Question

Nike's management team is considering two projects, a golf club project and a helmet project.

A. Using the table below, calculate firm’s weighted average cost of capital:

Nike:

% of debt in capital structure 25%

% of equity in capital structure 75%

Before-tax required cost of debt 6%

Tax rate 30%

Cost of equity 11%

B. Capital Budgeting

Project information:

Golf club project Helmet project

Upfront costs (10,000,000) (8,000,000)

Annual cash flows Year 1 $0 $3,000,000

Year 2 $0 $3,000,000

Year 3 $4,000,000 $2,000,000

Year 4 $10,000,000 $2,000,000

1. Which project is superior using the payback method?

2. What is the IRR for both projects?

3. What is the NPV for both projects? Use the WACC you calculated in Part A as your discount rate.

4. Just based on the NPV and IRR data, would you choose both projects, one, or none. If one, which one? Explain your answer.

5. The data provided above does not contain any measure of the riskiness of the projects. What are two ways that we could adjust the analysis if it were determined that the golf club project was a much riskier project whose cash flow projections were much more uncertain?

6. What specific information would the management team need to gather if they wanted to consider the relative riskiness in terms of the “portfolio effect”?

Answer #1

Ans A) Firm's WACC = weight of debt * (1 - tax rate) * cost of debt + weight of equity * cost of equity

= .25*.7*6% + .75*11% = 9.3%

Ans B)

1. Helmet project is better using payback method because payback period for Helmet project is 3 Years.

2. IRR for projects are as follows

Golf Club | 0 | 1 | 2 | 3 | 4 |

cashflows | -10000000 | 0 | 0 | 4000000 | 10000000 |

PV | |||||

IRR | 9.51% | ||||

Helmet | 0 | 1 | 2 | 3 | 4 |

Cashflows | -8000000 | 3000000 | 3000000 | 2000000 | 2000000 |

PV | |||||

IRR | 10.47% |

3.

Golf Club | 0 | 1 | 2 | 3 | 4 |

cashflows | -10000000 | 0 | 0 | 4000000 | 10000000 |

PV | -10000000 | 0 | 0 | 3063370 | 7006794 |

IRR | 9.51% | ||||

NPV | 70164.4 | ||||

Helmet | 0 | 1 | 2 | 3 | 4 |

Cashflows | -8000000 | 3000000 | 3000000 | 2000000 | 2000000 |

PV | -8000000 | 2744739 | 2511198 | 1531685 | 1401359 |

IRR | 10.47% | ||||

NPV | 188981.1 |

4. I will select both project because IRR for both project is greater than WACC and NPV is positive for both project.

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Cost of equity 11%
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