Nike Case

BACKGROUND

Kimi Ford, a portfolio manager of a large mutual fund management firm, is looking into the viability of investing in the stocks of Nike for the fund that she manages. Ford should base her decision on data on the company which were disclosed in the 2001 fiscal reports. While Nike management addressed several issues that are causing the decrease in market sales and prices of stocks, management presented its plans to improve and perform better. Third party sources also gave their opinions on whether the stock was a sound investment.

PROBLEMS:

1. What is the WACC and why is it important to estimate a firm's cost of capital? Do you agree with Joanna Cohen's WACC calculation? Why is it important to estimate a firm's cost of capital? What does it represent?

2. Calculate the costs of equity using CAPM and the dividend discount model. What are the advantages and disadvantages of each of these methods? Are they any other methods you could use?

3. What should Kimi Ford recommend regarding an investment in Nike? Is the price of Nike overpriced, underpriced, or fairly priced?

ASSUMPTIONS

Ð'* Corporate tax rate of 38%

Ð'* 20 year bond is 5.745

Ð'* The arithmetic mean of 7.50% for Equity Risk Premium

Ð'* Average Beta of 0.80

AN ALYSIS

In our analysis, we examine why WACC is important in decision making and we show how WACC for Nike Inc. is calculated correctly. Also, we calculate the company's cost of equity using two different models: the Capital Asset Pricing Model (CAPM), and the Earnings Capitalization Model (EPS/ Price).

Computation of the Cost of Equity

The CAPM is a model for pricing an individual security (asset) or a portfolio. For individual security perspective, we made use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:

Individual security's / beta = Market's securities (portfolio)

Reward-to-risk ratio Reward-to-risk ratio

,

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

Where:

Ð'* is the expected return on the capital asset

Ð'* is the risk-free rate of interest

Ð'* (the beta coefficient) the sensitivity of the asset returns to market returns, or also ,

Ð'* is the expected return of the market

Ð'* is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return). Note 1: the expected market rate of return is usually measured by looking at the arithmetic average of the historical returns on a market portfolio (i.e. S&P 500). Note 2: the risk free rate of return used for determining the risk premium is usually the arithmetic average of historical risk free rates of return and not the current risk free rate of return.

Rf on a 20 year bond 5.74%

?s on Nike's historic average beta from 96 to 00 .80

Rm, historical return on equity market 7.5%

(Rm-Rf) Historical equity risk premium

using arithmetic mean (7.5%-5.74%) = 1.76

Es = 0.574 + .80 (.0176)

Es = .0574 + .01

Cost