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Nike Case Study
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15th June 2012 – OneMBA 2013 – Justin Lee Bennett

1. How does Joanna’s analysis (exhibit 5) differ from BEHH best practice, HV Chapter 10 and/or my lecture notes?

a. The differences between Joanna’s calculation and the other sources mentioned above can be summarized as follows: a. She used statutory tax rates where as BEHH, Chapter 10 and class notes show best practice as using effective marginal rates b. When calculating the WACC Joanna used a single cost of capital as she believes that only the Cole-Hann business is different, given this only makes up a small part of revenues and all other businesses were sports related, this makes some sense however BEHH, chapter 10 and our course lecture state we should use different cost of capitals for each business. c. Joanna uses book values to calculate cost of debt; BEHH, chapter 10 and class lecture advise us to use market values. d. She used a market risk premium of 5.9% for her calculations that is equal to the geometric mean. BEHH agrees with this for bonds, but suggest arithmetic mean when using treasury bills (shorter time period). In our class notes it also states we use geometric mean for long term investments, but recommends 6% for OneMBA calculations e. For the cost of debt calculation Joanna used current interest payments which deviates from BEHH, Chapter 10 and class notes as all these stipulate that market yield of government bonds + estimated credit risk spread should be used. f. The use of beta differs between the three in that Joanna used the average beta, chapter 10 advises using published betas and in class we calculated the beta value. g. Redeemable preferred stock not included in Joanna’s calculation, in BEHH, chapter 10 and class notes they should be included

2. Calculate the effect of the differences on Nike’s cost of capital a. Calculating the ratios of equity and debt – For this I used the market values as follows (ref: calculation 1,2 & 4 in spreadsheet): i. Market value of equity = share price x outstanding shares = $42.09 x 271.5 = $11,427.4 M ii. Market value of debt = Current liabilities + notes payable + long term debt (discounted) + redeemable preferred stock
= $5.4 + $855.3 + ($435.9*0.956) + 0.3 = $1277.72 M
Therefore Equity = 89.94% and Debt = 10.06%
Equity + Debt Equity + Debt

b. Calculating the after tax cost of debt (ref: calculation 3 on attached spreadsheet): iii. We don’t know the number of bonds outstanding, nor do we know the credit rating for Nike, given this I approached this in two ways. First I estimated Kd by calculating the Yield to maturity, to do this I assumed a face value of the bond to be $100. 1. Kd = Yield to Market (YTM) = 7.1%, - reference calculation 3 in the attached spreadsheet, using excel formula 2. Since we need after tax cost of debt we need to find the marginal tax rate (Tc) and calculate (1-Tc). For this I took the next 5 years of tax payments and divided by the 5 years income before tax which equated to 1719.3/4534.9 = 37.9% 3. Kd x (1-Tc) = 7.1 x (1-37.9%) = 4.45% 4. Therefore cost of debt after tax - Kd = 4.45% iv. My second method for calculating Kd involved using the government bond yield and credit risk spread method, which chapter 10 highlights can be used if the firm has no bonds outstanding: 5. Cost of debt = market yield on government bonds + estimated credit risk spread a. From internet research Nike is rated A to A+, for this analysis I have used ‘A’ as the rating which gives a estimated credit risk spread of – 1.397% on US 10 year treasuries b. For the government bond yield I have taken the 10 year yield 5.39% - equal time period to treasury yield c. Therefore cost of debt = 5.39 + 1.397; Kd = 6.8% before tax d. Kd x (1-Tc) = 6.8 x (1-37.9%); KD after tax = 4.2 6. For WACC calculation I have used 7.1% as per calculation number 1, see note section at bottom of page for reasoning

c. Calculating the cost of equity, for this we use the CAPM model (Ref calculation number 5 in spreadsheet) v. Ke = Rf + (Rm-Rf) x beta equity – where Rf is the risk free rate and Rm-Rf is the risk premium vi. Assumptions – I have used the average beta values for Nike of 0.8 and risk free rate equal to the government bonds of 5.74% (20 year). For the risk premium we would use the geometric mean of 5.9%, however I have rounded this to 6.0% as per our class notes, therefore Rm-Rf = 6% vii. Ke = 5.74% + (6%) x 0.8 – therefore Ke = 10.54%

d. Finally I calculated the cost of capital using the WACC model viii. WACC = Kd x (1-Tc) x (D/E+D) + Ke x (E/E+D) ix. From prior calculations: 7. Kd x (1-Tc) = 4.45%, (D/E+D) = 10.06% & Ke = 10.54%, (E/E+D) = 89.94% x. Putting these into the equation we get: 8. (4.45% x 10.06%) + (10.54% x 89.94%) = 9.93% xi. WACC = 9.93%

3. What should Kimi’s decision be based on your revised cost of capital?

Using the sensitivity of equity table in exhibit 2 Kimi should recommend a buy. My reasoning for this is that at a 10% discount rate the equity value of Nike should be $50.92 vs the current share price of $42.09 and hence significant upside exists
Notes:
* Marginal tax rate is the highest rate payable within a given tax bracket, as this isn’t stated in the case I calculated this as stated in the above text * For the cost of debt second calculation I used 10 year yield to match with term of credit spread and an ‘A’ credit rating as I couldn’t find spreads for A+ rating. Using a 20-year government yield Kd would approximately equate to 7.1%, same as using YTM . Coupon rate / bond current price = 7.1% also. Given this I have used 7.1% as per first method of calculation.