Nike to Do It or Not

Aswath Damodaran! 1!

Nike: To Do or Not to Do!!

Aswath Damodaran

Stern School of Business


Executive Summary!

  On a stand-alone basis, this project is a good project, albeit not a great one. •  The average return on capital, even under the more conservative finite life

assumption, is 13.25%, which is higher than the cost of capital of 8.20%. •  The net present value of this project, using a cost of capital of 8.20%

•  is $ 399 million, under the conservative assumption of a finite life of 10 years •  is $ 1099 million, under the more realistic assumption of an infinite life

•  On the two variables that are the most critical - market share and operating margin - the firm has a reasonable margin for error on market share and a narrower margin for error on operating margins.

  If we consider the potential project synergies (i.e. the gains to the shoe division from having an apparel division), it will make this project a more attractive one.


Choices for Analysis!

  Firm or Equity Analysis Firm Equity

Earnings Operating Income (after tax) Net Income Book Value Book value of capital Book value of equity Accounting return Return on capital Return on equity Cash flows Cash flow before debt Cash flow after debt

Discount rate Cost of capital Cost of equity Decided to go with a firm analysis (Less work…)   Nominal or Real Analysis

•  The information on earnings and discount rates is provided in nominal terms but the inflation rate is also provided.

•  We chose to leave everything in nominal terms. Alternatively, we could have made our nominal cash flows into real cash flows and nominal discount rate into a real discount rate, by taking inflation out of both.


Cost of capital for the project: Three caveats…!

  Book values versus market values: While the book values of debt and equity are accessible on the balance sheet, the cost of capital is computed based upon markets.

  Nike’s current beta and cost of capital: Since the project is in a new business, the current beta (levered or unlevered) for Nike is not relevant and neither is a blended beta of any sort.

  Effective versus Marginal tax rates: The after-tax cost of debt is a function of the marginal tax rate, not the effective tax rate.


Weights for Debt and Equity!

  Market Value of Equity = $ 62* 493 mil = $ 30,566 mil   Market Value of Interest bearing Debt = $40.3 (PV of annuity, 5 yrs,

4.50%) + $812.1/1.0455 = $ 829 million

  Market Value D/E Ratio = (829+1520)/30566= 7.68%   MV Debt/Capital Ratio = 2349/(30566+2349) =7.13%

PV of lease commitments

Discounted back at pre-tax cost of debt of 4.5%

Treated lump sum of $588 as an annuity for 2 years


Unlevered Beta for the Apparel Business!

Median Aggregate AverageRegression Beta 1.41 1.45 1.41Debt to Equity Ratio 50.68% 23.61% 839.36%Unlevered Beta 1.0827 1.2662 0.2337Cash/Firm Value 4.93% 6.95% 17.49%Unlevered beta corrected for cash 1.1388 1.3608 0.2833

The “simple average” beta is skewed by outliers in the D/E ratio. I will use the median beta value, but I could have gone with the aggregate (weighted average), since it reflects larger firms in the sample.


Cost of Capital: Nike Apparel!

  Cost of equity computation •  Riskfree Rate = 3.5% •  Equity Risk Premium = 4.3% •  Cost of Equity = = 3.5% + 1.1913(4.3%) = 8.62%

  Cost of debt computation •  Default Spread based upon rating = 1.0% •  Pre-tax cost of debt = 3.5% + 1.0% = 4.5% •  After-tax cost of debt = 4.5% (1-.4) = 2.7%

  Cost of capital calculation for apparel project •  Debt to Capital Ratio = 7.13% •  Cost of Capital = 8.62% (.9287) + 2.7 (.0713) = 8.20%


Your estimates of cost of capital…!


Operating Income for Nike Apparel!

Year 0 1 2 3 4 5 6 7 8 9 10 11 12Total Market 75,000$ 78,750$ 82,688$ 86,822$ 91,163$ 95,721$ 100,507$ 105,533$ 110,809$ 116,350$ 122,167$ 128,275$ 134,689$ Market Share 0% 0% 0% 2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.00% 5.00% 5.00%

Revenues -$ -$ 1,736$ 2,279$ 2,872$ 3,518$ 4,221$ 4,986$ 5,817$ 6,108$ 6,414$ 6,734$ - Oper. Exp. -$ -$ 1,372$ 1,800$ 2,269$ 2,779$ 3,335$ 3,939$ 4,596$ 4,826$ 5,067$ 5,320$ - Deprec'n -$ -$ 300$ 240$ 192$ 154$ 235$ 200$ 190$ 180$ 172$ 98$ - Allocated G&A -$ -$ 166$ 187$ 210$ 235$ 262$ 291$ 323$ 339$ 356$ 374$ - Advertising Exp. -$ -$ 79$ 82$ 85$ 89$ 92$ 96$ 100$ 104$ 108$ 112$ Operating Profit -$ -$ (180)$ (30)$ 116$ 261$ 297$ 460$ 610$ 660$ 711$ 830$ Taxes -$ -$ (72)$ (12)$ 46$ 105$ 119$ 184$ 244$ 264$ 284$ 332$

EBIT(1-t) -$ -$ (108)$ (18)$ 69$ 157$ 178$ 276$ 366$ 396$ 427$ 498.22$

In years 3 and 4, the project will lose money but Nike will offset these losses against other profits to save taxes.


Some Thoughts on Operating Income...!

  There are a number of allocation mechanisms that can be used to compute operating income, and the return on capital is affected by decisions on allocation. For instance, I allocated the entire investment in the distribution system expansion to this project. If I had chosen to allocate 50%, the return on capital would have been much higher.

  Your choices on depreciation have profound effects on return on capital. Using a more accelerated depreciation method would raise your return on capital substantially.

  Note that the operating income is computed after marginal taxes (Why?) and does not include the tax savings due to interest expenses (Why?)


Nike Apparel: Return on Capital!


Your estimates of return on capital…!


Nike Apparel: After-tax Cash Flows!

Includes book value of fixed assets and working capital at the end of year 12

Year 0 1 2 3 4 5 6 7 8 9 10 11 12EBIT(1-t) -$ -$ (108)$ (18)$ 69$ 157$ 178$ 276$ 366$ 396$ 427$ 498.22$ + Deprec'n -$ -$ 300$ 240$ 192$ 154$ 235$ 200$ 190$ 180$ 172$ 98$ + Fixed Allocated Exp (1-t) -$ -$ 69$ 73$ 77$ 80$ 84$ 89$ 93$ 98$ 103$ 108$ - Cap Ex 1,000$ 1,000$ 500$ -$ -$ -$ -$ -$ -$ -$ -$ -$ -$ - Opp. Cost of Dist'n System 1,126$ (1,243)$ - Chg in WC -$ 121$ 38$ 41$ 45$ 49$ 53$ 58$ 20$ 21$ 22$ -$ + Salvage Value 1,470$ After-tax Cashflow (1,000)$ (1,000)$ (621)$ 224$ 253$ 293$ (784)$ 445$ 507$ 628$ 653$ 1,923$ 2,174$


Observations on Distribution System!

  The distribution system investment shows up in a number of ways: •  In year 6, I show a negative cash flow because of the investment Nike has

to make in the distribution system. •  In year 11, I show the saving due to the fact that Nike does not have to

make the investment in the distribution system. •  Between years 6 and 11, I include the depreciation associated with Nike

making the investment early. (I used a 20-year life and double declining balance depreciation… but I could very well have used straight line)

  The effect on the NPV is the difference in present values between investing in year 6 versus year 11: PV of investing early = 1126/1.082^6 – 1243/1.082^11 = - $179 million The depreciation tax benefits reduce this cost a little.


Nike Apparel: NPV and IRR!

  Internal Rate of Return = 10.03%

Year 0 1 2 3 4 5 6 7 8 9 10 11 12PV of Cash Flows (1,000)$ (924)$ (531)$ 177$ 185$ 197$ (489)$ 256$ 270$ 309$ 297$ 808$ 844$ Net Present Value 399$


Your estimates of NPV – Finite life!


Nike Apparel: Infinite Life!

Year 0 1 2 3 4 5 6 7 8 9 10 11 12 Term YearEBIT(1-t) -$ -$ (108)$ (55)$ 3$ 67$ 69$ 152$ 241$ 270$ 300$ 371$ 378$ + Deprec'n -$ -$ 300$ 301$ 302$ 304$ 417$ 407$ 398$ 391$ 384$ 311$ 317$ +Allocated Corporate G&A (1-t) -$ -$ 69$ 73$ 77$ 80$ 84$ 89$ 93$ 98$ 103$ 108$ 110$ - Cap Ex 1,000$ 1,000$ 500$ 306$ 307$ 308$ 310$ 426$ 416$ 406$ 398$ 391$ 317$ 324$ - Opp. Cost of Dist'n System 1,126$ (1,243)$ - Chg in WC -$ 121$ 38$ 41$ 45$ 49$ 53$ 58$ 20$ 21$ 22$ 9$ 10$ + Salvage Value 7,613$ ATCF (1,000)$ (1,000)$ (621)$ (82)$ (29)$ 29$ (1,034)$ 92$ 174$ 305$ 338$ 1,616$ 8,076$ 472$


Observations on Infinite Life!

  To make this project have infinite life, with a growth rate of the inflation rate, I have to preserve existing assets. I have assumed that the replacement of depleted assets will occur at a cost 2% over the depletion rate. Thus, to replace the assets that are depleted in year 1 (captured in the depreciation of $ 300 million), I assume that capital maintenance has to be $ 306 million….

  This additional capital maintenance will increase book value and depreciation in subsequent periods.

  None of the assets are salvaged in this case, since the project continues forever.

  If I had assumed a shorter extension after 10 years, there would have been lower capital maintenance expenditures all the way through. The net present value does not change much.


Terminal Value and NPV Calculations!

  Assumed cashflows grow at the inflation rate after year 12.   Terminal value in year 12 = CF in year 13/( Cost of capital - g) = 472/(.082 - .02) = $7,613 million

IRR of project = 10.06%

Year 0 1 2 3 4 5 6 7 8 9 10 11 12PV of Cash Flows (1,000)$ (924)$ (531)$ (65)$ (21)$ 19$ (644)$ 53$ 93$ 150$ 154$ 679$ 3,136$ Net Present Value 1,099$


Consistency in growth and investment assumptions!

After year 12 Capital Expenditure Assumption Project ends No (or very low) capital maintenance Let assets run down towards end of life

Infinite life; g=0% Capital maintenance = Depreciation�� Maintain invested capital at base level

Infinite life; g= inflation Capital maintenance > Depreciation�� Capital invested has to grow at inflation rate

Infinite life; g> inflation Capital investment to increase capacity Capital maintenance > Depreciation Capital invested has to grow to reflect real

growth


Your estimates of NPV – Longer life!


NPV, Market Share and Operating Margin!

16% 17% 18% 19% 20% 21% 22% 23% 24% 25%

3%4%

5%6%

7%-$1,000

-$500

$0

$500

$1,000

$1,500

$2,000

EBITDA Margin

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NPV, Market Share and Margin

Breakeven = 15%

Breakeven = 17%

Breakeven = 19%

Breakeven = 22%

Breakeven = 26 %


Your decision on the investment…!

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Nike to Do It or Not