Nike: Cost of Capital

Nike, Inc.: Cost of Capital

Statement of the Problem

Kimi Ford, a portfolio manager at NorthPoint Group, a mutual fund management firm, developed a discounted-cash-flow forecast to determine if Nike, Inc. is a good buy. Her forecast showed that at a discount rate of 12 percent, Nike is overvalued at its current share price of $42.09. However, performing a sensitivity analysis revealed that the company is undervalued at discount rates below 11.2 percent. The appropriate discount rate for Nike is its Weighted Average Cost of Capital (WACC). Therefore, it is important that the WACC is calculated correctly in order to obtain a precise measure of the firm’s profitability.

Alternative Solutions

The calculation of Nike’s WACC, as presented in Exhibit 5, is inconsistent with the proper procedure required in the estimation of the figure. The following expresses our proposed changes.

1. The Yield to maturity (YTM) should be used as the cost of debt.

2. The after tax cost of debt should be calculated using the marginal tax rate.

3. The market value of equity should be used in determining the firm’s capital structure.

4. The current yield on a 10 year treasury bond should be used as the risk free rate.

Also, Ford’s assistant, Joanna Cohen, uses the Capital Asset Pricing Model (CAPM) to determine the cost of equity. Although the CAPM approach is considered to be an accurate and precise measure, there are three other methods that can be used to calculate the cost of equity:

ˉ Dividend Discount Model (DDM)

ˉ Earnings Capitalization Model (ECM)

ˉ Arbitrage Pricing Theory (APT)

Analysis of Alternative Solutions

First, it is necessary to provide the formula for calculating WACC:

WACC= (E/V) X RE + (D/V) X RD X (1-TC)

Now, we reexamine the cost of debt (RD) which in this case is the YTM on bonds. The YTM is a good estimate for the cost of debt if the company had issued debt in the past and the bonds...