On a stand-alone basis, this project is a good project, albeit not a great one.
• The average return on capital, even under the more conservative finite life assumption, is 13.25%, which is higher than the cost of capital of 8.20%.
• The net present value of this project, using a cost of capital of 8.20%
• is $ 399 million, under the conservative assumption of a finite life of 10 years
• is $ 1099 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 reasonable margin for error on market share and a narrower margin for error on operating margins.
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
Operating Income (after tax)
Book value of capital
Return on capital
Cash flow before debt
Cost of capital
Equity
Net Income
Book value of equity
Return on equity
Cash flow after debt
Cost of equity
Earnings
Book Value Accounting return Cash flows Discount rate
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 = $ 62* 493 mil = $ 30,566 mil
Market Value of Interest bearing Debt = $40.3 (PV of annuity, 5 yrs, 4.50%) + $812.1/1.0455 = $ 829 million
PV of lease commitments
Discounted back at pre-tax cost of debt of 4.5%
Treated lump sum of $588 as an annuity for 2 years
Market Value D/E Ratio = (829+1520)/30566= 7.68%
MV Debt/Capital Ratio = 2349/(30566+2349) =7.13%
5!
Aswath Damodaran!
Unlevered Beta for the Apparel Business !
Regression Beta Debt to Equity Ratio Unlevered Beta Cash/Firm Value Unlevered beta corrected for cash
Median 1.41 50.68% 1.0827 4.93% 1.1388
Aggregate 1.45 23.61% 1.2662 6.95% 1.3608
Average 1.41 839.36% 0.2337 17.49% 0.2833
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.
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 !
Year EBIT(1-t) + Deprec'n + Fixed Allocated Exp (1-t) - Cap Ex - Opp. Cost of Dist'n System - Chg in WC + Salvage Value After-tax Cashflow 0
$ $ $ $ $
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 = 1126/1.082^6 – 1243/1.082^11 = - $179 million
The depreciation tax benefits reduce this cost a little.
Nike Apparel: Infinite Life !
Year EBIT(1-t) + Deprec'n +Allocated Corporate G&A (1-t) - Cap Ex - Opp. Cost of Dist'n System - Chg in WC + Salvage Value ATCF 0
$ $ $ $ $
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)
Consistency in growth and investment assumptions !
After year 12 Project ends
Infinite life; g=0%
Capital Expenditure Assumption
No (or very low) capital maintenance
Let assets run down towards end of life
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