calculating Ke Since Joannas FCF forecast reflects a ten year period, it could be argued that, for the involvement of consistency, the issuing of a risk free ten year protection should be used instead. ? An arithmetic mean estimation of the risk insurance subsidy is generally accepted as an appropriate approach by the investment community. * ? Since Nike is a multinational company, its revenue stream bears additional risk based on the specific allocations to various countries. This should reflect additional risk premium such as exchange rate risk, political risk and so on Such calculation goes beyond the scope of this case muchover it should not be ignored. Beta has been calculated as a historic average but the included value YTD 06/30/01 should be excluded not nevertheless since it is not consistent in terms of period length, but the apparels fear is seasonal with great portion of the revenues coming during the months of Dec. and Nov. Historic betas prior to 1996 should not be excluded. Calculating Kd ? Cost of debt is not properly calculated since electromotive force shareholders and creditors are not concerned with interest on outstanding debt, but rathe r the current market rate at which the company could draw to finance its operations and potential expansion. The technique used by Joanna is expedient however to get some rough insight on what Nike is nonrecreational on its existing debt. ? Joanna has undertaken an appropriate approach in calculating the subsequently tax cost of debt, since debt is tax deductible. ? Joanna is right to consider debt denominated in impertinent currency, however her approach is flawed since she is once again looking at outstanding debt, which arrangements that occurred some time in the past might significantly differ from the current market reality. ? Since existing Nike bonds are trading at discount, we already know that the market yield exceeds the coupon rate. 5 well arguments exist for using the geometric mean under certain circumstances. This prime entrust be further elaborated Agenda 1. What is the WACC and why is it important to estimate a firms cost of capital? Do you agree with Joann a Cohens WACC calculation? why or why not? 2. If you do not agree with Cohens analysis, calculate your own WACC for Nike and justify your assumptions. 3. Calculate the costs of equity using CAPM, the dividend discount model, and the earnings capitalization ratio. What are the advantages and disadvantages of each method? 4. What should Kimi cover recommend regarding an investment in Nike? Calculating Cost of Equity ? Rf = 5. 39% based on the current 10 year yield for the sake of consistency with the forecasted 10 year FCFF. ? Calculating risk premium based on arithmetic average vs geometric mean ? Arithmetic average assumes no ordered correlation and thus could be overstating the premium. ? Arithmetic average ignores estimation faulting and available data is limited. ? Arithmetic average works best for forecasting short term periods where large term periods seem to be break in captured by the geometric mean. Cost of Equity digest on 10-year Treasuries adventure premium develo ped market (geo. stake premium developed market (arit. ) 5. 39% 5. 90% 7. 50% Average risk premium Risk premium country specific Levered ? Unlevered Cost of Equity 6. 70% 0. 00% 0. 82 0. 77 10. 91% ? Both methods are acceptable and even though the arithmetic mean is widely accepted as the proper method, we are using an average of both since we are dealing with a long term period and the geometric mean could be potentially more representative. ? No additional country risk premium is assumed collectable to lack of data. ? Unlevered beta has been calculated in order to reflect only the amount of business risk.For any future beta projections it will be more appropriate to calculate relevered beta based on the targeted capital structure. Beta 1996 1997 1998 0. 98 0. 84 0. 84 1999 2000 Average 0. 63 0. 83 0. 82 7 Sources Ibbotson Associates, Aswath Damodaran Calculating Cost of Debt ? To calculate the appropriate yield to maturity we need to take into account that the settlement date (05/07/2011) move between coupon payments, meaning that the first period will be shorter than the remaining 40 (20 years of semiannual payments). ? We calculate a exertion damage (dirty damage) of USD 98. 9 using a YTM of approximately 7. 17%. After adjusting for the accrued interest we get the quoted price of USD 95. 60. ? We are not considering the legal YTM for the cost of debt since it is not clear whether the returns could be reinvested at the same rate due to the following reasons (list not exhaustive) ? The yield curve is usually not horizontal. ? The shape of the curve is dynamic and changes over time. ? Some premium should be considered on debt issued in foreign currency, but this goes beyond the scope of this assigning and no debt breakdown has been provided for that matter.Cost of Debt Coupon Years to maturity Periods inwardly one year Total periods Face value of c-bond trade price of c-bond YTM* Effective YTM 6. 75% 20. 03 2 40. 05 100. 00 95. 60 7. 17% 7. 30% Yi eld to Maturity Days from last coupon date Days to side by side(p) coupon date Days between coupon dates Transaction price Accrued interest adjustment Quoted price Yield to maturity 171 10 181 98. 79 3. 19 95. 60 7. 17% 8 * Calculations have been made based on a 360 day year Calculating WACC 10. 26% WACC Calculations of the weightings We use agree value of debt since not Weightings Ke / Kd onsider the market value of equity based on the current price per share and the diluted shares outstanding. 89. 87%* 10. 13%** all interest bearing debt is in the form of bonds maturing on 07/15/21 with a current YTD of 7. 17%. However, since the company has low leverage and is not under financial distress, there should not be a significant difference between the current market and book value of the outstanding debt. Cost of Equity After Tax Cost of Debt 10. 91% Calculations are based on revised 4. 44% beforehand tax cost of debt has been assumptions previously described. Cost of equity is not to be adjusted reviously calculated at 7. 17%. After applying tax rate of 38% the for taxes. after tax cost of debt amounts to 4. 44%. 9 * Market capitalization as of 05/07/2001 is USD 11. 5 bn. ** Total interest bearing debt (current + non-current) as of 31/05/2001 is USD 11. 3 bn. Figures as of 05/07/2001 are not provided for a go against estimate. Agenda 1. What is the WACC and why is it important to estimate a firms cost of capital? Do you agree with Joanna Cohens WACC calculation? Why or why not? 2. If you do not agree with Cohens analysis, calculate your own WACC for Nike and justify your assumptions. 3.Calculate the costs of equity using CAPM, the dividend discount model, and the earnings capitalization ratio. What are the advantages and disadvantages of each method? 4. What should Kimi Ford recommend regarding an investment in Nike? 10 Other Methods for Calculating Cost of Equity ? Po = Do(1+g)/(r-g) ? Could be used for mature companies, which pay dividends on a uncea sing basis, and it is reasonable to expect that they will also do so in the foreseeable future. ? The DDM model is overly sensitive over the value of assumed growth (g), however it is a very artless and straight forward method of calculating the fair value of a mature company. Since Nike is evaluate to undergo cost optimization over the side by side(p) years, as well as shift in sales strategy, we should consider a high growth period of the expected dividends, after which unremitting growth could be assumed. ? For the take aim of this case, however, we are given than dividends increase by 5. 50% on an annual basis, even though Joanne predicts a CAGR of NOPAT for the period 2002-2011 equal to approximately 10. 4%. Dividend Discount Model Earnings Cap. balance ? Po = EPSo(1+g)(1-b)/(r-g), where b is the retention ratio. ? EPS is an accounting figure. The ratio depends on dividend policy. ? effectual and simple approach for mature firms with easily predictable future EPS and cons tant growth rate and retention ratio. ? For simplicity, we are assuming g = 5. 50%, just like in the DDM method. 11 DDM and Earnings Capitalization symmetry Calculations ? D1 has been calculated as of 30/06/2002, assuming 5. 5% increase in annual dividends paid in both 2001 and 2002. Do captures the period 30/06/2000-30/06/2001. ? base on the DDM and Earnings Capitalization balance, we obtain a cost of equity of approximately 6. 7%-6. 8%.Both estimates seem unreasonably low. ? This is significantly lower than the calculated cost of equity using the CAPM model. out-of-pocket to the flaws of both the DDM and Earnings Capitalization Ratio methods described above, we should hold the CAPM approach as most reliable in calculating the cost of equity. ? The calculation of the cost of equity using both the DDM and and Earnings Capitalization Ratio methods has been based on assumed constant growth in perpetuity, which will most likely not be the case, especially considering Nikes new sal es strategy and cost optimization over the next hardly a(prenominal) years.Therefore, we are more likely going to observe a high growth period followed by a stable growth period. Dividend Discount Model g Po 5. 50% 42. 09 Do D1 r 0. 48 0. 53 6. 77% Earnings Cap. Ratio g Po b (retention ratio) EPSo EPS1 r 5. 50% 42. 09 77. 75% 2. 16 2. 28 6. 70% 12 Agenda 1. What is the WACC and why is it important to estimate a firms cost of capital? Do you agree with Joanna Cohens WACC calculation? Why or why not? 2.If you do not agree with Cohens analysis, calculate your own WACC for Nike and justify your assumptions. 3. Calculate the costs of equity using CAPM, the dividend discount model, and the earnings capitalization ratio. What are the advantages and disadvantages of each method? 4. What should Kimi Ford recommend regarding an investment in Nike? 13 Investment Decision Based on the calculated WACC value, using the CAPM approach, and the predicted UFCFF for the period 2002-2011, Nikes stock appears undervaluedSince the purpose of the assignment was to calculate the WACC value only, we have taken all predicted UFCFF levels as given, even though certain adjustments could be appropriate to better reflect the expected boost in sales resulting from the new sales strategy, and the expected cost optimizations. Based on the predicted NPV of UFCFF, we are given that the current price of USD 42. 09 suggests a 11. 17% discount rate. Since our calculations reveal that the actual discount rate ought to be 10. 26%, Nikes share price is trading under its intrinsic value. Therefore, Kimi Ford should recommend a buy on the stock. 14