On June 28, 2001, Nike held an analysts’ meeting to discuss a strategy for revitalizing the company. Kimi Ford, a portfolio manager at NorthPoint Group, was unable to make a clear decision from reading the meeting reports about whether to advise buying the stock or not. She forecasted that, with a discount rate of 12%, Nike was overvalued at its current share price of $42.09. She then asked her assistant, Joanna Cohen, to estimate Nike’s cost of capital. Joanna believed that Nike’s cost of capital was 8.4%. The central issue to be addressed is:
- Is $42.09 per share in Nike a reasonable price to buy for NorthPoint Group Clients?
We do not agree with the Jonna Cohen’s WACC calculations. We found that the weights for debt and equity were not calculated correctly. We also found Joann’s cost of debt to be about 3% lower than what we calculated. Our calculations and our assumptions are shown in exhibit 1. We found the cost of equity to be 10.1% using the CAPM equation. We also came up with a WACC of 9.65% which was 1.2% higher than what was estimated by Joanna. Our estimate for the risk free rate also used the 10 year US treasury bonds while Joanna used 20 year treasury bonds. WACC is a key assumption in this model and we believe that our new assumption is reasonable. The growth rate assumption is also a key variable and 7-6% is a reasonable assumption as it is within 1% of the historical equity risk premium.
Nike like any other organization in a perfectly competitive market environment has to operate under certain economic speculations based on the interpretation of the past and current market structure. Jonna however, exaggerates quite important consideration in interpreting the net worth and estimated growth of the entity in the near future. The greatest risk exaggeration in this case is that it exposes Nike as an enterprise to massive uncertainties and negative trends in the event of imminent impenitent financial changes that are bound to hit the global market. The WACC assumption model formulates its argument in half the time frame that Jonna applies for Nike. This model is therefore presents Nike with fewer risks in comparison to the 20 year treasury bonds time assumed by Jonna. In a nutshell, Jonna needs to revise all his assumptions for the organization downwards in order to narrow the managerial risks affiliated with a lengthy planning period. Adoption of Jonna’s assumptions will hinder Nike from realizing its realistic goals and entity since the assumptions are purely hypothetical and can easily dent the market ability of the organization. There is therefore need to revise these assumptions using a more realistic approach.
Nike is funded with both debt and equity which is why the WACC method is used.
|weighted average cost of capital||0.0964536|