1. Accounting Return Analysis

A. Estimate the operating income from the

proposed apparel division investment to Nike

over the next 12 years.

B. Estimate the after-tax return on capital

for the operating portion of this period

(Years 3-12)

C.Based upon the after-tax return on capital,

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

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.

Choices on depreciation have profound effects on return on capital. Using a

more accelerated depreciation method would raise return on capital

substantially.

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B. After tax return on capital

Return on Capital for Nike Apparel:

Year EBIT (1-t) Average BV ROC

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%

Average     16.24%Table: Return on Capital for Nike Apparel

ROC

-3.50%0.40%

4.98%10.16%11.02%

16.81%

22.68%25.68%

29.02%

45.15%

-0.1

0

0.1

0.2

0.3

0.4

0.5

1 2 3 4 5 6 7 8 9 10 11 12

ROC

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 the after-tax incremental 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 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.

Develop a net present value profile and

estimate the internal rate of return for this

project.

C.If the apparel division is expected to have a

life much longer than 12 years, estimate the

net present value of this project, making

reasonable assumptions about investments

and cash flows after year 12. Develop a net

present value profile and 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:

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 assumptions underlying the analysis.

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Sensitivity analysis:

A technique used to determine how different values of an independent 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 bond's price. Sensitivity analysis is a way to predict the outcome of a

decision if a situation turns out to be different compared to the key

prediction(s). Sensitivity analysis is very useful when attempting to determine

the impact the actual outcome of a 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 example, an analyst might create a financial model that will value a

company's equity (the dependent variable) given the amount of earnings 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 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 analysis technique to determine how to change of assumptions 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

versus what was assumed. Sensitivity analysis can be several types like

manually change assumptions, Threshold values, minimum/base case/maximum

and one or two data table.

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Sensitivity Analysis

Pricing 1 Pricing 2 Pricing 3

Sales Forecast

Year units units units

Price/unit in $ 10 11 9

1 10000 6500 11500

2 20000 16500 21500

3 20000 16500 21500

Pricing 1 Pricing 2 Pricing 3

Product Cost

Year units units units

Price/unit in $ 10 11 9

1 102000 125000 95000

2 175000 232000 155000

3 175000 185000 176000

Pricing 1 Pricing 2 Pricing 3

Marketing Cost

Year units units units

Price/unit in $ 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

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

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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.

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