Nike: To Do or Not to Do! !

Aswath Damodaran

Stern School of Business

Aswath Damodaran!

1!

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 nite 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 nite life of 10 years
is $ 1099 million, under the more realistic assumption of an innite life

On the two variables that are the most critical - market share and operating margin - the rm 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.

Aswath Damodaran!

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Choices for Analysis !

Firm or Equity Analysis

Firm


Operating Income (after tax)
Book value of capital

Return on capital

Cash ow before debt
Cost of capital

Equity

Net Income


Book value of equity

Return on equity

Cash ow after debt

Cost of equity

Earnings
Book Value Accounting return Cash ows Discount rate

Decided to go with a rm analysis (Less work)

Nominal or Real Analysis

The information on earnings and discount rates is provided in nominal terms but the ination rate is also provided.
We chose to leave everything in nominal terms. Alternatively, we could have made our nominal cash ows into real cash ows and nominal discount rate into a real discount rate, by taking ination out of both.

Aswath Damodaran! 3!

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.
Nikes 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.

Aswath Damodaran!

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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

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

Market Value D/E Ratio = (829+1520)/30566= 7.68%

MV Debt/Capital Ratio = 2349/(30566+2349) =7.13%

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Aswath Damodaran!

Unlevered Beta for the Apparel Business !

Regression Beta Debt to Equity Ratio Unlevered Beta Cash/Firm Value Unlevered beta corrected for cash

Median 1.41 50.68% 1.0827 4.93% 1.1388

Aggregate 1.45 23.61% 1.2662 6.95% 1.3608

Average 1.41 839.36% 0.2337 17.49% 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 reects larger rms in the sample.

Aswath Damodaran!

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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%

Aswath Damodaran!

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Your estimates of cost of capital !

Aswath Damodaran!

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Operating Income for Nike Apparel !

Year Total Market Market Share

Revenues - Oper. Exp. - Deprec'n - Allocated G&A - Advertising Exp. Operating Profit Taxes EBIT(1-t)

0 1 2 3 4 5 6 7 8 9 10 $ 75,000 $ 78,750 $ 82,688 $ 86,822 $ 91,163 $ 95,721 $ 100,507 $ 105,533 $ 110,809 $ 116,350 $ 122,167 $ 0% 0% 0% 2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.00%
$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 1,736 1,372 300 166 79 (180) (72) (108) $ $ $ $ $ $ $ $ 2,279 1,800 240 187 82 (30) (12) (18) $ $ $ $ $ $ $ $ 2,872 2,269 192 210 85 116 46 69 $ $ $ $ $ $ $ $ 3,518 2,779 154 235 89 261 105 157 $ $ $ $ $ $ $ $ 4,221 3,335 235 262 92 297 119 178 $ $ $ $ $ $ $ $ 4,986 3,939 200 291 96 460 184 276 $ $ $ $ $ $ $ $ 5,817 4,596 190 323 100 610 244 366 $ $ $ $ $ $ $ $ 6,108 4,826 180 339 104 660 264 396 $ $ $ $ $ $ $ $

11 128,275 $ 5.00%
6,414 5,067 172 356 108 711 284 427 $ $ $ $ $ $ $ $

12 134,689 5.00%
6,734 5,320 98 374 112 830 332 498.22

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

Aswath Damodaran!

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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?)

Aswath Damodaran!

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Nike Apparel: Return on Capital !

Aswath Damodaran!

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Your estimates of return on capital !

Aswath Damodaran!

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Nike Apparel: After-tax Cash Flows !

Year EBIT(1-t) + Deprec'n + Fixed Allocated Exp (1-t) - Cap Ex - Opp. Cost of Dist'n System - Chg in WC + Salvage Value After-tax Cashflow 0
$ $ $ $ $

1
1,000 $ $ $ $ $

1,000

2 500
121

3 4 $ (108) $ (18) $ 300 $ 240 $ 69 $ 73 $ $ $ 38 224 $ 41

5 $ 69 $ 192 $ 77 $ $ 45

6 $ 157 $ 154 $ 80 $ $ 1,126 $ 49

$

7 $ 178 $ 235 $ 84 $ $ 53

8 $ 276 $ 200 $ 89 $ $ 58

9 $ 366 $ 190 $ 93 $ $ 20

10 $ 396 $ 180 $ 98 $ $ 21

$ (1,000) $ (1,000) $ (621) $

$ 253

$ 293

(784) $ 445

$ 507

$ 628

$ 653

11 12 $ 427 $ 498.22 $ 172 $ 98 $ 103 $ 108 $ $ $ (1,243) $ 22 $ $ 1,470 $ 1,923 $ 2,174

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

Aswath Damodaran! 13!

Observations on Distribution System !

The distribution system investment shows up in a number of ways:

In year 6, I show a negative cash ow 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 benets reduce this cost a little.

Aswath Damodaran!

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Nike Apparel: NPV and IRR !

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

Internal Rate of Return = 10.03%

Aswath Damodaran!

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Your estimates of NPV Finite life !

Aswath Damodaran!

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Nike Apparel: Innite Life !

Year EBIT(1-t) + Deprec'n +Allocated Corporate G&A (1-t) - Cap Ex - Opp. Cost of Dist'n System - Chg in WC + Salvage Value ATCF 0
$ $ $ $ $

1
1,000 $ $ $ $ $

1,000

2 500
121

3 4 $ (108) $ (55) $ 300 $ 301 $ 69 $ 73 $ 306 $ 307

$ 38 $ 41

5 $ 3 $ 302 $ 77 $ 308
$ 45 29

6
$ $ $ $ $ $ 67 304 80 310 1,126 49

7 $ 69 $ 417 $ 84 $ 426
$ 53 92

8 $ 152 $ 407 $ 89 $ 416

$ 58

9 $ 241 $ 398 $ 93 $ 406

$ 20

10 $ 270 $ 391 $ 98 $ 398

$ 21

$ (1,000) $ (1,000) $ (621) $

(82) $ (29) $

$ (1,034) $

$ 174

$ 305

$ 338

11 12 $ 300 $ 371 $ 384 $ 311 $ 103 $ 108 $ 391 $ 317 $ (1,243) $ 22 $ 9 $ 7,613 $ 1,616 $ 8,076

Term Year $ 378 $ 317 $ 110 $ 324

$ $ 10 472

Aswath Damodaran!

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Observations on Innite Life !

To make this project have innite life, with a growth rate of the ination 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.

Aswath Damodaran!

18!

Terminal Value and NPV Calculations !

Assumed cashows grow at the ination rate after year 12.

Terminal value in year 12 = CF in year 13/( Cost of capital - g)




= 472/(.082 - .02) = $7,613 million

0 1 2 3 4 5 $ (1,000) $ (924) $ (531) $ (65) $ (21) $ 19 $ 1,099 6 7 $ (644) $ 53 8 $ 93 9 $ 150 10 $ 154 11 $ 679 12 $ 3,136

Year PV of Cash Flows Net Present Value

IRR of project = 10.06%

Aswath Damodaran!

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Consistency in growth and investment assumptions !

After year 12 Project ends

Innite life; g=0%
Capital Expenditure Assumption

No (or very low) capital maintenance

Let assets run down towards end of life

Capital maintenance = Depreciation
Maintain invested capital at base level
Innite life; g= ination
Capital maintenance > Depreciation
Capital invested has to grow at ination rate
Innite life; g> ination
Capital investment to increase capacity



Capital maintenance > Depreciation



Capital invested has to grow to reect real

growth

Aswath Damodaran!

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Your estimates of NPV Longer life !

Aswath Damodaran!

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NPV, Market Share and Operating Margin !

NPV, Market Share and Margin

$2,000 Breakeven = 15%

$1,500

Breakeven = 17%

$1,000 Breakeven = 19% $500 Breakeven = 22% $0 Breakeven = 26 % -$500 7% 6% 5% 4% 21% 22% 23% 3% 24% 25%

-$1,000 16% 17% 18% 19%

20%

EBITDA Margin

Aswath Damodaran!

Target Market Share

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Your decision on the investment !

Aswath Damodaran!

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