Nike Case Study - Cost of Capital

Case 1

Nike, Inc: Cost of Capital

Overview of Case:

In the beginning of 2001, Nike, Inc faced a significant decline in share price. This was an unpleasant, yet not too surprising, addition to many other areas of Nike that had not experienced stable growth in years. One person that hoped to find a way to help turn Nike around was Kimi Ford, a portfolio manager at NorthPoint Group. Ford managed the NorthPoint Large-Cap Fund, which primarily invested in Fortune 500 companies and had been experiencing impressive growth at some economically distressed times; while the stock market declined over an 18 month period at the time, North Point’s Large-Cap Fund had earned a return of 20.7% while S&P 500 fell 10.1%.

Eager to learn more about what caused Nike’s financial problems, Ford read the analysts’ reports from a meeting Nike held to disclose their fiscal-year 2001 results. To her dismay she found conflicting recommendations and opinions regarding the financial strength of Nike. In order to come to a clearer conclusion, Ford decided to have her new assistant, Joanna Cohen, develop her own discounted cash flow forecast.

Questions:

1.) What is the WACC and why is it so important to estimate a firm’s cost of capital? Do you agree with Johanna Cohen’s WACC calculation? Why or why not?

A company’s assets are financed by either debt or equity. Weighted Average Cost of Capital (WACC) is a calculation of a company’s cost of capital in which each category of capital is proportionately weighted. All capital sources are taken into consideration, including common stock, preferred stock, bonds and any other long-term debt. Ceteris paribus, the WACC of a firm increases as the beta and rate of return on equity increases. An increase in WACC also indicates a decrease in valuation and a higher risk.

It is important to estimate a firm’s WACC when valuing and selecting investments. The firm’s WACC represents the minimum rate of return at which a company produces value...