The objective of this case is for the students to apply their skills in capital budgeting and project analysis.

The Question

Reebok would choose Allen Iverson, the 6-foot 165 pound Philadelphia 76ers point guard and number one draft pick for 1996, over other rising athletes, on the basis of his positive perceptions in focus groups and his high scores in name-recognition surveys. Iversons endorsement would hopefully improve Reeboks position in the 12 to 18 year old male segment. This is the group willing to pay the $100 retail price of the shoe. The shoe would be named The Question in reference to Iversons nickname and tattoo, The Answer. Although Iversons endorsement of The Question is felt to be vital to the shoes success, the endorsement would not be cheap. For example, Reebok agreed to pay Iverson $50 million over 5 years (e.g., $10 million at the END of each of the next five years, i.e. t = 1, 2, 3, 4, 5). In addition, Reebok would have to invest in a new advertising and promotion campaign, a new factory and equipment to produce the shoe, inventory, and additional selling and administrative expenses. Furthermore, The Question is expected to reduce sales of other Reebok shoes, and the life of the shoe is expected to be only 6 years.

Reeboks CFO, Kenneth Watchmaker, had compiled the following information surrounding The Question project:

1. The life of the project is 6 years.

2. The retail price of the shoe is estimated to be in the $130-$150 range; Reeboks wholesale selling price will be $100.00

3. The athletic shoe market is projected to reach $18 billion during Year 1 and is growing at a rate of 3% per year. The market share projections for Reeboks The Question are: Year 1, 1.70%; Year 2, 1.75%; Year 3, 1.60%; Year 4, 1.45%; Year 5, 1.35%; and Year 6, 1.25%.

4. In order to produce the shoe, Reebok will need to build a factory in New Delhi, India. This will require an immediate outlay of $150 million, which will be depreciated on a 39 year MACRS basis. The depreciation percentages for the first six years, respectively, are: 2.6%, 5%, 4.7%, 4.5%, 4.3%, and 4.0%. Reebok analysts estimate that the building will be sold for $102.35 million at the project's termination. Note that this salvage value is not taken into consideration when computing the annual depreciation charges here.

5. Reebok must also immediately purchase equipment costing $15 million. Freight and installation of the equipment will cost $5 million. The equipment and freight/installation costs will be depreciated on a 5-year MACRS basis. The depreciation percentages for the six years, respectively, are: 20%, 32%, 19%, 12%, 11%, and 6%. It is believed that the equipment can be sold for $3 million at the project's termination.

6. In order to manufacture The Question, two of Reeboks working capital accounts are expected to increase immediately. The inventory balance is expected to increase by $60 million and the accounts payable account is expected to increase by $15 million. These balances will be maintained until the final year of the project, at which time they will be recovered.

7. Sales of The Question are expected to reduce sales of other Reebok basketball sneakers. Specifically, Reeboks other sneaker sales are expected to decrease by $170 million during each year of the project. Assume these lost sales have the same margins as The Question.

8. Variable costs of producing the shoe are expected to be 31% of the shoe's sales.

9. Selling, General and Administrative Expenses are expected to be $7 million per year for the project.

10. Reebok would agree to pay Iverson $10 million dollars annually for five years.

11. Other advertising and promotion costs are expected to be $20 million per year.

12. Reebok has already spent $2 million in Research & Development on The Question.

13. The company's federal plus state marginal tax rate is 40%.

Meers was also worried about the marketing approach (i.e., going after 12 to 18 year old males) for The Question for several reasons. Firstly, womens sports were on the rise and doing well, especially with the recent introduction and promotion of the WNBA. Secondly, demographic studies show the average age of athletic footwear purchasers to be 26.7, up from 24.6 three years ago.4 This trend is expected to continue as the US population becomes older. Lastly, Meers was concerned about selling $100 sneakers to inner-city youths and the public relations impression that this may make, especially in the wake of the previous years uproar over the use of child labor in Reeboks overseas facilities.

Persistence

Robert Meers was still contemplating "The Question" project when Janet McCutchins, the Vice President of New Products Development, came into Meers office anxious to meet with him. McCutchins was excited about a proposal she had developed for a new Reebok hiking shoe. The hiking shoe would be named "Persistence". The hiking sector is one of the fastest growing areas of the footwear industry -- and one that Reebok had not yet entered.6 Furthermore, Reebok's strategic plans were to enter into new areas of the athletic shoe industry with high anticipated growth, such as hiking and walking shoes. McCutchins was confident that hiking shoes would be the largest footwear trend in the next decade and suggested that, at the projects end, Reebok follow-up with another hiking shoe. In fact, she urged Reebok to investigate introducing an entire hiking shoe product line in the future. The target market for this shoe would be men and women in the 25 to 40 year old age category.

McCutchins needs to produce a projected capital budgeting cash flow statement for "Persistence," and after some preliminary analysis, decides on the following:

1. The life of the project would be only 3 years, given the steep technological learning curve for this new product line.

2. The manufacturer's selling price of the shoe will be $90.00

3. This segment of the athletic shoe market is projected to reach $350 million during Year 1 and is growing at a rate of 15% per year. The segment market share projections for "Persistence" are: Year 1, 10%; Year 2, 16%; and Year 3, 19%.

4. Reebok will be able to use an idle section of one of its factories to produce the hiking shoe. A cost accountant has estimated that, according to the square footage in the factory, this sections overhead allocation would amount to $1.8 million per year. Note that Reebok would still incur these costs if the product is not undertaken. In addition, this section would remain idle for the life of the project if the Persistence project is not undertaken.

5. Reebok must purchase manufacturing equipment costing $10 million. The equipment falls into the five year MACRS depreciation category. As such, the depreciation percentages for the first three years, respectively, are: 20%, 32%, and 19%. The cash outlay will be today, at year 0, and depreciation will start in year 1. Reebok analysts estimate that the equipment can be sold for book value at the end of the projects life.

6. Inventory and accounts receivable accounts (TOGETHER) will increase by $25 million at time t=0 ONLY and will be recovered at the end of the project (year 3). The firms accounts payable balance is projected to increase by $10 million at year 0 and will also be recovered at the end of the project.

7. Because Reebok has not yet entered the hiking shoe market, the introduction of this product is not expected to have an impact on sales of Reeboks other shoe lines.

8. Variable costs of producing the shoe are expected to be 17% of the shoe's sales.

9. General and Administrative Expenses for Persistence will be 20% of revenues per year.

10. The product will not have a celebrity endorser, but advertising and promotion costs are expected to be $3 million per year, beginning in year 1.

11. The company's federal plus state marginal tax rate is 40%.

12. In order to begin immediate production of Persistence, the design technology and manufacturing specifications for a simple hiking shoe will be purchased from an outside source for $50 million before taxes. It is assumed this outlay takes place immediately and will be expensed immediately for tax purposes.

The Decision

Meers has asked for your assistance with his decision. Reebok only has the resources to undertake either The Question or Persistence, but not both. Two main factors were guiding Meers decision-making process: the profitability of the project and its alignment to the companys strategy. Should Meers authorize the launch of The Question or Persistence? Use the following questions to assist you in your recommendation. Assume that Reeboks cost of capital (discount rate) is 11% for The Question and 14% for Persistence.

Produce a projected capital budgeting cash flow statement for the both projects by completing the following:

Please fill in the blanks in the table below with data for "The Question.: T=0 T=1 T=2 T=3 OCF A in NWC CAPEX FCF T=4 T=5 T=6 OCF A in NWC CAPEX FCF Please fill in the blanks in the table below with data for Persistence.": T=0 T=1 T=2 T=3 OCF A in NWC CAPEX FCF Please fill in the blanks in the table below with data for "The Question.: T=0 T=1 T=2 T=3 OCF A in NWC CAPEX FCF T=4 T=5 T=6 OCF A in NWC CAPEX FCF Please fill in the blanks in the table below with data for Persistence.": T=0 T=1 T=2 T=3 OCF A in NWC CAPEX FCF