With its dominance of the athletic shoe and sporting apparel businesses, Nike generated $2.81 billion in operating income on revenues of $20.9 billion in the fiscal year that ended in May 2011. While its stock price has rebounded in the last three years (see Exhibit 1), its sales and earnings are being affected by increased competition from both established firms (like Reebok and Adidas) and upstarts (such as Under Armour). Exhibit 2 summarizes Nikes income statement for the last 4 years, and Exhibit 3 summarizes its balance sheet for the last 2 years.

Nike, which currently views itself as operating in the sporting wear (shoes and clothes) segment, 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 $ 1.4 billion to establish a presence in this business. Of this amount, the total investment will be spent right now acquiring land, equipment and other assets needed for the business. The business will be operational at the start of the third year.

2. The initial investment is fully depreciable over 12 years starting in the third year (consider 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 Nikes potential in the market. 1

4. The total market for casual apparel is estimated to be $ 75 billion currently, growing at 4% a year. Nike is expected to gain a 2.5% 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 eighth year.2 Beyond that point, Nikes revenues are expected to grow at the same rate as the overall market. Nike expects to generate 50% of the apparel revenues to come from the United States, 20% from China, 20% from India and 10% from Brazil.

5. The pre-tax gross profit margins (prior to depreciation, advertising expenses and allocations of corporate costs) are expected to be 23% of revenues.

6. Nike will allocate 5% of its existing general and administrative costs to the new division. These costs now total $ 2 billion for the entire firm and are expected to grow 5% a year for the next 15 years, irrespective of whether Nike enters the apparel business. In addition, it is expected that Nike will have an increase of $ 80 million in general and administrative costs in year 3 when the new division starts generating revenues, and that this amount will grow with the new divisions 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. Nike spent $ 1 billion in advertising expenses in the most recent year and expects these expenses to grow 4% a year for the next 15 years, if the casual apparel division is not created. 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 from year 3 (the first year of sales for the division) to year 15.

8. Nike expects to finance this apparel division using a loan at the beginning of the second year of $390 million at interest rate of 12.5% per year for 12 years the loan amortization (principal and interest) will start at the beginning of the third year.

9. Nikes cost of capital is 9.5% and the effective tax rate is 30%

Added Clarifications

1. 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.

2. Depreciation: For any assets that you may invest in, where no depreciation schedule is given, assume straight line depreciation and a reasonable life.

3. Accounting allocations: If you have to allocate any expenses, where an allocation schedule is not provided, make a reasonable assumption about allocation and move on.

4. For tax purposes, only the amount of the interests is deductible.

Questions.

1. Estimate the pre-tax cash flows, net present value, internal return rate and annual equivalent value from the proposed apparel investment to Nike over the next 15 years.

2. Estimate the after-tax cash flows, net present value and internal return rate from the proposed apparel investment to Nike over the next 15 years.

3. Based upon the after-tax analysis, would you accept or reject this project? Explain, briefly.

Exhibit 1: Nike -Stock Prices EquityGP DELAY 11:05 Vol 516,501 0p 108.89 B Hi 108.96 D Lo 108.07 D ValTrd 56061104 GP Line Chart Mov. Avgs Mov. Avg Currency Upper Lower ISD eEvents 09/30/08-03/01/12 Trade Line eriod lone 49 2012 Australia 61 3777 0600 Bree1& SS11 3049 4S00 Europ. 44 20 7220 7900 Geraenu 49. 69 9204 1210 Hon Keng esz 2977 s000 N636136 E7 nt-s:00 6653-16-0 1-fer-2012 11 20-42 Exhibit 1: Nike -Stock Prices EquityGP DELAY 11:05 Vol 516,501 0p 108.89 B Hi 108.96 D Lo 108.07 D ValTrd 56061104 GP Line Chart Mov. Avgs Mov. Avg Currency Upper Lower ISD eEvents 09/30/08-03/01/12 Trade Line eriod lone 49 2012 Australia 61 3777 0600 Bree1& SS11 3049 4S00 Europ. 44 20 7220 7900 Geraenu 49. 69 9204 1210 Hon Keng esz 2977 s000 N636136 E7 nt-s:00 6653-16-0 1-fer-2012 11 20-42