I. Statement of the problem
Nike has new investment endeavors revamp its recent drops in net income and market share. Wall Street analyst reactions to the endeavors are mixed, with some recommending Nike as a “Strong Buy” and others recommending a “Hold.” In case 13, Nike Inc.: Cost of Capital, I am acting as a portfolio manager to estimate Nike’s cost of capital to determine whether the stock is overvalued or undervalued.
II. Alternative Solutions
• Dividend Growth Model (DGM) see appendix for calculations
• Capital Asset Pricing Model (CAPM) see appendix for calculations
• Weighted Average Cost of Capital (WACC) see appendix for calculations
III. Analysis of the Alternatives
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According to Exhibit 2 NorthPoint Group management firm was only interested in the discounted cash flow forecast based of up to 10 years. Also long-term bond yields more closely reflect the default-free holding period return on long-lived investments.
In calculating my market risk premium I took the average of both the Geometric mean and the Arithmetic mean of the Historical Equity Risk Premiums (1926-1999) (Exhibit 4). The arithmetic mean is noted as the best estimator of expected return, while the geometric mean accurately portrays historical investment experience and has been noted to give a better estimate of expected returns over long periods of time. In estimating the cost of equity with risk adjustment, I used the current Beta Coefficient (.69) instead of the average. In much of corporate finance and valuation, our interest is in the beta looking forward and not the beta looking back. A regression beta, even if well estimated, reflects the firm as it existed over the period of the regression. If the firm has changed, some can argue that the beta looking forward will be different from the historical beta, which is why I used the most current.
Although CAPM accounts for risk, it requires estimates. The Beat coefficient (β) and market risk premium are estimated. If estimates are poorly made, the resulting cost of equity will be inaccurate.
• Weighted Average Cost of Capital (WACC)
The weighted average cost of capital accounts for both a company’s debt and equity positions. In analyzing the work done by Kimi Ford’s assistant Joanna Cohen, I noticed that the cost of debt was determined incorrectly. To determine the cost of debt I calculated the yield to maturity (YTM) based on the information available on the Current Yield on Publicly Traded Nike Debt (Exhibit 4). Cost of debt is the interest rate the firm must pay on new borrowing, which can be seen in the financial markets. Since Nike has bonds outstanding, then the YTM on those...