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 Nikes 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 Nikes 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, Nikes 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.

Nikes 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.

Added Clarifications

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.

Question

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