Nike Case Team 5 – Windsor Cohort (Heidi Limmonen, Oksana Simakina, Masayuki Kondo, Rui Dias, Andres Losada, Zsolt Makai)
1. What is the the WACC and and why is it important important to estimate estimate a firm’s firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not? WACC is the rate that a company is expected to pay to debtors and creditors. A weighted average of the component cost of debt, preferred stock, and common equity. (Birgham & Houston, 2009) This is the minimum rate that a company must earn on its assets in order to satisfy the company’s shareholders (most importantly, the creditors and the owners). WACC is calculated as a weighted average, or composite, of the various types of funds used over time, regardless of the specific financing used in a given year. (Birgham & Houston, 2009) The WACC is a useful tool to measure how a company is financed and what the cost costs s are are of its its capi capita tal. l. Furt Furthe herm rmor ore e WACC WACC sets sets the the mi mini nimu mum m leve levell that that a compan company y has to earn earn in order order to satis satisfy fy credit creditors ors and owners owners (see above above), ), therefore the model can be used as a benchmark figure (a minimum return rate) that a new project has to meet. The expected rate of return when evaluating such new projects has to be higher than the WACC (benchmark) in order to be profitable. We don’ don’tt agre agree e with with the the way way Joa Joanna nna Cohe Cohen n calc calcul ulat ated ed the the WACC WACC.. Her Her assu assump mpti tion ons s made made to calc calcula ulate te the the cost cost of equi equity ty by the the CAPM CAPM were were not not accur accurat ate. e. She made made assum assumpti ptions ons about about the genera generall econom economic ic enviro environme nment, nt, namely the risk-free rate of return and the market risk premium. We believe that the value of beta can’t be more precise, because of the limitations of the data provided.
2. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and justify your assumptions.
As mentioned above, we do not agree with the way the WACC was calculated in the case study, namely the way Joanna Cohen calculated the cost of capital by the CAPM method. WACC should be calculated as follows: WACC = Kd x ( 1 - T ) x ( D /( D + E ) ) + Ke x ( E /( D + E ) ) •
Kd – Cost of debt = (58.7 / ((1,444.6 + 1,296.60) / 2)) x 100 = 4.3% 2001 Current portion of long- 5.40 term debt Notes Payable 855.30 Long-term debt 435.90 1,296. 60 3,494. Equity 50
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27.06 % 72.94 %
( 1 – T ) = ( 1 – ( 35% + 3% ) ) = 62% U.S. Statutory tax rate = 35% Tax varied yearly from 2.5% to 3.5% → average 3% ( D / (D + E) ) = 27.06% ( E / (D + E) ) = 72.94% K e = cost of equity CAPM method kI = Rf + βI(RM-Rf ) kI is the cost of capital of asset i βI is the beta of asset i Rf is the risk-free rate
2000 50.1 924.2 470.3 1,444. 60 3,136. 00
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31.54 % 68.46 %
(RM-Rf ) is the (usually historical) market risk premium CAPM method cost of equity calculation step by step Rf - Risk-free rate Current Yields on US Treasuries 3-month 3.59% 20-year 5.74% Average 4.46% → Rf Estimating the risk-free rate of return: “The 90-day T-bill yields are more consistent with the CAPM as originally derived and reflect truly risk free returns, in the sense that T-bill investors avoid material loss in value from interest rate movements. However, long-term bond yields more closely reflect the default-free holding period returns available on long lived investments and thus more closely mirror the types of investments made by companies.” (Bruner R., Eades K, Harris R. & Higgins R, 1998) As this is not a corporate acquisition, the use of the 20 year T-bond is not the most appropriate solution. Instead, NorthPoint Large-Cap Fund is analyzing Nike in order to make an investment, which can be short or long term, according to the data presented by Joanna Cohen and the consequent decision. Due to this, our suggestion is to use the average of the Current Yield in U.S. given in Exhibit 4. βI - beta of asset i Due to the lack of information available in order to find the true Beta value, we will assume that the calculated average will be enough for our calculations and therefore that β=0.8. (RM-Rf ) market risk premium For typical investment horizons, the proper compounding rate is in-between these two values (arithmetic and geometric means). Specifically, unbiased estimates of future portfolio value require that the current value be compounded forward, at a weighted average of the arithmetic and geometric rates. (Jacquier E., Kane A., & Marcus A. 2002) The Premium Risk rate used by Joanna Cohen was the geometric mean of Historical Equity Risk Premiums (1926 – 1999), which is 5.90%. This mean is more accurate when analysing long term valuations, while the arithmetic average (7.50% in this case) is more accurate in short term investment. We decided to apply an average of both values, considering the market risk premium (RM-Rf ) = 6.70%. Applying all the considered elements kI = Rf + βI(RM-Rf ) kI = 4.46% + 0.8*6.7% kI = 9.82% Returning to the calculation of the WACC and considering all the delivered values WACC = K d x ( 1 - T ) x ( D / (D + E) ) + K e x ( E / (D + E) )
= 4.3% x 62% x 27.06% + 9.82% x 72.94% WACC = 7.88%
3. Calculate the costs of equity using CAPM, the dividend discount model, and the earnings capitalization ratio. What are the advantages and disadvantages of each method? Assumption As already mentioned above, our suggestion is to use the average Current Yield in the U.S. given in Exhibit 4.
Rf avg = 4.46% The Premium Risk rate used was the geometric mean, but this mean is more accurate when dealing with long term valuations, and the arithmetic is more accurate in short term investments. (Jacquier E., Kane A., & Marcus A. 2002) According to this information: Rm avg = 6.70% Due to the lack of information required to calculate the true Beta value, we will assume that the calculated average will be enough for our analysis. β=0.8 With the previous Data we can calculate a new CAPM kI = Rf + βI(RM-Rf ) 9.82 = 4.46% + 0.8*6.7% Advantages: It was one of the first models to consider the investments in portfolios including the correlation of the share values (Tsorakidis N., 2011) It is a simple model to calculate the Cost of equity, if the β (Betas) are given or the information to calculate is available It is the most widely used method to calculate the cost of equity (Atrill P. & McLaney E., 2006) •
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Disadvantages Finding the Market Premium could lead to 3 potential problems such as (Atrill & McLaney, 2006): Deciding the number of years to use to calculate the average o o The use of data from 1926 is an arbitrary choice o This historical premium is likely to be misleading when the current market premium changes The historical data only holds the information of the companies that o survived and doesn’t include the losses, which will positively bias the information •
In recent studies, the relationship between market stocks and the Betas were questioned as Atrill & McLaney (2006) mentioned. Assumptions, like transaction costs don’t occur in the real world, but are used in our calculations to simplify the analysis (Fama & French, 2004) •
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****** The dividend discount model (DDM) values the future dividend payments of the shares at their present value. It values the shares (and the company) by computing the cash flows of the future dividends that an investor would actually receive when holding the company’s share. To find its value, the following formula should be used: Po= D1/(r-g) Solved for r: R=D1/Po + g R=0.48/42.09+0.055=0.0664 r=6.6% Where Do is the average price of the dividend, P o is the current share price and g is the forecasted growth rate. Advantages The approach of valuating the shares based on the present value of the future cash flows of dividend payments Very useful over a short period of time (up to about 5 years). It can also be used over longer period of time, given that the economy of the industry is stable and current dividend payout policies remain (Qfinance 2011) •
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Disadvantages The model is useless when estimating the value of a company that doesn’t pay dividend. This is not a problem when evaluating mature industries (i.e. utilities) The model is less useful in industries with high R&D and technology development (i.e. Nike). In such industries, investors look for share price appreciation rather than high dividend payment. It is hard to accurately estimate how a company’s dividend payment policy will change in the long run. (Qfinance 2011) Long term forecasting – similarly to NPV – is difficult Additionally, it is also difficult to forecast how a company will actually adopt its dividend payment policy •
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***** The Earnings Capitalization Model (ECM) is calculated by dividing the estimated earnings per share by its current market price. The model measures the rate at which investors would capitalize a firm's expected earnings in the future. A low E/P ratio indicates that the increase of earnings is above market average (Invest Your Dictionary 2011).
The Earnings Capitalization Model (ECM) does not consider the growth rate of the company. In our case, it is better to reject this model. ECM = E1/Po = 2.32/42.09 = 5.51% Where E1 is the forecasted earnings for the upcoming year and P o is the current share price.
4. What should Kimi Ford recommend regarding an investment in Nike?
The shares of Nike are undervalued based on the WACC (11.17%-7.88%) and the CAPM (11.17%- 9.82%) models. Under these circumstances we strongly recommend Joanna Cohen to buy Nike shares in the short term, because the CAPM overvalues or gives a fair market share price in the long run, due to the increase of the T-Bond rates. Also, the difference between the market value and the true intrinsic value are close, because this difference may not be a long-term occurrence. Nevertheless, she has to look out for Nike’s results in the next trimester/semester, because the success expectations of the new strategy might differ between the various investment agencies.
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Birgham & Houston, Fundamentals of Financial management, Chapter 9, Stocks and their Valuation, ed. 12, pp. 308, 310, Robert F. Bruner, Kenneth M. Eades, Robert S. Harris, & Robert C. Higgins, Best Practices in Estimating the Cost of Capital: Survey and Synthesis, Financial Practice and Education, ed. Spring/Summer 1998, pg. 19. Jacquier, E., Kane, A., & Marcus, A. (2002, Dec 18). Geometric or Arithmetic Mean: A Reconsideration. Forthcoming: Financial Analysts Journal. Retrieved May 20, 2003, from http://web.mit.edu/~jacquier/www/papers/geom.faj0312.pdf Tsorakidis N. 2011, ‘Portfolio selection and the CAPM’, Finance Module A, Hult International business School. Atrill P. & McLaney E. ‘Risk and Rates of Retourn’, in Prentice Hall, ACCOUNTING AND FINANCE for Non-Specialists, Fifth edition, Pearson Education Limited, pp 252, 257 Fama. E.F – French K.R: “The Capital Asset Pricing Model: Theory and evidence” Journal of Economic Perspectives, 2004, vol. 18, pp 3, 25-46. Qfinance 2011, Using Dividend Discount Models, viewed November 14th 2011
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http://www.qfinance.com/asset-management-checklists/using-dividenddiscount-models Invest Your Dictionary 2011. earnings-price ratio (E/P ratio) investment & finance definition, viewed, November 14th 2011 http://invest.yourdictionary.com/earnings-price-ratio-e-p-ratio
