Download Nike Apparel: The Ten Essential Components (each worth a point)

Nike Apparel: The Ten Essential Components (each worth a point)
Component
Cost of equity
Debt Ratio
What needs to be done…
1. Compute the unlevered beta for apparel
companies and lever using Nike’s debt to
equity ratio.
2. Compute a weighted average equity risk
premium across regions of operatinos.
Convert operating lease commitments into debt
(Will yield between $ 1.5 and $1.7 billion,
depending upon assumption made about lump sum
in year 6) by taking the present value of leases,
using the pre-tax cost of debt
Add the market value of interest bearing debt to PV
of leases. If you count only ST Borrowing and LT
Borrowings as debt and use the interest expense of
$34 million, this works out to $ 696 million.
Distribution
By investing in this project, you find yourself
System
running out of capacity in year 6 instead of year 11.
The present value of the difference between
investing in year 6 and 11 is your opportunity cost.
If you want to be fully accurate, you should also
show the depreciation benefits occurring earlier as a
result of the investment in year 6. (However, it is
still a present value effect and probably too small to
make a difference)
Sunk Costs
The 250 million in R&D that has already been spent
is not only a sunk cost but it should not be part of
capital invested, since it was expensed before you
did the analysis.
Allocated G&A You should add back the portion of G&A that is
allocated. However, remember to multiply it by (1tax rate) since you are working with after-tax
numbers.
Non-cash
The non-cash working capital investment is the
Comments
Most groups did the right thing, though the bottom up beta
did vary depending upon how the debt to equity ratio for
comparable firms was computed. (If you used the simple
average of the D/E ratio, you got a lower beta… That is fine)
You cannot use Nike’s beta or a weighted average of Nike’s
beta and the furniture beta to evaluate this project.
Using a broader measure as debt will yield a much higher
debt ratio. Thus, counting all LT liabilities as debt will lead
to almost $ 4 billion in debt. One reason I am skeptical
(though I will not take any points off) of this view is that it is
incompatible with the interest expense being only $ 34
million.
If you show the cost of the investment in year 6, you have to
show the savings in year 11. If you do not, it is not fair to this
project, since making the earlier investment saves you the
money on the later investment. Any allocation judgments
you make will affect your accounting returns but should have
no effect on your incremental cash flows.
If you did not consider depreciation on the expansion or
expensed it, I did not penalize you.
The expense and the tax benefits from the expense are both
non-incremental (you would get them anyway) and should
not affect your incremental cash flows.
Adding back allocated G&A makes sense only if subtracted
it out to get to operating income in the first place. If you used
only incremental G&A to get to operating income, don’t add
back the allocated G&A.
Non-cash working capital = Accounts Receivable plus
Working
Capital
Salvage value
in finite life
case
Terminal value
in infinite life
case
Capital
Maintenance
What-if
analysis
change in working capital each year. It begins at the
end of year 2 (to cover revenues in year 3) and
affects cash flows each year, as it increases with
revenues. At the end of the project lifetime (only in
the finite life case), don’t forget to get it back.
This should include the book value of the fixed
assets that have not been depreciated by year 10 plus
the working capital salvage. You can also add in the
salvage value of the expansion facilities, though it is
unlikely that Nike will actually sell them.
The terminal value should be estimated using the
inflation rate as the growth rate. It should also
reflect reasonable assumptions about capital
maintenance in perpetuity.
Consistency and common sense demand that there
should be more capital maintenance (even over the
next 10years and not just after), if you are trying to
run this as an infinite life business. What is a
reasonable cap ex? If depreciation represents
depletion in the assets, capital maintenance should
at the least make it up.
The NPV is sensitive to profit margins and market
share. While you can look at changes in the inflation
rate or interest rate, it is more difficult to hold
everything else constant.
Inventory minus Accounts Payable. It is only the change that
should affect your cash flow, not the total working capital.
If you did put the change in working capital at the end of
each year rather than the beginning, you will get a slightly
higher NPV.
If you don’t salvage working capital and recover book value
of assets, you should at least show the tax benefits from
having a capital loss. You cannot just ignore them.
You cannot keep a project going without investing in it. In
fact, here is a very simple test. If you look at your cashflow
in year 10, it includes a cash inflow from depreciation. If you
assume that this cashflow will grow in perpetuity, and you
have no capital investment, you will run out of capital to
depreciation very soon. In other words, that cashflow cannot
be sustained.
If you set your terminal growth rate > 2%, you will need new
capacity to meet the additional real demand..
If you just extend the life of the project without allowing for
capital maintenance, projects will always look better with
longer lives than shorter ones. The key, though, is to match
the capital maintenance assumptions to assumptions about
project life. With the finite life scenario, it makes little sense
to pump huge amounts into capital maintenance, especially
as you wind the project down.
It can be taken as a given that there will be some scenarios
under which the NPV will turn negative. Rejecting a project
with a positive NPV for this reason strikes me as double
counting.
1. Cost of capital calculation
1a. Used beta for company instead of beta for project (-0.5 point)
1b. Used weighted average of the business betas (for HD) (-0.5 point)
1c. Did not adjust equity risk premium for country risk (-0.5 point)
1d. Mistakes in computing market value of debt and leases (-0.5 point)
1e. Other
2. Operating income and investment calculation
2a, Used effective instead of marginal tax rate (-0.5 point)
2b. Subtracted interest expense to get to income (which would give you net income) while using cost of capital as discount rate (-0.5 point)
2c. Included sunk cost initial investment (-0.5 points)
2d. Did not include $1 billion in undepreciated cap ex as initial investment (-0.5 point)
2e. Other
3. Incremental cash flow calculation (finite life case)
3a. Change in working capital computed incorrectly (-0.5 point)
3b. Distribution system: Counted incremental investment in year 6 (as negative cash flow) but failed to adjust for the savings in year 11 (as
positive cash flow) or allocated investment into distribution system (-0.5 point)
3c. Forgot to add back non-incremental allocated overhead (-0.5 point)
3d. Salvage value incorrectly computed (-0.5 point)
3e. Other
4. Incremental cash flow calculation (longer life)
4a. Used growth rate > inflation rate, without investing in additional capacity (if you set growth above inflation, you are assuming real growth
which will require new capacity investments) (-0.5 point)
4b. Inadequate capital maintenance investment (Should be significantly greater than in finite life case). (-1 point)
4c. Other: