Nike Inc. Case

III. Statement of Situation

Kimi Ford thought about investing in Nike. After reading the reports from Nike's analyst meeting, she still was not sure whether to invest or not. Lehman Brothers determined Nike was a great investment; however, UBS Warburg and CSFB analysts disagreed. Since the reports did not help Kimi Ford out with her decision, she decided to develop her own discounted cash flow analysis. As shown in Exhibit 1, Kimi Ford projected her own discounted cash flow analysis with her assumptions. She assumed revenue would increase by 7.0% in 2002 then the percentage would start to decrease in subsequent years. To come up with the operating income, she multiplied revenue in 2001, $9,488.8 million, by the revenue growth percentage then added the growth amount to the revenue. The projected revenue for 2002 is $10,153 million. Then she multiplied cost of goods sold percentage of sales, 60.0%, and the selling and administrative percentage of sales, 28.0%, by the projected revenue of 2002. After subtracting the two amounts from the projected net income, the projected operating income for 2002 is $1,218.4 million.

The net working capital equation is current assets minus current liabilities. To calculate the projected current assets and current liabilities accounts, Kimi Ford's assumed percentages of 38.0% current assets and 11.5% current liabilities should each be multiplied by the projected revenue for 2002. When the current liabilities are subtracted from current assets, the number is the net working capital. To calculate the change in net working capital, the current liabilities on the balance sheet should be subtracted from the current assets on the balance sheet. When that number is computed, subtract the net working capital number from the balance sheet numbers and that will be the change in net working capital. Kimi Ford computed a change in net working capital of $8.8 million. She calculated the enterprise value as $11,415.4 million and the current outstanding debt of $1,296.6 million. The difference between the two is $10,118.8 million, representing the equity value. When dividing the equity value into the current shares outstanding, the equity value per share is $37.27.

For Kimi Ford to further determine whether to invest in Nike or not, Ford asked Joanna Cohen to calculate Nike's cost of capital. When Cohen calculated the weights of debt and equity, she used book values. The debt capital sources that were used from the balance sheet, Exhibit 2, were: current portion of long- term debt at $5.4 million, notes payable at $855.3 million, and long-term debt of $435.9 million. The equity from the shareholders' equity section of the balance sheet was $3,494.5 million. After adding the total amounts together and dividing each portion of debt and equity into the total amount, the weight of debt Cohen calculated was 27.0% and the weight of equity was 73.0%.

To come up with the cost of debt, Cohen took the total interest expense, Exhibit 3, and divided it into the average debt balance. The debt balance from May 31, 2000 was $1,444.6 million and from 2011 was $1,296.6 million. The tax rate used was 38%. Cohen used a 38% tax rate because the United States statutory tax rate was 35% and she added 3% for state taxes. Her estimated cost of capital was 4.3%; however, after adjusting for tax, Cohen's cost of debt was 2.7%

Joanna Cohen could have calculated the cost of equity by using the capital-asset-pricing model (CAPM), the dividend-discount model (DDM), or the earnings-capitalization ratio. Cohen chose to calculated cost of equity by using CAPM. As the risk free rate, she chose the current yield on 20-year Treasury bonds, 5.39%. The market risk premium she used was the geometric mean of 5.90% and the chosen beta was the Nike average from 1996-2000. All of these amounts can be found in Exhibit 4. When Cohen put all of the amounts in the weighted average cost of capital (WACC) equation, she came up with a WACC of 8.4%.

IV. CONSTRAINTS ON SOLUTION

In order for Nike stock to be a good investment, it stock must be undervalued. To determine

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