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Northpoint Investment Group

Essay by   •  April 11, 2011  •  Essay  •  762 Words (4 Pages)  •  1,882 Views

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The Purpose

The main goal of our research is to discover the accurate cost of capital in order to correctly value Nike's equity. By doing this, we will then obviously be able to determine whether or not the stock price is overvalued or undervalued. In order to determine this, we first need to study the analysis that was conducted by Kimi and Joanna in the given exhibits, and assess which aspects are accurate and relevant in determining the true cost of capital.

The Problems

Before we were able to begin calculations, we first needed to identify the major flaws in the given analysis. Joanna calculated the cost of capital to be 8.4% based upon the book values recorded in the balance sheet. As a result of these inaccurate assumptions, the results that were drawn from them were inaccurate as well. Book values should not be used when projecting the present values of future cash flows. We instead need to interpret the market value of the current equity in order to identify the true balance of debt and equity financing.

In addition to using the wrong method to calculate the appropriate weights of debt and equity, Joanna also misreported the appropriate cost of debt. According to Exhibit 5, she used an incorrect interpretation involving the interest expense and the book value of the total debt. This is, again, draws conclusions of future cash flows based solely on historical data, and cannot be trusted.

Our Findings

Based upon their research, the price of Nike should be slightly under $50.00 per share given that terminal value of perpetual cash flows is discounted aggressively at 12% and the cash flows from 2002 though 2011 are discounted at 8.4%. We, however, know their calculation of WACC is inaccurate. Based upon our own findings, the weighted average cost of capital is instead 9.84%. We arrived at this solution assuming the following:

We first must assume that the market values of the firm are being used to assess the value of the future cash flows. This can be supported by both the Cash Flows and Evaluations spreadsheet. The true value of the equity value is obtained by multiplying current share price with shares outstanding. Likewise, by using the bond policy, it reflects the current market price of the debt. Although we can do very little to nothing with the actual amount of long term debt, the required return must be manipulated to reflect the yield to maturity on those corporate bonds.

In order to identify the required return on equity, we referred to both the Capital Asset Pricing Model and the Dividend Discount Model, although we deferred to the return generated by the CAPM method in order to approximate debt. This method is a more complete picture of projected performance as it measures not only its performance against the market, but its relative unsystematic risk as well. We found the method



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