Case Study Assignment
FIN 631: Managerial Finance – Nike, Inc. Case Study
Dr. Dana Leland
February 20, 2011
Nike, Inc. is an athletic shoe manufacturer. NorthPoint Group, a mutual fund management firm, is trying to decide whether to invest in Nike, Inc., since its share price declined significantly in mid-2001. During that same time period, Nike management communicated their plans for revitalizing the company. Plans included the following components:
• Develop a line of mid-priced athletic footwear
• Push the apparel line
• Long-term growth target of 8 – 10%
• Earnings growth target of 15%
• Tighten control of expenses
In this ...view middle of the document...
WACC is calculated taking into account the relative weights of each component of the capital structure (debt and equity) and is used to see if the investment is worthwhile to undertake. Clearly only those investments that are expected to increase stock price or cost of capital would be recommended. Because of the key role it plays in financial decision making, the importance of the cost of capital cannot be overemphasized (Gitman, 2009)
Management always takes into account the cost of capital while making financial decisions and thus signals its importance. For example, the cost of capital may be used as a measuring tool for accepting or rejecting an investment proposal in the capital budgeting process. The firm evaluates projects on the basis of their return on investment. By knowing the cost of capital, the firm would be wise to reject any proposal in which the return would be less than the amount necessary to finance the cost of capital. The cost of capital is a key factor in selecting the right project in the capital budgeting process as it measures the financial performance and determines the acceptability of all investment opportunities.
The cost of capital is significant in designing the firm’s capital structure. The cost of capital is influenced by the opportunities in capital structure. A good financial manager will always keep an eye on capital market fluctuations and try to achieve the most sound and economical structure for the firm. The manager will look at various methods of finance in order to minimize the cost of capital and improve the market value and earnings per share. Weighted Average Cost of Capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. The equation for finding Weighted Average Cost of Capital is (Weighted Average Cost Of Capital (WACC) Definition, 2010):
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
According to Exhibit 5, Cohen calculated a weight average cost of capital of 8.4% by using the capital asset pricing model (CAPM) for Nike, Inc. Although Team A agreed with using the CAPM method to calculate the cost of equity, we disagreed with the figures Cohen used in her calculation. First, Cohen used the book value for both debt and equity. Although book value of debt is an accepted estimate of market value, book value of equity should not be used when calculating the cost of capital. “Market value weights are appealing because the market values of securities more closely approximate the actual dollars to be received from their sale. Moreover, because firms calculate the costs of the various types...