NIKE

Case Study
Professor Corwin
This case study includes several problems related to the valuation of Nike. We will work through these
problems throughout the course to demonstrate some of the most important steps in a valuation from start
to finish. The problems will be assigned individually as a component of your regular homework.
However, please note that the solution from one problem may carry over as an important input on
subsequent problems. You should therefore consider the case study not as a set of individual problems,
but as one larger assignment that will be completed in steps.
To solve the Nike problems, you will make use of Nikes most recent financial statements as well as the
notes to the financial statements. Nike's financial statements from the most recent fiscal year ending May
31, 2014 are included with this document. The notes to the financial statements and full 10K are
available on the class web site.

An overview of the individual questions and their relation to the lecture topics is provided below.

Question 1 Financial Ratio Analysis (Lecture 1)

Question 2 Cost of Capital (Lecture 2)

Question 3 Operating Lease Adjustments (Lecture 3)

Question 4 Capitalization of Advertising Expenses (Lecture 3)

Question 5 Taxes (Lecture 3)

Question 6 Estimating Cash Flows (Lecture 3)

Question 7 Fundamental Growth in Earnings (Lecture 4)

Question 8 Cash Flow Discounting and Stock Price Estimation (Lecture 5)

Question 9 Relative Valuation (Lecture 6)

1. Financial Ratio Analysis

a. Using Nike's financial statements and any additional resources that are necessary, calculate the
profitability ratios we discussed in class (ROC, ROE, After-tax Operating Profit Margin, Net
Profit Margin). Compare these ratios to those we calculated in class for Home Depot and note any
important similarities/differences between the two firms. For the purposes of this assignment, we
will assume that Nike and Home Depot are comparable firms.

b. Show the decomposition of Nikes Return on Capital (ROC) into After-tax Operating Margin and
Capital Turnover. Show the decomposition of Nikes Return on Equity (ROE) into Net Profit
Margin, Capital Turnover, and Financial Leverage. What do these decompositions suggest about
the performance of Nike relative to Home Depot's performance, as discussed in class?

2. Cost of Capital
In this problem, you will calculate the cost of equity and weighted average cost of capital for Nike as
of May 31, 2014. Be sure to explain any assumptions you make to arrive at your answers.
a. Collect monthly return data for both Nike and the S&P 500 Index for the 60-month period ending
in May 2014. Using this data, estimate the Beta for Nike based on a market model (CAPM)
regression. Using this Beta estimate, calculate the cost of equity (Ke) for Nike based on the
CAPM model. Note that you must choose an appropriate risk-free rate and market risk premium
to use in the CAPM equation. Briefly explain your choice for each of these variables.

b. Assume that the value of Nikes operating lease debt is $2,437 million and the firms employee
stock options have an after-tax value of $1,789 million. Estimate the market value of debt and the
market value of equity for Nike as of May 31, 2014. Use the firm's A+ rating and the default
spreads provided in the course notes to estimate the firm's cost of debt (Kd). Using these
estimates and your answer to (a), calculate the weighted average cost of capital (WACC) for
Nike. Assume a marginal tax rate of 24.4%.

3. Operating Lease Adjustments

Using Nikes most recent 10K, identify the firms future operating lease commitments and the
amount the firm paid in operating lease (rental) expenses for the most recent fiscal year. Use this
information to answer the questions below.
a) In Case Study Question (2), we found the cost of debt for Nike to be 3.20%. Using this cost of
debt, calculate the value of Nikes operating lease debt and operating lease assets as of May 31,
2014 (the end of Nikes fiscal year). Use these values and any necessary information from Nike's
financial statements to estimate the adjusted book values of debt and assets for Nike.

b) Using your answers from prior questions and any necessary information from Nike's financial
statements, calculate the values of after-tax operating income and Net Income in the most recent
fiscal year, both before and after adjusting for operating leases. Assume a marginal tax rate of
24.4%.

4. Capitalization of Advertising
Although Nikes R&D expenses are limited, the firm invests heavily in advertising and other
promotional expenses. Because you believe these expenses create benefits that accrue to the firm
over multiple periods, you decide to capitalize these expenses in your valuation of Nike. Total
advertising expenses for Nike in each of the past six fiscal years are listed below. Use this
information to answer the subsequent questions.

Year
2010
2011
2012
2013
2014

Advertising
Expense
($ millions)
2,356.0
2,344.0
2,607.0
2,745.0
3,031.0

a) Assuming a three-year life for advertising, calculate the Advertising Amortization for Nike in the
most recent fiscal year and the unamortized value of Nike's Advertising asset at the end of the
fiscal year (May 31, 2014). Use your answers and any necessary information from Nike's
financial statements to calculate the adjusted book values of equity and assets.

b) Using your answer above and any necessary information from Nike's financial statements,
calculate the value of after-tax operating income and Net Income for Nike in the most recent
fiscal year after adjusting for the both operating lease and the capitalization of Advertising.

5. Taxes
Using your answers from prior questions and any necessary information from Nike's financial
statements, answer the following questions about Nikes taxes.
a) Calculate Nike's effective tax and marginal tax rates for the fiscal year ending May 31, 2014.

b) McKinsey & Co. recommend estimating the taxes actually paid on the operating income of the
firm. They refer to this as operating cash taxes. Estimate the operating cash taxes for Nike in the
most recent fiscal year using the following steps: (1) start with reported taxes, (2) subtract the
taxes paid on non-operating income, (3) add back the tax shield related to interest expenses on the
firm's debt (including debt listed on the balance sheet and operating lease debt), and (4) subtract
(add) any increase (decrease) in net deferred tax liabilities. For steps (2) and (3), estimate the tax
adjustments using a marginal tax rate of 24.4%.

6. Estimating Cash Flows

Using your answers from prior questions and any necessary information from Nike's financial
statements, answer the following questions about Nikes cash flows in the most recent fiscal year.
a) Calculate FCFF for Nike in the most recent fiscal year.

b) Calculate FCFE for Nike in the most recent fiscal year. Note that this calculation requires you to
use the cash flow statement to determine the firms net debt issues during the year.

7. Fundamental Growth in Earnings

Using your answers from prior questions and any necessary information from Nike's financial
statements, answer the following questions about fundamental growth in earnings for Nike. Note that
most of the information you need to answer these questions can be found in the prior solutions.
a) Using the fundamental growth formulas we discussed in class and assuming the ROC will remain
constant, estimate the expected growth in EBIT for Nike in the coming year. Be sure to
incorporate any necessary adjustments made in prior assignments (for example, adjustments for
one-time charges, operating leases, capitalization of advertising, etc.). How does your estimate of
future growth compare to the firms actual growth in EBIT over the previous year?

b) Using the fundamental growth formulas we discussed in class and assuming the ROE will remain
constant, estimate the expected growth in Net Income for Nike in the coming year. Be sure to
incorporate any necessary adjustments made in prior assignments (for example, adjustments for
one-time charges, capitalization of advertising, etc.). How does your estimate of future growth
compare to the firms actual growth in Net Income over the previous year?

8. Cash Flow Discounting and Stock Price Estimation

a) To perform a discounted cash flow analysis for Nike, begin with your Free Cash Flow to the Firm
(FCFF) estimate from Case Study Question (6a). This value will represent your year zero cash
flow estimate. Based on the fundamental growth estimates from Case Study Question (7), you
forecast that this cash flow will grow at 6.0% in year one, with the growth rate decreasing by
0.7% per year until it stabilizes at 2.5% in year six. Based on these forecasts and your cost of
capital (WACC) estimate from Case Study Question (2), estimate the present value of FCFF for
Nike. Show your work on a separate page if necessary.

b) As of May 31, 2014, Nike's shares outstanding include 178 million class A shares and 692
million class B shares. In addition, Nike's stock was trading at a price of $76.91, the firm's
marginal tax rate was 24.4%, and the yield on 10-year treasuries was 2.48%. Use this
information, along with any necessary information from the firm's financial statements (and notes
to the financial statements) to estimate the value of Nike's outstanding employee stock options as
of May 31, 2014. Attach a printout of the spreadsheet or other option pricing model used to
calculate the option price.

c) Nike has no minority interests or majority active holdings, but does have other long-term nonoperating assets (i.e., investments) and liabilities. Using your answers to (a) and (b) above, along
with any other necessary information from the firm's financial statements, estimate the per share
value of Nike's stock (Note: you can assume that class A and B shares are identical).

9. Relative Valuation
a) Nikes stock price and shares outstanding as of May 31, 2014 were $76.91 and 870 million.
Calculate the P/E ratio for Nike based on this information and the EPS from the most recent fiscal
year. Recalculate an adjusted version of the P/E ratio by dividing the current market value of
equity by the net income from the most recent fiscal year, incorporating all appropriate
adjustments (Note that all of the information you need to complete these calculations is contained
in the previous homework solutions). How did the ratio change after incorporating the
adjustments, and why?

b) Using information from the end of Nikes most recent fiscal year (May 31, 2014), calculate the
Enterprise Value to EBITDA ratio for Nike. Recalculate an adjusted version of the ratio,
incorporating all appropriate adjustments (Note that all of the information you need to complete
these calculations is contained in the previous homework solutions). How did the ratio change
after incorporating the adjustments, and why?

PART II

NIKE, Inc. Consolidated Statements of Income

2014

(In millions, except per share data)

Income from continuing operations:

Revenues
Cost of sales
Gross profit
Demand creation expense
Operating overhead expense
Total selling and administrative expense
Interest expense (income), net (Notes 6, 7, and 8)
Other expense (income), net (Note 17)
Income before income taxes
Income tax expense (Note 9)
NET INCOME FROM CONTINUING OPERATIONS
NET INCOME (LOSS) FROM DISCONTINUED OPERATIONS
NET INCOME
Earnings per share from continuing operations:
Basic earnings per common share (Notes 1 and 12)
Diluted earnings per common share (Notes 1 and 12)
Earnings per share from discontinued operations:
Basic earnings per common share (Notes 1 and 12)
Diluted earnings per common share (Notes 1 and 12)
Dividends declared per common share
The accompanying Notes to Consolidated Financial Statements are an integral part of this statement.

88

Year Ended May 31,

2013

2012

27,799 $
15,353
12,446
3,031
5,735
8,766
33
103
3,544
851
2,693

2,693 $

25,313 $
14,279
11,034
2,745
5,051
7,796
(3)
(15)
3,256
805
2,451
21
2,472 $

23,331
13,183
10,148
2,607
4,472
7,079
4
54
3,011
754
2,257
(46)
2,211

$
$

3.05 $
2.97 $

2.74 $
2.68 $

2.45
2.40

$
$
$

$
$
0.93 $

0.02 $
0.02 $
0.81 $

(0.05)
(0.05)
0.70

PART II

NIKE, Inc. Consolidated Balance Sheets

May 31,
2014

(In millions)

ASSETS
Current assets:
Cash and equivalents
Short-term investments (Note 6)
Accounts receivable, net (Note 1)
Inventories (Notes 1 and 2)
Deferred income taxes (Note 9)
Prepaid expenses and other current assets (Notes 6 and 17)
Total current assets
Property, plant and equipment, net (Note 3)
Identifiable intangible assets, net (Note 4)
Goodwill (Note 4)
Deferred income taxes and other assets (Notes 6, 9, and 17)
TOTAL ASSETS
LIABILITIES AND SHAREHOLDERS EQUITY
Current liabilities:
Current portion of long-term debt (Note 8)
Notes payable (Note 7)
Accounts payable (Note 7)
Accrued liabilities (Notes 5, 6, and 17)
Income taxes payable (Note 9)
Liabilities of discontinued operations (Note 15)
Total current liabilities
Long-term debt (Note 8)
Deferred income taxes and other liabilities (Notes 6, 9, 13 and 17)
Commitments and contingencies (Note 16)
Redeemable preferred stock (Note 10)
Shareholders equity:
Common stock at stated value (Note 11):
Class A convertible 178 and 178 shares outstanding
Class B 692 and 716 shares outstanding
Capital in excess of stated value
Accumulated other comprehensive income (Note 14)
Retained earnings
Total shareholders equity
TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
The accompanying Notes to Consolidated Financial Statements are an integral part of this statement.

90

2013

2,220 $
2,922
3,434
3,947
355
818
13,696
2,834
282
131
1,651
18,594 $

3,337
2,628
3,117
3,484
308
756
13,630
2,452
289
131
1,043
17,545

7 $
167
1,930
2,491
432

5,027
1,199
1,544

57
98
1,669
2,036
84
18
3,962
1,210
1,292

3
5,865
85
4,871
10,824
18,594 $

3
5,184
274
5,620
11,081
17,545

PART II

NIKE, Inc. Consolidated Statements of Cash Flows

Cash provided by operations:

Net income
Income charges (credits) not affecting cash:
Depreciation
Deferred income taxes
Stock-based compensation (Note 11)
Amortization and other
Net gain on divestitures
Changes in certain working capital components and other assets and liabilities:
(Increase) decrease in accounts receivable
(Increase) in inventories
(Increase) in prepaid expenses and other current assets
Increase in accounts payable, accrued liabilities and income taxes payable
Cash provided by operations
Cash (used) provided by investing activities:
Purchases of short-term investments
Maturities of short-term investments
Sales of short-term investments
Additions to property, plant and equipment
Disposals of property, plant and equipment
Proceeds from divestitures
Increase in other assets, net of other liabilities
Settlement of net investment hedges
Cash (used) provided by investing activities
Cash used by financing activities:
Net proceeds from long-term debt issuance
Long-term debt payments, including current portion
Increase (decrease) in notes payable
Payments on capital lease obligations
Proceeds from exercise of stock options and other stock issuances
Excess tax benefits from share-based payment arrangements
Repurchase of common stock
Dividends common and preferred
Cash used by financing activities
Effect of exchange rate changes
Net (decrease) increase in cash and equivalents
Cash and equivalents, beginning of year
CASH AND EQUIVALENTS, END OF YEAR
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest, net of capitalized interest
Income taxes
Non-cash additions to property, plant and equipment
Dividends declared and not paid

Year Ended May 31,

2013

2,693 $

2,472 $

2012

2,211

518
(11)
177
114

438
20
174
66
(124)

373
(59)
130
23

(298)
(505)
(210)
525
3,003

142
(219)
(28)
27
2,968

(323)
(815)
(141)
425
1,824

(5,386)
3,932
1,126
(880)
3

(2)

(1,207)

(4,133)
1,663
1,330
(598)
14
786
(2)

(940)

(3,245)
2,663
1,721
(563)
2

(14)
22
586

(60)
75
(17)
383
132
(2,628)
(799)
(2,914)
1
(1,117)
3,337
2,220 $

986
(49)
10

313
72
(1,674)
(703)
(1,045)
100
1,083
2,254
3,337 $

(203)
(47)

468
115
(1,814)
(619)
(2,100)
67
377
1,877
2,254

53
856
167
209

20
702
137
188

FORM 10-K

2014

(In millions)

29
638
99
165

The accompanying Notes to Consolidated Financial Statements are an integral part of this statement.

NIKE, INC.

2014 Annual Report and Notice of Annual Meeting

91