Written Analysis case

“Nike Fund Research Fall 2019”

NIKE, Inc. (NYSE: NKE)

Consumer Discretionary – Sportswear

Edition of the WACC Study

by

JOSHUA MEDILO

Problem Statement
 A firm’s Weighted Average Cost of Capital (WACC) represents its
blended cost of capital across all sources, including common shares,
preferred shares, and debt. The cost of each type of capital is weighted
by its percentage of total capital and they are added together. This guide
will provide a detailed breakdown of what WACC is, why it is used, how
to calculate it, and will provide several examples. WACC is used in
financial modeling as the discount rate to calculate the net present value
of a business. The purpose of WACC is to determine the cost of each part
of the company’s capital structure based on the proportion of equity, debt,
and preferred stock it has. Each component has a cost to the company.
The company pays a fixed rate of interest on its debt and a fixed yield on
its preferred stock. Even though a firm does not pay a fixed rate of return
on common equity, it does often pay dividends in the form of cash to
equity holders. The weighted average cost of capital is an integral part of
a DCF valuation model and, thus, it is an important concept to understand
for finance professionals, especially for investment banking and corporate
development roles. This article will go through each component of the
WACC calculation. Nike WACC % Calculation, the weighted average
cost of capital (WACC) is the rate that a company is expected to pay on
average to all its security holders to finance its assets. The WACC is
commonly referred to as the firm’s cost of capital. Generally speaking, a
company’s assets are financed by debt and equity. WACC is the average
of the costs of these sources of financing, each of which is weighted by
its respective use in the given situation. By taking a weighted average, we
can see how much interest the company has to pay for every dollar it
finances.
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
Where:
E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate
An extended version of the WACC formula is shown below, which
includes the cost of Preferred Stock (for companies that have it). The cost
of equity is calculated using the Capital Asset Pricing Model (CAPM)
which equates rates of return to volatility (risk vs reward). Below is the
formula for the cost of equity:
Re = Rf + β × (Rm − Rf)
Where:
Rf = the risk-free rate (typically the 10-year U.S. Treasury bond yield)
β = equity beta (levered)
Rm = annual return of the market
The cost of equity is an implied cost or an opportunity cost of capital. It is
the rate of return shareholders require, in theory, in order to compensate
them for the risk of investing in the stock. The Beta is a measure of a
stock’s volatility of returns relative to the overall market (such as the
S&P 500). It can be calculated by downloading historical return data
from Bloomberg or using the WACC and BETA functions.

Objectives
 The Weighted Average Cost of Capital serves as the discount rate
for calculating the Net Present Value (NPV) of a business. It is also used
to evaluate investment opportunities, as it is considered to represent the
firm’s opportunity cost. Thus, it is used as a hurdle rate by companies. A
company will commonly use its WACC as a hurdle rate for evaluating
mergers and acquisitions (M&A), as well as for financial modeling of
internal investments. If an investment opportunity has a lower Internal
Rate of Return (IRR) than its WACC, it should buy back its own shares
or pay out a dividend instead of investing in the project. Nominal free
cash flows (which include inflation) should be discounted by a nominal
WACC and real free cash flows (excluding inflation) should be
discounted by a real weighted average cost of capital. Nominal is most
common in practice, but it’s important to be aware of the difference.
Determining the cost of debt and preferred stock is probably the
easiest part of the WACC calculation. The cost of debt is the yield to
maturity on the firm’s debt and similarly, the cost of preferred stock is the
yield on the company’s preferred stock. Simply multiply the cost of debt
and the yield on preferred stock with the proportion of debt and preferred
stock in a company’s capital structure, respectively. Since interest
payments are tax-deductible, the cost of debt needs to be multiplied by (1
– tax rate), which is referred to as the value of the tax shield. This is not
done for preferred stock because preferred dividends are paid with after-
tax profits. Take the weighted average current yield to maturity of all
outstanding debt then multiply it one minus the tax rate and you have the
after-tax cost of debt to be used in the WACC formula.
Risk-free Rate
The risk-free rate is the return that can be earned by investing in a risk-
free security, e.g., U.S. Treasury bonds. Typically, the yield of the 10-
year U.S. Treasury is used for the risk-free rate.
Equity Risk Premium (ERP)
Equity Risk Premium (ERP) is defined as the extra yield that can be
earned over the risk-free rate by investing in the stock market. One
simple way to estimate ERP is to subtract the risk-free return from the
market return. This information will normally be enough for most basic
financial analysis. However, in reality, estimating ERP can be a much
more detailed task. Generally, banks take ERP from a publication called
Ibbotson’s.
Levered Beta
Beta refers to the volatility or riskiness of a stock relative to all other
stocks in the market. There are a couple of ways to estimate the beta of a
stock. The first and simplest way is to calculate the company’s historical
beta (using regression analysis) or just pick up the company’s regression
beta from Bloomberg. The second and more thorough approach is to
make a new estimate for beta using public company comparables. To use
this approach, the beta of comparable companies is taken from
Bloomberg and the unlevered beta for each company is calculated.
Unlevered Beta = Levered Beta / ((1 + (1 – Tax Rate) * (Debt / Equity))
Levered beta includes both business risk and the risk that comes from
taking on debt. However, since different firms have different capital
structures, unlevered beta (asset beta) is calculated to remove additional
risk from debt in order to view pure business risk. The average of the
unlevered betas is then calculated and re-levered based on the capital
structure of the company that is being valued.
Levered Beta = Unlevered Beta * ((1 + (1 – Tax Rate) * (Debt / Equity))
In most cases, the firm’s current capital structure is used when beta is re-
levered. However, if there is information that the firm’s capital structure
might change in the future, then beta would be re-levered using the firm’s
target capital structure. After calculating the risk-free rate, equity risk
premium, and levered beta, the cost of equity = risk-free rate + equity risk
premium * levered beta.

Alternative Course of Action

The WACC or the ‘Weightage Average Cost of Capital’ is a method

of calculating a firm’s cost of capital where the total capital is broken
down in terms of its components and weights are assigned to the
components that make up the capital. Typically, a firm’s capital is made
up of common stock, preferred stock, any other long-term debt and
bonds, each of these are used for calculating the WACC and a weightage
is assigned to each in terms of a percentage of the total capital. The total
value of equity is made up of these different types of stocks and the total
value of debt is taken from the total long term debt of a company
including bonds. This method of calculating the cost of capital gives an
average rate of return which is the minimum rate of return after tax that
each of a firm’s capital component must earn. The method of calculation
is simple where the cost of each component of a firm’s capital is
determined and then it is multiplied with the relevant proportion of that
component to the total capital. The proportionate costs are then summed
up. This method is important as it determines whether the shareholder’s
wealth is being increased by a particular project or not. In Nike’s case,
calculating the WACC would help in estimating whether the firm’s
ventures are adding value to the shareholder’s wealth or whether they are
just covering the costs. . In a broader prospect, the rate calculated through
the WACC is used in calculating the Net Present Value in budgeting
decisions. It should be noted though that the WACC is just one of the
estimates of cost of equity and other models may present different
pictures so it should not be used as the ultimate factor for justifying
whether a project is worthwhile or not. Cohen’s method of calculating the
cost of capital is correct as per the specified method used for calculating
this value as it has taken into account all the components of the formula
which are needed in this calculation. Cohen has calculated the cost of
debt to be 4.3% which has been calculated after adjusting for tax where
the tax rate has been taken as 38% which includes the state tax of 3% as
well.  An average tax of 3% has been added to the statutory tax rate as
well to make the rate more conservative. For calculating the cost of
equity, Cohen has used the CAPM model which is a popular method of
calculating the price of an asset suggesting that her method has made use
of the method ways of calculating both the cost of debt and the cost of
equity.  The risk free rate that Cohen has used is the current yield on the
20 year treasury bonds and since treasury bonds are considered a risk free
investment, this would be a good estimate for CAPM. She took the
average of Nike’s betas from 1996 to the present, so a good estimate for
beta has also been calculated. Additionally she took the risk premium at
5.9% which is the average premium of treasury bonds so an average rate
of a market benchmark has also been determined. Even in terms of
calculating the weightages, Cohen has considered the Nike’s
segmentation. Since Nike has multiple business segments, the decision
was difficult in terms of whether the cost of capital was to be single or
multiple. Since 60% of Nike’s business is footwear and 30% of the
revenue is generated from apparel and 3.6% of the revenue is contributed
by sports accessories and 4.5% from Non-Nike brands, there are multiple
cost avenues.  In terms of a broader segmentation, only the Cole Haan
Line is different while the rest of the products can be categorized under
sports related businesses.  Even the marketing and distribution channels
for the apparel and footwear are the same so a single cost of capital
makes more sense as compared to computing multiple costs of capital.

Conclusion

WACC or amply the weighted average cost of capital is a rate to

the firm that shows the cost of capital of running that firm. It is a
calculation of a firm’s cost of capital showing how each category is
weighted proportionally showing the categories percentage of the total
capital of running the firm. In the calculation of the WACC, all capital
sources like stock (common and preferred), debentures, bonds, and other
sources including short and long-term debt are incorporated in the
calculation of WACC. It should also be noted that WACC is a rate which
increases as the data and rate of return of firm’s equity also increases. We
however should note that the increase in WACC shows a decrease in
valuation and shows a high risk. The WACC formular without taxes is
given by. By expanding the expression, we have.. But because debt and
equity literally own the firm, we have. Where weight of debt is, and
weight of equity is in this formular, WE is the weight of equity, rE is the
percentage of equity of the total capital, WD is the debt weight and rD is
the percentage of debt of the total capital. Since any firm’s assets are
financed by debt and or equity, the average of these costs are weighed by
their respective use in a given situation. This helps to see how much
interest the firm has to pay for every unit cost of financing. The firm’s
WACC overall is required and is used internally by the directors so that
they can determine the economic situation and feasibility of opportunities
of expansion and or mergers. Having seen the derivation of WACC,
showing that a firm’s value is the sum of expected value of debt and
expected value of equity and comparing this with the Ms. Joanna Cohen,
her calculation with returns the WACC as 8.4% because it incorporates
all components of the WACC calculation. It however does not involve tax
and preferred stocks.
Capital asset pricing model (CAPM), according to Corporate
Finance (2019), is the expected rate of return can be calculated from. This
gives us Advantages of CAPM, It considers only systematic risk which
reflects reality in which most investors have diversified portfolios and
from the same unsystematic risk has been eliminated.
CAPM generates theoretically- derived relationship between the required
rate of return and the systematic risk which is subject to frequent real
research and testing.
Recommendation

CAPM is applied to all companies as long as data for such

companies can be computed. Disadvantages of CAPM, It requires
estimating the expected premium of market risk and this varies over time.
We need to estimate beta for the company, which varies over time CAPM
relies on past data to predict the future, and this is not always reliable.
Dividend Growth Model. The dividend growth model is calculated from
the formular where Re is the rate of return of equity, P is the price
earnings per share, C is the current share price and Rg is the rate of
dividend growth. We now have it is easy to understand and use.
However, the dividend growth model (DGM) is not all very reliable as it
has demerits. Some of the demerits of the DGM are that; The DGM is
mainly (or only) applied to companies that are paying dividends to their
shareholders at the time the DGM is used to determine the cost of capital
when it is made. The DGM is also not applied where the dividends being
paid by the company are not growing at a recognizable steady rate. The
other point to note about the DGM is that it does not explicitly take into
account all the risks that are associated with the capital used to run the
company at the particular moment in time. Dividend growth model does
not also explicitly consider risk. P/E Ratio, this price – earnings ratio
compares the current share price and the earnings from the same over a
period of about four quarters. From the given data, the current share price
is $42.09 and the earning per share is $2.16. A high P/E ratio would mean
that we invest in the shares of the firm. The P/E is given therefore from.
This ratio however does not explicitly tell the story about the rate of
return to advise whether or not to invest in the company. This ratio has
disadvantages in that it does not fully give advice about the firm in
question. It is only useful when it is used compare different companies in
the same industry, comparing a firm to the general market or to the firm
history. A good ratio is about 20 to 25 times, basing on WACC, CAPM,
P/E and DGM ratios regarding Nike Corporation, these comparables all
being positive and high, they reflect the market behavior. It is advisable
therefore to invest in the corporation shares. Since Nike’s capital has both
debt and equity capital, Janna Cohen has been right in terms of
calculating the Weighted Average Cost of Capital method (WACC) for
which she has used 27% weightage for debt and 73% weightage for
equity.
Although Cohen’s method of calculation and her justification for
using them is accurate, it should be noted that Cohen’s calculation has an
inaccuracy since she has calculated the debt percentage as 27% whereas it
is actually 37%. Her analysis and method of calculation is accurate but
there could be a slight difference in the estimates because of this error in
her calculation. Excel sheet 4 shows the corrected calculation of WACC
which shows that the cost of capital is just 7.7 % for Nike instead of the
8.4% calculated by Cohen.