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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 312)

C.Based upon the after-tax return on capital, would you accept or reject this project?

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.

B. After tax return on capital


Return on Capital for Nike Apparel:
Year 1 2 3 4 5 6 7 8 9 10 11 12 Average EBIT (1t) 0 0 -87 9 104 199 229 336 436 469 504 579 Average BV 1500 2310 2489 2258 2085 1959 2074 1999 1921 1827 1736 1282 -3.50% 0.40% 4.98% 10.16% 11.02% 16.81% 22.68% 25.68% 29.02% 45.15% 16.24% ROC

Table: Return on Capital for Nike Apparel

ROC
0.5 45.15% 0.4 0.3 0.2 0.1 0 1 -0.1 2 29.02% 25.68% 22.68% 16.81% 11.02% 10.16% 4.98% 0.40% -3.50% 3 4 5 6 7 8 9

ROC

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Figure: The return on capital

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.

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.

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.

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.

3.0 Sensitivity Analysis

Estimate the sensitivity of your numbers to changes in at least three of the key assumptions underlying the analysis.

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.

Sensitivity Analysis
Pricing 1 Year Price/unit in $ 1 2 3 units 10 10000 20000 20000 Pricing 1 Year Price/unit in $ 1 2 3 units 10 102000 175000 175000 Pricing 2 units 11 6500 16500 16500 Pricing 2 units 11 125000 232000 185000 Pricing 3 units 9 11500 21500 21500

Sales Forecast

Pricing 3 units 9 95000 155000 176000

Product Cost

Pricing 1 Pricing 2 Pricing 3 Year Price/unit in $ 1 2 3 units 10 55000 85000 85000 units 11 68000 16500 105000 units 9 45000 75000 75000

Marketing Cost

Table: Sensitivity Analysis of Sales Forecast, Product Cost, Marketing Cost

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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.

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