NIKE INC

(5) Cash Flow Estimation

- We assume that the company you selected is considering a new project. The project has 8 years life. This project requires initial investment of $380 million to purchase equipment, and $25 million for shipping & installation fee. The fixed assets fall in the 7-year MACRS class. The salvage value of the fixed assets is 15% of the purchase price (including the shipping & installation fee). The number of units of the new product expected to be sold in the first year is 1,660,000 and the expected annual growth rate is 8.5%. The sales price is $250 per unit and the variable cost is $185 per unit in the first year, but they should be adjusted accordingly based on the estimated annualized inflation rate of 2.8%. The required net operating working capital (NOWC) is 12% of sales.Please use the corporate tax rate obtained in Step (4) for the project. The project is assumed to have the same risk as the corporation, so you should use the WACC you obtained from prior steps as the discount rate. Note: you may revise the partial model in the fileCh11 P18 Build a Model.xlson the website of the textbook (also posted in this final project learning module in Blackboard) for capital budgeting analysis, but you are NOT required to strictly follow the partial model. Actually, you are encouraged to build a better model by yourself.

- Compute the depreciation basis and annual depreciation of the new project. (Please refer to Table 11A-2 MACRS allowances on P.469 in the textbook)

- Estimate annual cash flows for the 8 years.

- Draw a time line of the cash flows.

(6) Capital Budgeting Analysis

-Using the WACC obtained from in Step (4) as the discount rate for this project, apply capital budgeting analysis techniques (NPV, IRR, MIRR, PI, Payback, Discounted Payback) to analyze the new project.

- Perform asensitivity analysisfor the effects of key variables (e.g., sales growth rate, cost of capital, unit costs, sales price) on the estimated NPV or IRR in order to demonstrate the sensitivity of the model. TheScenario analysisof several variables simultaneously is encouraged (but not required). A PDF document namedSensitivity Analysis in Excelis provided in this learning module. The article introduces the Data Table method that you can use for performing sensitivity analysis in Excel.

- Discuss whether the project should be taken and summarize your report.

Solution Chapter: Problem: 11 18 Webmasters.com has developed a powerful new server that would be used for corporations' Internet activities. It would cost $10 million at Year 0 to buy the equipment necessary to manufacture the server. The project would require net working capital at the beginning of each year in an amount equal to 10% of the year's projected sales; f example, NWC0 = 10%(Sales1). The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 3%. The company's nonvariable costs would be $1 million at Year 1 and would increase with inflation. The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. Also, the project's returns are expected to be highly correlated with returns on the firm's other assets. The firm believes it could sell 1,000 units per year. The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of t equipment at the end of the project's 4-year life is $500,000. Webmasters' federal-plus-state tax rate is 40%. Its cos of capital is 10% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 an 1.2. Low-risk projects are evaluated with a WACC of 8%, and high-risk projects at 13%. a. Develop a spreadsheet model, and use it to find the project's NPV, IRR, and payback. Input Data (in thousands of dollars) Equipment cost Net operating working capital/Sales First year sales (in units) Sales price per unit Variable cost per unit (excl. depr.) Nonvariable costs (excl. depr.) Market value of equipment at Year 4 Tax rate WACC Inflation in prices and costs Estimated salvage value at year 4 $10,000 10% 1,000 $24.00 $17.50 $1,000 $500 40% 10% 3.0% $500 Intermediate Calculations Units sold Sales price per unit (excl. depr.) Variable costs per unit (excl. depr.) Nonvariable costs (excl. depr.) Sales revenue Required level of net operating working capital Basis for depreciation Annual equipment depr. rate Annual depreciation expense Ending Bk Val: Cost - Accum Dep'rn Salvage value Profit (or loss) on salvage Tax on profit (or loss) Net cash flow due to salvage Cash Flow Forecast Sales revenue Variable costs 0 $2,400 $10,000 $10,000 0 Key Results: NPV = IRR = Payback = $3,463 21.1% 2.90 1 2 1,000 $24.00 $17.50 1,000 $24,000 $2,472 1,000 $24.72 $18.03 1,030 $24,720 $2,546 20.00% $2,000 $8,000 32.00% $3,200 $4,800 1 $24,000 17,500 Years 2 $24,720 18,025 Nonvariable operating costs Depreciation (equipment) Oper. income before taxes (EBIT) Taxes on operating income (40%) Net operating profit after taxes Add back depreciation Equipment purchases Cash flow due to change in NOWC Net cash flow due to salvage Net Cash Flow (Time line of cash flows) 1,000 2,000 $3,500 1,400 $2,100 2,000 1,030 3,200 $2,465 986 $1,479 3,200 -$10,000 -$2,400 -$72 -$74 -$12,400 $4,028 $4,605 Key Results: Appraisal of the Proposed Project Net Present Value (at 10%) = IRR = MIRR = Payback = Data for Payback Years $3,463 21.09% 16.99% 2.90 Net cash flow Cumulative CF Part of year required for payback 0 -$12,400 -$12,400 1 $4,028 -$8,372 1.00 Years 2 $4,605 -$3,767 1.00 b. Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and number of units sold. Set these variables' values at 10% and 20% above and below their basecase values. Include a graph in your analysis. % Deviation from Base Case -20% -10% 0% 10% 20% SALES PRICE Base NPV $24.00 $3,463 $19.20 -$5,893 $21.60 -$1,215 $24.00 $3,463 $26.40 $8,141 $28.80 $12,820 % Deviation from Base Case -20% -10% 0% 10% 20% VARIABLE COST Base NPV $17.50 $3,463 $14.00 $10,401 $15.75 $6,932 $17.50 $3,463 $19.25 -$6 $21.00 -$3,475 Note about data tables. The data in the column input should NOT be input using a cell reference to the column input cell. For example, the base case Sales Price in Cell B86 should be the number $24.00 you should NOT have the formula =D28 in that cell. This is because you'll use D28 as the column input cell in the data table and if Excel tries to iteratively replace Ce D28 with the formula =D28 rather than a series of numbers, Excel will calculate the wrong answer. Unfortunately, Excel won't tell you that there is a problem, so you'll just get the wrong values for the data table! % Deviation from Base Case -20% -10% 0% 10% 20% NPV ($) 11,000 9,000 7,000 5,000 Sale s Price Units Sold 1st YEAR UNIT SALES Base NPV 1,000 $3,463 800 $1,045 900 $2,254 1,000 $3,463 1,100 $4,673 1,200 $5,882 NPV ($) 11,000 9,000 7,000 5,000 3,000 1,000 (1,000) -20% (3,000) (5,000) (7,000) Sale s Price Units Sold -10% 0% 10% 20% Variable Cost Percentage Deviation from Base Deviation NPV at Different Deviations from Base from Sales Variable Base Case Price Cost/Unit Units Sold -20% -$5,893 $10,401 $1,045 -10% -$1,215 $6,932 $2,254 0% $3,463 $3,463 $3,463 10% $8,141 -$6 $4,673 20% $12,820 -$3,475 $5,882 Range $18,712 $13,876 $4,837 c. Now conduct a scenario analysis. Assume that there is a 25% probability that best-case conditions, with each o the variables discussed in Part b being 20% better than its base-case value, will occur. There is a 25% probability o worst-case conditions, with the variables 20% worse than base, and a 50% probability of base-case conditions. Scenario Best Case Base Case Worst Case Probability Sales Price Unit Sales Variable Costs 25% 50% 25% $28.80 $24.00 $19.20 1,200 1,000 800 $14.00 $17.50 $21.00 NPV $25,435 $3,463 ($11,990) Expected NPV = Standard Deviation = Coefficient of Variation = Std Dev / Expected NPV = $5,093 $13,332 2.62 d. If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and payback. CV range of firm's average-risk project: Low-risk WACC = 8% WACC = 10% High-risk WACC = 13% Risk-adjusted WACC = 13% 0.8 to 1.2 Risk adjusted NPV = IRR = Payback = $2,387 21.09% 2.90 e. On the basis of information in the problem, would you recommend that the project be accepted? At this point, the project looks risky but acceptable. There is a good chance that it will produce a positive NPV, but there is also a chance that the NPV could be quite low. The problem gave no information about the size of the project relative to the total corporation. If the company were quite large, and this were but one of many projects, and if the projects were independent of one another, then it should be accepted. However, if the firm were relatively small, and this project under bad conditions could bankru the company, then the decision is not clear. If management is highly risk averse, they might turn it down. Howeve well-diversified investors would probably prefer to see it accepted. So, to maximize the stock price, it should be accepted. We indicate in the problem that this project's returns will tend to be highly correlated with the firm's other projects' returns. Thus, its stand-alone risk (which is what we have been analyzing) also reflects its within-firm risk. If this were not true, then we would need to make further risk adjustments. rporations' Internet activities. It he server. The project would % of the year's projected sales; for ebmasters believes that variable costs will increase at the inflation ould increase with inflation. must be continued for the entire 4 s on the firm's other assets. The The estimated market value of the plus-state tax rate is 40%. Its cost f variation of NPV between 0.8 and 13%. yback. 3 1,000 $25.46 $18.57 1,061 $25,462 $2,623 4 1,000 $26.23 $19.12 1,093 $26,225 $0 19.20% $1,920 $2,880 11.52% $1,152 $1,728 $500 -$1,228 -$491 $991 3 $25,462 18,566 4 $26,225 19,123 Years 1,061 1,920 $3,915 1,566 $2,349 1,920 1,093 1,152 $4,858 1,943 $2,915 1,152 -$76 $2,623 $991 $7,681 $4,193 Years 3 $4,193 $425 0.90 4 $7,681 $8,106 0.00 ges in the sales price, variable 0% above and below their base- data in the column input should erence to the column input cell. Sales Price in Cell B86 should be d NOT have the formula =D28 in u'll use D28 as the column input xcel tries to iteratively replace Cell ther than a series of numbers, g answer. Unfortunately, Excel problem, so you'll just get the ble! best-case conditions, with each of ccur. There is a 25% probability of bility of base-case conditions. risk-adjusted NPV, IRR, and ject be accepted? t will produce a positive NPV, but corporation. If the company were endent of one another, then it der bad conditions could bankrupt they might turn it down. However, ze the stock price, it should be ted with the firm's other projects' flects its within-firm risk. If this Nike Corporate Tax Rate = T = 18.66% Interest Rate on Debt = rd = 3.61% After-tax cost of debt = Interest Rate - Tax Savings = rd-rdT = rd(1-T) = 3.61(1-.1866) = 3.61*(0.8134) Component Cost of Debt: = 2.94% Risk Free Rate = rRF = 2.31% Beta = b = .60 Market Risk Premium = RPM = 3.82% CAPM = Risk Free Rate + (Market Risk Premium x Beta) = rRF + (RPM x b) = 2.31 + (3.82 x .6) = 2.31 + 2.29 CAPM Approach = 4.60% Market Value of Common Equity Weight = Wce = 72% Market Value of Debt Weight = Wd = 28% After Tax Cost of Debt = rd(1-T) = 2.94% Average Cost of Common Equity = rs = 8.08% WACC = Wd((rd(1-T))+Wce(rs) WACC = .28(2.94%)+.72(8.08%) = .82% + 5.82% = 6.64% Current Stock Price as of 7/24/17 = P0 = Dividend Paid = D0 = $.62 Expected Growth Rate = g = 11.53% Dividend Expected = D1 = D0(1+g) DCF = Dividend Expected/Current Price + DCF Approach Bond Yield = cost of debt = 2.94% Estimated Bond Risk Premium = 4.0% BYPRM = Bond Yield + Bond Risk Premiu BYPRM Approach ock Price as of 7/24/17 = P0 = $58.95 Paid = D0 = $.62 Growth Rate = g = 11.53% Expected = D1 = D0(1+g) = .62(1+.1153) = .62(1.1153) = .69 dend Expected/Current Price + Expected Growth = (.69/58.95) + 11.53 = 1.17% + 11.53% = 12.70% d = cost of debt = 2.94% Bond Risk Premium = 4.0% Bond Yield + Bond Risk Premium = 2.94 + 4.0 = 6.94%