With its dominance of the athletic shoe and sporting apparel businesses, Nike generated $2.45 billion in operating income on revenues of $19 billion in the fiscal year ended in May 2009. However, its stock price has stagnated for the last 2 years ? see Exhibit 1 for the stock price over last 2 years - and its future sales and earnings are likely to be adversely affected by increased competition from both established firms (like Reebok and Adidas) and upstarts (such as Underarmour). Exhibit 2 summarizes Nike?s income statement for the last 4 years, and Exhibit 3 summarizes its balance sheet for the last 2 years.

Nike is considering an expansion into the fashion apparel business, producing high-priced casual clothing for teenagers and young adults. You have been asked to collect the data to make the assessment and have come back with the following information:

• You estimate that it will cost Nike $ 2.5 billion to establish a presence in this business. Of this amount, $ 1 billion will have to be spent right now acquiring land, equipment and other assets needed for the business. There will be an additional $ 1 billion investment a year from now, and final investment of $ 0.5 billion at the end of 2 years. The business will be operational at the start of the third year.
• Of the initial investment of $ 2.5 billion, $1.5 billion is fully depreciable over 10 years starting in the third year.
• You have employed a major market-testing organization to do a market study. Their initial study, which has already been completed and expensed, cost $ 250 million and has provided you 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 $ 75 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 (which is the third year), and to increase its market share by 0.5% a year to reach 5% of the market in the ninth year[1]. Beyond that point, Nike?s revenues are expected to grow at the same rate as the overall market.
• The pre-tax gross profit margins (prior to depreciation, advertising expenses and allocations of corporate costs) are expected to be 21% of revenues
• The existing general and administrative expenses are $ 500 million for the entire firm. In addition, it is expected that Nike will have an increase of $ 50 million in general and administrative costs in year 3 when the new division starts generating revenues. The latter cost is directly related to the new divisions and will be charged to them.
• Nike spent $ 1 billion in advertising expenses in the most recent year and expects these expenses to grow 4% a year for the next 12 years, if the apparel division is not created. If the 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 from year 3 (the first year of sales for the division) to year 12.
• The apparel division will create working capital needs, which you have estimated as follows:
• The sale of apparel on credit to wholesalers and large retailers will create accounts receivable amounting to 5% of revenues each year.
• Inventory (of both raw material and finished goods) will be approximately 10% of the cost of goods sold (not including depreciation, allocations or advertising expenses).
• The credit offered by suppliers will be 7.5% of the cost of goods sold (not including depreciation, allocations or advertising expenses).

All of these working capital investments will have to be made at the beginning of each year in which goods are sold. Thus, the working capital investment for the third year will have to be made at the beginning of the third year.

The levered beta for Nike is 0.88, calculated using monthly returns over the last 5 years and against the S&P 500 Index. Nike is currently rated A+, and A+ rated bonds trade at a default spread of 1.0% over the long-term treasury bond rate. The current stock price for the firm is $ 62 and there are 493 million shares outstanding.Nike expects to finance this apparel division using the same mix of debt and equity (in market value terms) as it is using currently in the rest of its business. Nike?s tax rate is 40%.The current long-term Treasury bond rate is 3.5%. You can use the historical risk premium of 4.3% as your equity risk premium.Time: You can assume that the current year has just ended and that now is time 0. Year 1 begins today and the end of year 1 is a year from today.

For missing information, please make your own assumption.

Questions on the Project

1. Accounting Return Analysis

• Estimate the operating income from the proposed apparel division investment to Nike over the next 12 years.

2. Cash Flow Analysis

• Estimate the after-tax incremental cash flows (FCFF) from the proposed apparel investment to Nike over the next 12 years.
• If the project is terminated at the end of the 12th year, and both working capital and investment in other assets can be sold for book value at the end of that year, estimate the net present value of this project to Nike and the modified internal rate of return.

[1] The market share in year 4 will be 2.50%, in year 5 will be 3% etc?

Financial Feasibility Study Case: Nike This case is a group project that is due on May 3, 2010 before class begins at 9:00. Format: Each group will turn in one report. . Each report should have a cover page that contains the following -the names of the group members and the following summary information on the analysis: Decision on the project: Accept or Reject NPV: $ value IRR: % Nike is considering an expansion into the fashion apparel business, producing high-priced casual clothing for teenagers and young adults. You have been asked to collect the data to make the assessment and have come back with the following information: 1. You estimate that it will cost Nike $ 2.5 billion to establish a presence in this business. Of this amount, $ 1 billion will have to be spent right now acquiring land, equipment and other assets needed for the business. There will be an additional $ 1 billion investment a year from now, and final investment of $ 0.5 billion at the end of 2 years. The business will be operational at the start of the third year. 2. Of the initial investment of $ 2.5 billion, $1.5 billion is fully depreciable over 10 years starting in the third year, and will be depreciated using straight line depreciation. 3. You have employed a major market-testing organization to do a market study. Their initial study, which has already been completed and expensed, cost $ 250 million and has provided you with a sense of the magnitude of this market, and Ni k e ' spot e nt i a li nt hema r ke t .(hint: sunk cost is excluded from project cost) 4. The total market for casual apparel is estimated to be $ 75 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 (which is the third year), and to increase its market share by 0.5% a year to reach 5% of the market in the ninth year1. Beyond that point, Ni k e ' sr e ve nue sa r ee xpe c t e dt ogr owa tt hes a mer a t ea st heove r a l lma r ke t . 5. The cost of sold (excluding depreciation, advertising expenses and allocations of corporate costs) are expected to be 79% of revenues. 6. Nike will allocate 20% of its existing general and administrative costs to the new 1 Themar ketshar ei ny ear4wi l lbe2. 50%,i ny ear5wi l l be3% et c... division. These costs now total $ 500 million for the entire firm and are expected to grow 5% a year for the next 12 years, irrespective of whether Nike enters the apparel business. In addition, it is expected that Nike will have an increase of $ 50 million in general and administrative costs in year 3 when the new division starts generating revenues, and that this amount will grow with t hene w di vi s i on' s revenues after that. The latter cost is directly related to the new divisions and will be charged to them in addition to the allocated corporate G&A costs. 7. While the new business will need distributional support, it is anticipated that Nike can use excess capacity in its existing distribution network. The shoe business is currently using 60% of the distribution capacity and are growing 3% a year (it will use 63% next year, 66.3% the year after and so on..). The apparel business will use 10% of the capacity in year 3 (which is the first year of revenue generation) and its usage will track revenue growth beyond that point. When Nike runs out of distribution capacity, it will have to pay for an expansion of the distribution network. This is a major endeavor and will cost a substantial amount and have to be capitalized. (The current estimate of the cost of expansion is $ 1 billion, but this cost will grow at the inflation rate.) 8. Nike spent $ 1 billion in advertising expenses in the most recent year and expects these expenses to grow 4% a year for the next 12 years, if the apparel division is not created. If the 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 from year 3 (the first year of sales for the division) to year 12. (hint: use incremental cost only) 9. The apparel division will create working capital needs, which you have estimated as follows: (1) The sale of apparel on credit to wholesalers and large retailers will create accounts receivable amounting to 5% of revenues each year. (2) Inventory (of both raw material and finished goods) will be approximately 10% of the cost of goods sold (not including depreciation, allocations or advertising expenses). (3) The credit offered by suppliers will be 7.5% of the cost of goods sold (not including depreciation, allocations or advertising expenses). All of these working capital investments will have to be made at the beginning of each year in which goods are sold. Thus, the working capital investment for the third year will have to be made at the beginning of the third year. 10. Ni k e ' swe i g ht e da ve r a g ec os to fc a pi t a li s8% a ndits effective tax rate is 24%. Questions 1. Cash Flow Analysis - Estimate the after-tax incremental cash flows from the proposed investment to Nike over the next 12 years. - If the project is terminated at the end of the 12th year, and both working capital and investment in other assets can be sold for book value at the end of that year, estimate the net present value (NPV) of this project. Develop a net present value profile and estimate the internal rate of return (IRR) for this project. 2. Sensitivity Analysis - Estimate the sensitivity of your numbers to changes in at least three of the key assumptions underlying the analysis (You get to pick what you think are the three key assumptions). 3. Scenario Analysis - If the project division is expected to have a life much longer than 12 years, estimate the net present value of this project, making reasonable assumptions about investments and cash flows after year 12. Develop a net present value profile and estimate the internal rate of return for this project. Based upon your analysis, would you accept this project or reject it? Explain your decision