Managing for Corporate Value
This report discusses Case 13 of Case Studies in Finance: Managing for Corporate Value Creation, Fifth Edition, The McGrawHill Company, 2007. The case, titled “Nike Inc. : Cost of Capital”, presents Nike’s past financial data. This data is used by analysts from Northpoint Group, a mutual fund management firm, to help them arrive at a recommendation on whether to add this stock to the fund’s portfolio. The first analyst, Kimi Ford, constructed a Discounted Cash Flow (DCF) model using this data, while the second analyst, Joanna Cohen, used it to calculate the cost of capital using the CAPM method.
In the following sections we will give an overview of the company and the industry it is in, followed by a discussion on Joanna Cohen’s cost of capital calculation. We will present other methods of arriving at the cost of capital and suggest the most suitable method to use, as well as the appropriate value to adopt. Finally, we will give our recommendation on whether this is a good stock for Northpoint Group to acquire. 1. Introduction a. Nike Fast Facts Back before the Swoosh logo and long before the days the company was renamed as Nike, there was Blue Ribbon Sports
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It was founded by Phil Knight and Bill Bowerman in 1964 with the sole mission of providing athletes with better shoes. Their humble beginnings were exemplified by first year sales totalling $8,000. In 1971, BRS introduced the concept of the Greek winged Goddess of victory-Nike. Sales were unprecedented and in December 1980 Nike went public. In contemporary times, Nike employs more than 33,000 people globally and for the fiscal year ending May 31 2009, Nike reported record revenues of $19. 2 billion, a 3% increase over last year’s earnings. b. Industry Overview in 2001
Turning back the wheel to 2001, the sporting apparel industry was facing a tumultuous period. 1. The U. S. consumer market, which had grown heroically since 1997, hit the predictable down side of the cycle. 2. After a period of large-scale retail floor expansion, the U. S. consumer industry had a major square footage contraction. The current downside in the consumer cycle coupled with overbuilt retail spelt bad news for Nike. 3. The Asian economies melted down in 1997 – 1998. Asia was then and still is a market with huge upsides and huge risks.
The local retailers, for the better part of a couple years, were just afraid to order. 4. In a period of immense technological change in the industry, Nike launched a massive three-year supply chain overhaul. In the short run, implementing the new technology disrupted its production capacity to supply the U. S. market. 5. The post Dot-Com bubble burst posed additional challenges. Dot-Com was a speculative bubble covering roughly the 1998-2001 period during which stock markets in Western nations saw their equity value rise rapidly from growth in the more recent Internet sector and related fields.
Over 1999 and early 2000, the U. S. Federal Reserve increased interest rates six times to rein in inflation and the economy was beginning to lose speed heralding in the Dot-Com bubble burst, numerically, on March 10, 2000. Hiring freezes, layoffs, and consolidations followed in several industries, especially in the dot-com sector. Consumer confidence was considerably shaken and spending decreased. c. Nike’s Challenges in 2001 Transition into a Global Company At the end of fiscal year 1997, Nike was finishing up a three-year run where literally every bounce went their way.
In those three years, Nike went from being a strong company with growing market share and $3 billion in revenues to one with a dominant market share and revenues of over $9 billion. Emboldened, Nike focused on rebuilding and restructuring itself into a global company with widespread retail influence. Nike ventured into new areas but stumbled in their core business which is the mid- and low-priced shoes industry in the U. S. Competition was mounting and Nike had not matched orders and production well.
Unfavorable Currency Valuations Nike’s global business can be segregated into four regions: the United States, Europe, Asia Pacific, and the Americas. While each region increased revenue in FY ’01, most of Nike’s growth came from outside the United States. Fiscal 2001 saw Nike-brand revenues outside the United States grow by 19 percent in constant dollars, but only ten percent in real dollars. Currency valuations are unfavourable as the U. S. dollar remained relatively strong against most world currencies, especially the euro.
Although Nike adopted hedging strategies help minimize the exchange rate risk, doing business in more than 140 countries had exposed Nike to vagaries in the global economy. Slowing Revenue Growth With revenues growing at a slower rate, Nike was aggressive in containing their spending levels. The cost of creating demand and running the business grew by just three percent. Much of the increased spending came early in the fiscal year during Nike’s marketing support for the Sydney Olympics and the European Championships 2000.
Despite such efforts, gross margins were decreasing. In addition, Nike experienced difficulties implementing new demand and supply planning software in the third quarter. This created a two-fold problem: the creation of excess overall footwear inventory and insufficient inventory of key products for which retailers had placed orders. This contributed to full-year gross margins falling to 39 % of sales compared to 39. 9% in the prior year. d. Nike’s Opportunities in 2001 Branding and Innovation
Nike experienced considerable success in Asia founded on authentic sports positioning and the ability to innovate technology-based performance products. Solid design from Nike continued to change thinking in global footwear. New concepts like spring-loaded performance in trainers led the field by miles. With the World Cup coming to Japan and Korea in 2002, Nike had a great opportunity to leverage on their football footwear and apparel success into expanded brand power. Nike had also launched a blitz in commercial branding.
An example is the Nike hoops reinvigorated by the frenzy around the Nike Freestyle commercial. Stellar Performance of Endorsed Athletes Nike continued to be buoyed by the performances of the athletes they support every day in all types of sports around the world. 2000 Sidney Olympics seen many a Nike athlete step onto the podium with a swoosh logo on his or her apparel. Nike also had the paramount branding aid in the mould of golf prodigy Tiger Woods. His seemingly impossible yet continual success had stamped his face with a ‘swoosh’ on his chest on many sports cover pages.
2. Cost of Capital Calculation In the case study, Kimi Ford, an analyst of Northpoint Group, was trying to identify new stocks to be included in her company’s mutual fund portfolio. She developed a Discounted Cash Flow model using a 10-year forecast of Nike’s financials, based on the company’s data from 1995 to 2001. Her assistance, Joanna Cohen, carried out the cost of capital calculation using the CAPM method. In the following section we analyse Joanna Cohen’s cost of equity calculations and review various assumptions she has made.
We will then look at the various options available to calculate cost of equity, and recommend the most suitable one for this case. This will be followed by a recommendation on the cost of capital to use and the intrinsic value of Nike’s share. a. Weight of capital structure To calculate the weights to be used in the computation of the CAPM, Joanna has used the ending book value of equity and debt. The ideal capital structure to use as weights is the target capital structure.
For managers trying to maximize the value of the firm, the target capital structure will be the same as the optimal capital structure. In practice, the firm’s actual capital structure tends to fluctuate around the target capital structure. Given that the target capital structure is not known, the actual capital structure can be used as a good proxy. Notably, the actual capital structure to be used would thus be the market values (and not the book value) of equity and debt. Furthermore, Joanna should also have considered the market value of the preference shares as well.
The market value of the equity for a publicly traded company, like Nike, is simply the share price multiplied by the number of current outstanding shares which is USD 11,503m (USD 42. 09 x 273. 3m1). The market value of the debt is easily obtainable when the company has publicly traded debt. Using the current price of the publicly traded Nike debt as provided in the case study, Nike’s market value of its debt is USD 1,240m [(USD 5. 4m + USD 855. 3m + USD435. 9m) x 0. 956] As per 10-K SEC filing, Nike has issued redeemable preference shares, $1 par value which is redeemable at the option of NIAC or the Company at par value aggregating $0.3 million.
A cumulative dividend of $0. 10 per share is payable annually on May 31 and no dividends may be declared or paid on the common stock of the Company unless dividends on the Redeemable Preferred Stock have been declared and paid in full. As mentioned, market value should be used when calculating the value of the preferred shares. However, based on the characteristics of the preferred stock, the issued preference shares is in essence analogous to the debt issued by the company.
Thus, in the absence of a publicly traded market for the preferred shares, the book value of the preference shares can be used when assessing Nike’s capital structure if the company has not experienced significant changes in its credit rating. Given that the book value of Nike’s preferred stock is negligible in the overall capital structure context, we shall ignore the preference shares as well. Hence the weight of capital structure assigned to equity and debt is approximately 87% and 23% respectively.