Analysis Slides-wacc Nike
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Case Study Nike Inc.: Cost of Capital
Nike Inc.:
Case Background:
• NorthPoint Large Cap Fund – consider to buy Nike’s stock? • Nike declines in sales growth, profits and market share. • Strategic Plan – to increase exposure in mid-price footwear and apparel lines; commits to cut down expenses. • Market response: mixed signals • Kimi Ford has done a cash flow estimation, and ask her assistant, Joanna Cohen to estimate cost of capital.
What is WACC? Why is it important to estimate a firm’s cost of capital?
Cost of capital - rate of return required by a capital provider in exchange for foregoing an investment in another project or business with similar risk (or opportunity cost). Invest only in projects that generate returns in excess of WACC. The WACC is set by the investors (or markets), not by managers. Cannot observe the true WACC, only estimate it.
What is WACC?
WACC: rdebt (1-t)(D/V) + requity (E/V) where V = D + E => (total value of debt) + (market value of equity)
Cost of Debt (rdebt): After-tax yield of outstanding debt. (t = tax) Cost of Equity (requity): requity = risk-free rate + beta (market risk premium)
Assumptions and Considerations to determine intrinsic value?
Issues • Projected free cash flow • Single cost or Multiple Cost of WACC? • Cost of debt • Cost of equity • Weights of capital components
Free cash flow projections
Assumptions • What is FCF? • Sales growth – different business units? • Capital Expenditure requirement? • Working capital • Depreciation • Tax • Terminal value – growth at what rate?
I. Single cost or Multiple Cost?
Use different cost of capital for footwear and apparel divisions? In this case, use single cost instead of multiple costs of capital. Other related businesses is relatively small to impact major component of business. business segments of Nike basically have about the same risk; thus, a single cost is sufficient for this analysis. Estimating WACC is to value the cash flows for the entire firm
II. To determine the weights Key considerations: Book value or market value of debt and equity? How calculate debt? (consider longterm debt only) Equity – market capitalization
Weights of capital components
Wrong to use book values as the basis for debt and equity weights Market values should be used in calculating weights. Use market weights to estimate WACC - how much it will cause the firm to raise capital today. That cost is approximated by the market value of capital, not by the book value of capital.
Weights of capital components – market value of equity
For market value of equity: share price: $42.09 No. of shares: 271.5 mil shares Market value = price x no. shares = $11,427 mil. Different from book value of equity of $3,494 mil.
Weights of capital components – market value of debt
Market value of debt is found by: Adding current portion of LT debt, notes payable, and LT debt discount at Nike’s current coupon: = 5.40 (current LTD) + 855.30 (NP) + 416.72 (LTD discount) = $1,277.42
WACC
Market value of weight: Equity = 11,503 / (11,503+1,291) = 89.9%; Debt = 1 – 0.899 =10.1%.
III. Calculation of cost of debt
KEY CONSIDERATION: Book value or current debt? Which period bonds to use? Interest is tax deductible – what tax rate to use? (home country tax rate?) Estimate tax rate – in real life, effective tax rate that counts!
Cost of debt
The WACC is used for discounting cash flows in the future, thus all components of cost must reflect firm’s concurrent or future abilities in raising capital. Mistake to use the historical data in estimating the cost of debt. Cohen’s divided the interest expenses by the average balance of debt to get 4.3% of before tax cost of debt. It may not reflect Nike’s current or future cost of debt.
The cost of debt, estimated by i. yield to maturity of bond, or ii. according to credit rating. Calculated by using data provided in Exhibit 4. Calculate the current yield to maturity of the Nike’s bond to represent Nike’s current cost of debt. • • • • •
PV= 95.60 N=40 (semi-annual coupon for 20 years) Pmt= 3.375 FV=-100 Compute Int = 3.58% (semiannual) 7.16% (annual)
After tax cost of debt = 7.16%(1-38%) = 4.44% (assume 38% tax rate in US)
IV. Cost of equity
KEY CONSIDERATIONS: Risk free rate – long-term bond or short term (Tbills)? Beta – use current or historical average? (Beta normally available in Bloomberg or if not, need to determine (but how?)) Market risk premium (use arithmetic or geometric mean?) In Malaysia (can be obtained from Bloomberg or refer to publications)
Cost of equity
Cohen uses CAPM to estimate cost of equity. Her number comes from following: 10.5% = 5.74% +(5.9%)*0.80 Assumptions: • Risk free rate comes from 20-year T-bond rate • Average beta from 1996 to July 2001, 0.80. • Cohen uses a geometric mean of market risk premium 5.9%
Comments on cost of equity – The risk-free rate
Use T-Bills or long-term bond rate? Better to use 20-year T-bond rate to represent risk-free rate The cost of equity and the WACC are used to discount cash flows of very long run, use T-bond with 20 years maturity, 5.74%, is the longest rate that are available (number of years left in 25 year bond). ***not wrong to consider 10 years bond to match same period of forecast projection of revenue.
Comments on cost of equity – The market risk premium
Use a geometric mean of market risk premium 5.9% is also correct – if available – ( normally available from Bloomberg). Using arithmetic mean to represent true market risk premium, we have to have independently distributed market risk premium. It is often found that market risk premium are negatively serial correlated.
Comments on cost of equity – The market risk, beta
Cohen uses average beta from 1996 to July 2001, 0.80 to be the measure of systematic risk. Need to identify a beta that is most representative to future beta. Use the most recent beta estimate provided, 0.69. **Note - beta varies according to time and depend on the which type of stock indices as reference for market)
Cost of equity Therefore: Estimate of cost of equity will be: 5.74% + (5.9%)* 0.69 = 9.81%
WACC
Based on the values obtained: Calculation of the WACC is as follow: WACC: rdebt (1-t)(D/V) + requity (E/V)
4.44%*0.101 + 9.81%*0.899 = 9.27%
Next Step
Use WACC as the discount rate to bring the FCF and TV to present value You get the firm value Need to minus the debt to get shareholder value (equity) Divided by no. of shares to get intrinsic value Compare with current stock market price of Nike!!!
2001 Free Cah Flows to Firm Terminal Value Cash flows The Firm Value $17,079 Less: Current debt 1296.6 Equity Value $15,782 Shares Number 271.5 Equity Value per share 58.13052 Terminal Value 2012 Cash Flow Permanent Growth WACC
2002 764.1
2003 663.1
2004 777.6
2005 866.2
764.1
663.1
777.6
866.2
25835.42 1619.881 0.03 0.0927
2006 2007 2008 2009 2010 2011 1014 1117.6 1275.1 1351.7 1483.7 1572.7 25835.42 1014 1117.6 1275.1 1351.7 1483.7 27408.12
Conclusion
What should Kimi Ford recommend regarding an investment in Nike? Discount cash flows (see Exhibit 2) Calculated WACC 9.27%, the present value equals $58.13 per share, which is more than current market price of $42.09. Some might think this value is still understated, due to that current growth rate used (6% to 7%) is much lower than that estimated by manager (8% to 10%). So the recommendation is to BUY!
Nike Inc.:
Case Background:
• NorthPoint Large Cap Fund – consider to buy Nike’s stock? • Nike declines in sales growth, profits and market share. • Strategic Plan – to increase exposure in mid-price footwear and apparel lines; commits to cut down expenses. • Market response: mixed signals • Kimi Ford has done a cash flow estimation, and ask her assistant, Joanna Cohen to estimate cost of capital.
What is WACC? Why is it important to estimate a firm’s cost of capital?
Cost of capital - rate of return required by a capital provider in exchange for foregoing an investment in another project or business with similar risk (or opportunity cost). Invest only in projects that generate returns in excess of WACC. The WACC is set by the investors (or markets), not by managers. Cannot observe the true WACC, only estimate it.
What is WACC?
WACC: rdebt (1-t)(D/V) + requity (E/V) where V = D + E => (total value of debt) + (market value of equity)
Cost of Debt (rdebt): After-tax yield of outstanding debt. (t = tax) Cost of Equity (requity): requity = risk-free rate + beta (market risk premium)
Assumptions and Considerations to determine intrinsic value?
Issues • Projected free cash flow • Single cost or Multiple Cost of WACC? • Cost of debt • Cost of equity • Weights of capital components
Free cash flow projections
Assumptions • What is FCF? • Sales growth – different business units? • Capital Expenditure requirement? • Working capital • Depreciation • Tax • Terminal value – growth at what rate?
I. Single cost or Multiple Cost?
Use different cost of capital for footwear and apparel divisions? In this case, use single cost instead of multiple costs of capital. Other related businesses is relatively small to impact major component of business. business segments of Nike basically have about the same risk; thus, a single cost is sufficient for this analysis. Estimating WACC is to value the cash flows for the entire firm
II. To determine the weights Key considerations: Book value or market value of debt and equity? How calculate debt? (consider longterm debt only) Equity – market capitalization
Weights of capital components
Wrong to use book values as the basis for debt and equity weights Market values should be used in calculating weights. Use market weights to estimate WACC - how much it will cause the firm to raise capital today. That cost is approximated by the market value of capital, not by the book value of capital.
Weights of capital components – market value of equity
For market value of equity: share price: $42.09 No. of shares: 271.5 mil shares Market value = price x no. shares = $11,427 mil. Different from book value of equity of $3,494 mil.
Weights of capital components – market value of debt
Market value of debt is found by: Adding current portion of LT debt, notes payable, and LT debt discount at Nike’s current coupon: = 5.40 (current LTD) + 855.30 (NP) + 416.72 (LTD discount) = $1,277.42
WACC
Market value of weight: Equity = 11,503 / (11,503+1,291) = 89.9%; Debt = 1 – 0.899 =10.1%.
III. Calculation of cost of debt
KEY CONSIDERATION: Book value or current debt? Which period bonds to use? Interest is tax deductible – what tax rate to use? (home country tax rate?) Estimate tax rate – in real life, effective tax rate that counts!
Cost of debt
The WACC is used for discounting cash flows in the future, thus all components of cost must reflect firm’s concurrent or future abilities in raising capital. Mistake to use the historical data in estimating the cost of debt. Cohen’s divided the interest expenses by the average balance of debt to get 4.3% of before tax cost of debt. It may not reflect Nike’s current or future cost of debt.
The cost of debt, estimated by i. yield to maturity of bond, or ii. according to credit rating. Calculated by using data provided in Exhibit 4. Calculate the current yield to maturity of the Nike’s bond to represent Nike’s current cost of debt. • • • • •
PV= 95.60 N=40 (semi-annual coupon for 20 years) Pmt= 3.375 FV=-100 Compute Int = 3.58% (semiannual) 7.16% (annual)
After tax cost of debt = 7.16%(1-38%) = 4.44% (assume 38% tax rate in US)
IV. Cost of equity
KEY CONSIDERATIONS: Risk free rate – long-term bond or short term (Tbills)? Beta – use current or historical average? (Beta normally available in Bloomberg or if not, need to determine (but how?)) Market risk premium (use arithmetic or geometric mean?) In Malaysia (can be obtained from Bloomberg or refer to publications)
Cost of equity
Cohen uses CAPM to estimate cost of equity. Her number comes from following: 10.5% = 5.74% +(5.9%)*0.80 Assumptions: • Risk free rate comes from 20-year T-bond rate • Average beta from 1996 to July 2001, 0.80. • Cohen uses a geometric mean of market risk premium 5.9%
Comments on cost of equity – The risk-free rate
Use T-Bills or long-term bond rate? Better to use 20-year T-bond rate to represent risk-free rate The cost of equity and the WACC are used to discount cash flows of very long run, use T-bond with 20 years maturity, 5.74%, is the longest rate that are available (number of years left in 25 year bond). ***not wrong to consider 10 years bond to match same period of forecast projection of revenue.
Comments on cost of equity – The market risk premium
Use a geometric mean of market risk premium 5.9% is also correct – if available – ( normally available from Bloomberg). Using arithmetic mean to represent true market risk premium, we have to have independently distributed market risk premium. It is often found that market risk premium are negatively serial correlated.
Comments on cost of equity – The market risk, beta
Cohen uses average beta from 1996 to July 2001, 0.80 to be the measure of systematic risk. Need to identify a beta that is most representative to future beta. Use the most recent beta estimate provided, 0.69. **Note - beta varies according to time and depend on the which type of stock indices as reference for market)
Cost of equity Therefore: Estimate of cost of equity will be: 5.74% + (5.9%)* 0.69 = 9.81%
WACC
Based on the values obtained: Calculation of the WACC is as follow: WACC: rdebt (1-t)(D/V) + requity (E/V)
4.44%*0.101 + 9.81%*0.899 = 9.27%
Next Step
Use WACC as the discount rate to bring the FCF and TV to present value You get the firm value Need to minus the debt to get shareholder value (equity) Divided by no. of shares to get intrinsic value Compare with current stock market price of Nike!!!
2001 Free Cah Flows to Firm Terminal Value Cash flows The Firm Value $17,079 Less: Current debt 1296.6 Equity Value $15,782 Shares Number 271.5 Equity Value per share 58.13052 Terminal Value 2012 Cash Flow Permanent Growth WACC
2002 764.1
2003 663.1
2004 777.6
2005 866.2
764.1
663.1
777.6
866.2
25835.42 1619.881 0.03 0.0927
2006 2007 2008 2009 2010 2011 1014 1117.6 1275.1 1351.7 1483.7 1572.7 25835.42 1014 1117.6 1275.1 1351.7 1483.7 27408.12
Conclusion
What should Kimi Ford recommend regarding an investment in Nike? Discount cash flows (see Exhibit 2) Calculated WACC 9.27%, the present value equals $58.13 per share, which is more than current market price of $42.09. Some might think this value is still understated, due to that current growth rate used (6% to 7%) is much lower than that estimated by manager (8% to 10%). So the recommendation is to BUY!
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