A project evaluation case study: NIKE NIKE designs, develops, markets and sells athletic footwear, apparel, equipment, accessories and services worldwide. It is the largest seller of athletic footwear and apparel in the world. With its dominance of the athletic shoe and sporting apparel businesses, Nike generated $4.03 billion in net income on revenues of $39.12 billion in the fiscal year that ended in December 2019. Its comparative stock price performance is shown in Exhibit 1.
Despite the rosy picture portrayed above, the athletic footwear, apparel and equipment industry is highly competitive on a worldwide basis. Nike competes internationally with a significant number of athletic and leisure footwear companies, athletic and leisure apparel companies, and sports equipment companies, including adidas, Anta, ASICS, Li Ning, lululemon athletica, Puma, among others. The intense competition and the rapid changes in technology and consumer preferences in the markets for athletic and leisure footwear and apparel and athletic equipment, constitute significant risk factors in Nike’s operations. Its sales and earnings are also being affected by these factors (see exhibit 2).
To reduce business risk and diversify its operations, Nike is considering an expansion into the fashion apparel business, producing high-priced casual clothing for teenagers and young adults.
- It has been estimated that it will cost Nike $ 3.0 billion to establish a presence in this business. Of the initial investment of $3 billion, $2.50 billion will be used to purchase land, building, equipment and machineries; and .5 billion is the net working capital requirement at the inception of the project. The initial investment is subject to straight line depreciation over a 10-year period.
- A major market-testing organization was employed to do a market study. Their initial study, which has already been completed and expensed, cost $ 200 million and has provided with a sense of the magnitude of this market, and Nike’s potential in the market.
- The total market for casual apparel is estimated to be $ 100 billion currently, growing at 5% a year. Nike is expected to gain a 2% market share in the first year that it enters the market, and to increase its market share by 1% a year until the tenth year. Beyond that point, Nike’s revenues are expected to grow at the same rate as the overall market.
- Variable cost of production is 40% of sales revenue. Nike will allocate 5% of its existing general and administrative (fixed) costs to the new division for the accounting purposes. These costs now total $1 billion for the entire firm irrespective of whether Nike enters the apparel business. In addition, it is expected that Nike will have an increase of $20 million in general and administrative costs when the new division starts generating revenues, and that this amount will grow with the new division’s revenues after that.
- Nike spent $1 billion in advertising expenses in the most recent year. If the casual apparel division is added to the company, total advertising expenses are expected to be 7% higher than they would have been without the apparel division each year to year 10.
- The apparel division will create a continuous working capital needs, which have been estimated as follows:
o The sale of apparel on credit to wholesalers and large retailers will create accounts receivable amounting to 5% of revenues each year.
o Inventory (of both raw material and finished goods) will be approximately 3% of revenues.
o The credit offered by suppliers will be 5% of revenue.
All of these working capital investments will have to be made at the beginning of each year in which goods are sold.
- Nike has an effective corporate tax rate of 40%. The required rate of return on the projects is 10% per annum
You have been appointed as an analyst. Your responsibility is to conduct a project appraisal to recommend Nike whether they should go ahead with the proposed fashion apparel business. More specifically, you need to answer the questions listed in the next two pages
Question 1 (10 marks)
Calculate the NPV for the project.
Question 2 (2 marks) Calculate IRR for the project.
Question 3 (3 marks)
a) Based on your NPV and IRR calculations, would you recommend Nike to go ahead with the project. (1 mark)
b) Discuss why your investment decision is either the same or different when using the IRR compared with the NPV. (2 marks)
Question 5 (4 marks)
(a) Calculate the payback and discounted payback period for the project. (2 marks)
(b) Discuss the weaknesses of the payback period method to evaluate the project. (2 marks)
Question 6 (7 marks)
The management team at Nike is worried that the actual market share might differ from the expected one. The management believe that the base-case scenario is still a 2% market share in the first year that Nike enters the market, and to increase its market share by 1% a year until the tenth year. Beyond that point, Nike’s revenues are expected to grow at the same rate as the overall market. However, the best-case scenario is a 3% market share in the first year that Nike enters the market, and to increase its market share by 1.5% a year until the tenth year. Beyond that point, Nike’s revenues are expected to grow at the same rate as the overall market. The worst-case scenario, however, is a 1% market share in the first year that Nike enters the market, and to increase its market share by 0.5% a year until the tenth year. Beyond that point, Nike’s revenues are expected to grow at the same rate as the overall market. The management team is further concerned that the proportion of variable cost may change in the subsequent year. In the best-case scenario, the variable cost may decrease to 30% of sales revenue while at the worst-case scenario the variable cost may increase to 50% of sales revenue.
(a) Calculate how sensitive the NPV of the project is to these alternative estimates of the
market share and variable cost. (5 marks)
(b) Briefly discuss your results. (2 marks)
Question 7 (9 marks)
An analyst working for Nike has proposed that as the firm is only financed with equity and all of the firm’s projects have the same level of risk, the cost of equity capital should be used as the discount rate in NPV analysis.
(a) Collect daily stock price of Nike and S&P500 index from yahoo finance (https://au.finance.yahoo.com/quote/NKE/history?p=NKE). Estimate a regression model to calculate beta of Nike. (4 marks)
(b) Calculate Nike’s cost of equity capital. Consider the risk-free rate is 4% per annum. and the expected return on the equity market portfolio is 10%. (2 marks)
(c) Using the cost of equity capital as the discount rate for cash flows, re-calculate the NPV for the project. (1 marks)
(d) Discuss any reasons why your results from the NPV analysis using the cost of equity capital might be different from your analysis where the discount rate was assumed to be 10%. (2 marks)
Question 8 (5 marks)
Nike has decided to fund 50% of the project by issuing perpetual bonds. Nike is currently rated AAA and AAA-rated bonds carry a 1% default spread over the long-term treasury bond rate which is currently 8%. The market yield on equivalent corporate bonds is 8.5% per annum, compounding semi-annually:
(a) Calculate the number of bonds Nike would need to be issued to fund the required investment. (2.5 marks)
(b) Calculate the weighted average cost of capital considering 50% debt – 50% equity mix. (2.5 marks)