Page 120 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 5: Cost of Capital

Notes
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Case Study Nike, Inc. – Cost of Capital

n July, Kimi-ford, a portfolio manager at North Point Group, a mutual-fund-
management firm, pored over analysts' write-ups of Nike, Inc., the athletic-shoe
Omanufacturer. Nike's share price had declined significantly from the start of the
year. Ford was considering buying some shares for the fund she managed, the North Point
Large-Cap Fund, which invested mostly in fortune 500 companies, with an emphasis on
value investing. Its top holdings included Exxon Mobile. General Motors, McDonald's,
3M, and other large-cap. It had performed extremely well. In 2000, the fund earned a
return of 20.7 per cent even as the S&P 500 fell 10.1 per cent. The fund's year-to-date returns
at the end of June 2001 stood at 6.4 versus the S&P - 7.3 per cent.
Only a week ago, on June 28,2001, Nike held an analyst' meeting to disclose its fiscal-year
2001 results. The meeting, however had another purpose: Nike management wanted to
communicate a strategy for revitalizing the company. Since 1997 Nike's revenues had
plateaued at around $9 billion, while net income had fallen from almost $ 800 million to
$580 million (see Exhibit 1). Nike's markets in the U.S. had fallen from 48 per cent in 1997
to 42 per cent in 2000. In addition, recent supply-chain issues and the adverse effect of a
strong dollar had negatively affected revenue.
At the meeting, the management revealed plans to address both-line growth and operating
performance. To boost revenue, the company would develop more athletic-shoe products
in the mid-priced segment - a segment that had been overlooked in the recent years. Nike
also planned to push its apparel line, which, under the recent leadership of industry
veteran Mindy Grossman had performed extremely well. On the cost side, Nike would
exert more effort on expense control, finally, the company's executives reiterated their
long-term revenue growth targets of 8-10 per cent and earnings-growth targets of above
1 percent.
The Analysts reactions were mixed. Some thought, the financial targets too aggressive ;
other saw significant growth opportunities in apparel and in Nike's international
businesses.
Ford read all the analysts reports that she could find about the June 28 meeting, but the
reports gave her no clear guidance: a Lehman Brothers report recommended a "Strong
Buy", while UBS analysts expressed misgiving about the company and recommended a
"Hold". Ford decided instead to develop her own discounted-cash-flow forecast to come to
a clearer conclusion.

Her forecast showed that, at discount rate of 12 per cent, Nike was overvalued at its current
share price of $42.09 (see Exhibit 2). She had, however, done a quick sensitivity analysis
that revealed Nike was valued at discount rates below 11.2 per cent. As she was about to go
into a meeting, she asked her new assistant, Joanna Cohen, to estimate Nike's cost of
capital.
Cohen immediately gathered all the data she though she might need (Exhibits 1,2,3 and 4)
began to work on her analysis. At the end of the day, she submitted her cost-of-capital
estimate and a memo (Exhibit 5) explaining her assumption to Ford.

Contd...

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