1. Accounting Return Analysis
A.
Estimate Estimate the operatin operating g income income from the
propose proposed d apparel apparel division division investme investment nt to Nike over the next 12 years.
B.Esti B.Estimat mate e the afterafter-tax tax retur return n on capita capitall for the operating portion of this period (Years 312)
C.Base C.Based d upon upon the the after after--tax tax retu return rn on capi capita tal, l, would you accept or reject this project?
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A. 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. There are a number of allocation mechanisms that can be used to compute oper op erat atin ing g inco income me,, and and the the retu return rn on capi capita tall is affe affect cted ed by deci decisi sion onss 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. Choices on depreciation have profound effects on return on capital. Using a more mo re acce accele lera rate ted d depr deprec ecia iati tion on metho ethod d wou ould ld rais raisee retu return rn on capit apital al substantially.
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B. After After tax return return on capital Return on Capital for Nike Apparel:
Year
EBIT (1t)
Average BV
1
0
1500
2
0
2310
3
-87
2489
-3.50%
4
9
2258
0.40%
5
104
2085
4.98%
6
199
1959
10.16%
7
229
2074
11.02%
8
336
1999
16.81%
9
436
1921
22.68%
10
469
1827
25.68%
11
504
1736
29.02%
12
579
1282
45.15%
ROC
Average
16.24%
Table: Return on Capital for Nike Apparel
ROC 0.5 45.15% 0.4
0.3
29.02% 25.68% 22.68%
0.2
ROC
16.81% 11.02% 10.16%
0.1
4.98% 0 1
2
0.40% -3.50% 3 4 5 6
7
8
9
10 10
11
12
-0.1
Figure: The return on capital
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C. Decision Regarding Project Investment
Based on the after tax return on capital over 12 years we can see that, on average the return percentage is 16.24% which is positive. In year 3, the though the return is negative but in year 4 it covered up and from year 5 to year 12 the return on capital is increasing. So the project is accepted.
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2. Cash Flow Analysis
A.
Estimate Estimate the after-tax after-tax increme incrementa ntall cash
flows from the proposed apparel investment to Nike over the next 12 years.
B.If the project is terminated at the end of the 12th year, and both wo wor rking capital and inve invest stme ment nt in ot othe her r asse assets ts can can be sold sold fo for r book value at the end of that year, estimate the net present value of this project to Nike. Develop a net present value profile and estimate the internal rate of return for this project. project.
C.If the apparel division is expected to have a life much longer than 12 years, estimate the net net pre present ent valu value e of thi this proje roject ct,, mak making reaso reasona nable ble assum assumpti ption ons s about about inves investme tment nts s and cash flows after year 12. Develop a net present present
value value
profile profile
and
estimate estimate
the
internal rate of return for this project.
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A. After-tax Cash Flows for Nike Apparel:
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.
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Assumption: Assumption:
Based on the after tax return on capital over 12 years we can see that, on average the return percentage is 16.24% which is positive. In year 3, the though the return is negative but in year 4 it covered up and from year 5 to year 12 the return on capital is increasing. So the project is accepted.
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3.0 Sensitivity Analysis •
Estimate the sensitivity of your numbers to changes in at least three of the key key assumptio ption ns under derlyin lying g the analysis.
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Sensitivity analysis: A technique used to determine how different values of an independent variable variable will impact a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that will depend on one or more input variables, such as the effect that changes in interest rates will have on a bo bond nd's 's pric price. e. Sens Sensit itiv ivity ity analy analysi siss is a way way to pred predict ict the the ou outc tcom omee of a deci decisi sion on if a situ situat atio ion n turn turnss out to be diffe iffere rent nt com compare pared d to the the key prediction(s). prediction(s). Sensitivity Sensitivity analysis is very useful when when attempting attempting to determine determine the impact the actual outcome of a particular particular variable will have if it differs from what was previously assumed. By creating a given set of scenarios, the analyst can determine how changes in one variable(s) will impact the target variable.
For For exam exampl ple, e, an anal analys ystt migh mightt crea create te a fina financ ncia iall mo mode dell that that will will valu valuee a company company's 's equity equity (the (the depend dependent ent variabl variable) e) given given the amount amount of earning earningss per share (an independent variable) the company reports at the end of the year and the company's price-to-earnings multiple (another independent variable) at that time. The analyst can create a table of predicted predicted price-to-earnings price-to-earnings multiples and a corresponding value of the company's equity based on different values for each of the independent variables. It is an analy analysis sis tech techniq nique ue to dete determi rmine ne ho how w to chang changee of assum assumpti ption onss or variables (sales volume, investment size etc) used in a certain financial model will affect the result (profitability, NPV, IRR etc). It is an effective way to understand the outcome of a decision if the situation turns out to be different vers versus us what what was was assu assume med. d. Sens Sensit itiv ivit ity y anal analys ysis is can can be seve severa rall type typess like like manually change assumptions, Threshold values, minimum/base case/maximum and one or two data table.
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Sensitivity Analysis
Sales Forecast
Product Cost
Year Price/unit in $
Pricing 1
Pricing 2
Pricing 3
units
units
units
10
11
9
1
10000
6500
11500
2
20000
16500
21500
3
20000
16500
21500
Year Price/unit in $
Pricing 1
Pricing 2
Pricing 3
units
units
units
10
11
9
1
102000
125000
95000
2
175000
232000
155000
3
175000
185000
176000
Pricing 1 Pricing 2 Pricing 3
Marketing Cost
Year Price/unit in $
units
units
units
10
11
9
1
55000
68000
45000
2
85000
16500
75000
3
85000
105000
75000
Table: Sensitivity Analysis of Sales Forecast, Product Cost, Marketing Cost
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The average average return return on capital capital,, even even und under er the more conser conservati vative ve finite finite life 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 project synergies synergies (i.e. the gains to the shoe division division from having an apparel division) it will make this project a more attractive one.
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