Nike Inc.: Cost of Capital

Introduction

Kimi Ford, a portfolio manager at NorthPoint Group was considering investing in the athletic shoe manufacturer Nike Inc., which, since 1997 had witnessed revenue levels stagnant at $9B, net income fell from $800M to $580M while market share fell from 48% to 42%. In June 2001, Nike announced a strategy for revitalizing the company through the increase in developing new athletic shoe products, putting more emphasis on its apparel line. Nike Executives reiterated their long tern revenue growth targets of 8% to 10 % and earnings target growth of 15%. Kimi read the market analyst reports which were mixed; Lehman Brothers recommended a strong buy while UBS and SCFB recommended a hold. Kimi developed her own discounted cash flow forecast and it showed that at a discount rate of 12%, Nike was overvalued at a share price of $42.09; however the sensitivity analysis revealed that Nike Inc. share was undervalued at discount rates below 11.17%. Kimi asked her assistant Joanna Cohen to estimate Nike’s cost of capital. This report will discuss what the cost of capital is and why is important in the business world, it will also evaluate Cohen’s calculation of the cost of capital, additionally it will provide an estimate of the Nike Inc. Cost of capital and finally based on the estimated weighted average cost of capital (WACC), it will provide a recommendation to Kimi about investing in Nike Inc.

WACC and its importance

Cost of capital is the required rate of return for a capital investment (Parrino & Kidwell, 2009) This is the cost of a company funds i.e. debt and equity and is usually used for evaluating capital projects. WACC is the weighted average of the cost of each different type of financing used by the company (Parrino & Kidwell, 2009). For example, if a company has capital financed by debt and equity, it shows what proportion of the total capital is financed through debt and how much is financed through equity and additionally how much each type costs...