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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: