Nike: To Do or Not to Do! Aswath Damodaran Stern School of Business Aswath Damodaran! 1!
Executive Summary! On a stand-alone basis, this project is a mildly positive project, albeit not a great one. The average return on capital, even under the more conservative finite life assumption, is 16.24%, which is higher than the cost of capital of 10.84%. The net present value of this project, using a cost of capital of 10.84% is $ 79 million, under the conservative assumption of a finite life of 10 years is $ 236 million, under the more realistic assumption of an infinite life On the two variables that are the most critical - market share and operating margin - the firm has a small margins for error on both variables.. If we consider the potential project synergies (i.e. the gains to the shoe division from having an apparel division), it will make this project a more attractive one. Aswath Damodaran! 2!
Choices for Analysis! Firm or Equity Analysis Firm Equity Earnings Operating Income (after tax) Net Income Book Value Book value of capital Book value of equity Accounting return Return on capital Return on equity Cash flows Cash flow before debt Cash flow after debt Discount rate Cost of capital Cost of equity Decided to go with a firm analysis (Less work ) Nominal or Real Analysis The information on earnings and discount rates is provided in nominal terms but the inflation rate is also provided. We chose to leave everything in nominal terms. Alternatively, we could have made our nominal cash flows into real cash flows and nominal discount rate into a real discount rate, by taking inflation out of both. Aswath Damodaran! 3!
Cost of capital for the project: Three caveats! Book values versus market values: While the book values of debt and equity are accessible on the balance sheet, the cost of capital is computed based upon markets. Nike s current beta and cost of capital: Since the project is in a new business, the current beta (levered or unlevered) for Nike is not relevant and neither is a blended beta of any sort. Effective versus Marginal tax rates: The after-tax cost of debt is a function of the marginal tax rate, not the effective tax rate. Aswath Damodaran! 4!
Weights for Debt and Equity! Market Value of Equity = $ 106.79* 368.94 mil = $ 39,400 mil Market Value of Interest bearing Debt = $34 (PV of annuity, 5 yrs, 4%) + $663.1/1.04 5 = $ 696 million PV of lease commitments Discounted back at pre-tax cost of debt of 4% Treated lump sum of $535 as an annuity for 2 years Market Value D/E Ratio = (669+1598)/39400= 5.82% MV Debt/Capital Ratio = 2267/(39400+2267) =5.50% Aswath Damodaran! 5!
Unlevered Beta for the Apparel Business! The simple average beta is skewed by outliers in the D/E ratio. I will use the median beta value, but I could have gone with the aggregate (weighted average), since it reflects larger firms in the sample. Aswath Damodaran! 6!
Cost of Capital: Nike Apparel! Cost of equity computation Riskfree Rate = 3% Equity Risk Premium =6%*.5+ 7.05%*0.2+9.00%*0.2+8.63%*0.1= 7.07% Levered beta = 1.14*(1+(1-.4)(.0582)) = 1.1786 Cost of Equity = = 3% + 1.1786(7.07%) = 11.34% Cost of debt computation Default Spread based upon rating = 1.0% Pre-tax cost of debt = 3% + 1.0% = 4% After-tax cost of debt = 4% (1-.4) = 2.4% Cost of capital calculation for apparel project Debt to Capital Ratio = 5.50% Cost of Capital = 11..34% (.945) + 2.4% (.055) = 10.84% Aswath Damodaran! 7!
Your estimates of cost of capital! Aswath Damodaran! 8!
Operating Income for Nike Apparel! In years 3 and 4, the project will lose money but Nike will offset these losses against other profits to save taxes. Aswath Damodaran! 9!
Some Thoughts on Operating Income...! There are a number of allocation mechanisms that can be used to compute operating income, and the return on capital is affected by decisions on allocation. For instance, I allocated the entire investment in the distribution system expansion to this project. If I had chosen to allocate 50%, the return on capital would have been much higher. Your choices on depreciation have profound effects on return on capital. Using a more accelerated depreciation method would raise your return on capital substantially. Note that the operating income is computed after marginal taxes (Why?) and does not include the tax savings due to interest expenses (Why?) Aswath Damodaran! 10!
Nike Apparel: Return on Capital! Aswath Damodaran! 11!
Your estimates of return on capital! Aswath Damodaran! 12!
Nike Apparel: After-tax Cash Flows! Includes book value of fixed assets and working capital at the end of year 12 Aswath Damodaran! 13!
Observations on Distribution System! The distribution system investment shows up in a number of ways: In year 6, I show a negative cash flow because of the investment Nike has to make in the distribution system. In year 11, I show the saving due to the fact that Nike does not have to make the investment in the distribution system. Between years 6 and 11, I include the depreciation associated with Nike making the investment early. (I used a 20-year life and double declining balance depreciation but I could very well have used straight line) The effect on the NPV is the difference in present values between investing in year 6 versus year 11: PV of investing early = 1126/1.1084^6 1243/1.1084^11 = - $206.5 million The depreciation tax benefits reduce this cost a little. Aswath Damodaran! 14!
Nike Apparel: NPV and IRR! Internal Rate of Return = 11.26% Aswath Damodaran! 15!
Your estimates of NPV Finite life! Aswath Damodaran! 16!
Nike Apparel: Infinite Life! Aswath Damodaran! 17!
Observations on Infinite Life! To make this project have infinite life, with a growth rate of the inflation rate, I have to preserve existing assets. I have assumed that the replacement of depleted assets will occur at a cost 2% over the depletion rate. Thus, to replace the assets that are depleted in year 1 (captured in the depreciation of $ 300 million), I assume that capital maintenance has to be $ 306 million. This additional capital maintenance will increase book value and depreciation in subsequent periods. None of the assets are salvaged in this case, since the project continues forever. If I had assumed a shorter extension after 10 years, there would have been lower capital maintenance expenditures all the way through. The net present value does not change much. Aswath Damodaran! 18!
Terminal Value and NPV Calculations! Assumed cashflows grow at the inflation rate after year 12. Terminal value in year 12 = CF in year 13/( Cost of capital - g) = 555/(.1084 -.02) = $6,268 million IRR of project = 11.75% Aswath Damodaran! 19!
Consistency in growth and investment assumptions! After year 12 Capital Expenditure Assumption Project ends No (or very low) capital maintenance Let assets run down towards end of life Infinite life; g=0% Capital maintenance = Depreciation Maintain invested capital at base level Infinite life; g= inflation Capital maintenance > Depreciation Capital invested has to grow at inflation rate Infinite life; g> inflation Capital investment to increase capacity Capital maintenance > Depreciation Capital invested has to grow to reflect real growth Aswath Damodaran! 20!
Your estimates of NPV Longer life! Aswath Damodaran! 21!
NPV, Market Share and Operating Margin! NPV, Market Share and Margin $2,000 Breakeven = 15% $1,500 Breakeven = 17% $1,000 Breakeven = 19% $500 Breakeven = 22% $0 Breakeven = 26 % -$500 -$1,000 16% 17% 18% 19% 20% EBITDA Margin 21% 22% 23% 24% 25% 3% 4% 7% 6% 5% Target Market Share Aswath Damodaran! 22!
Your decision on the investment! Aswath Damodaran! 23!
The big lessons..! When assessing an investment, consider the risk of the investment in making the decision, not the risk of the investor. Be consistent about matching cash flows to discount rates. If your cash flows are after debt payments, i.e., equity cash flows, your discount rate should be a cost of equity. If they are before debt payments, your discount rate should be a cost of capital. If your cash flows are in a specific currency, your discount rate should be in that currency too. Always look at incremental cash flows. Make assumptions about reinvestment (cap ex) that are consistent with your assumptions about how long your investment will last and how fast it will grow. Aswath Damodaran! 24!