NIKE

Case Study Solutions

Professor Corwin

This case study includes several problems related to the valuation of Nike. We will work through these
problems throughout the course to demonstrate some of the most important steps in a valuation from start
to finish. The problems will be assigned individually as a component of your regular homework.
However, please note that the solution from one problem may carry over as an important input on
subsequent problems. You should therefore consider the case study not as a set of individual problems,
but as one larger assignment that will be completed in steps.

To solve the Nike problems, you will make use of Nike’s most recent financial statements as well as the
notes to the financial statements. Nike's financial statements from the most recent fiscal year ending May
31, 2014 are included with this document. The notes to the financial statements and full 10K are
available on the class web site.

An overview of the individual questions and their relation to the lecture topics is provided below.

• Question 1 – Financial Ratio Analysis (Lecture 1)

• Question 2 – Cost of Capital (Lecture 2)

• Question 3 – Operating Lease Adjustments (Lecture 3)

• Question 4 – Capitalization of Advertising Expenses (Lecture 3)

• Question 5 – Taxes (Lecture 3)

• Question 6 – Estimating Cash Flows (Lecture 3)

• Question 7 – Fundamental Growth in Earnings (Lecture 4)

• Question 8 – Cash Flow Discounting and Stock Price Estimation (Lecture 5)

• Question 9 – Relative Valuation (Lecture 6)

1. Financial Ratio Analysis

a. Using Nike's financial statements and any additional resources that are necessary, calculate the
profitability ratios we discussed in class (ROC, ROE, After-tax Operating Profit Margin, Net
Profit Margin). Compare these ratios to those we calculated in class for Home Depot and note any
important similarities/differences between the two firms. For the purposes of this assignment, we
will assume that Nike and Home Depot are comparable firms.

As in my Home Depot calculations, I will use the beginning of period (previous fiscal year) debt
and equity values when computing ROC and ROE. It would also be acceptable to use the average
of beginning and ending period balance sheet values. The profitability ratios for Nike are as
follows:

851
Effective Tax Rate = = 24.0%
3544

(12446 - 8766)(1 - .240) 2796.8

Aftertax Operating Profit Margin = = = 10.06%
27799 27799

2693
Net Profit Margin = = 9.69%
27799

(12446 - 8766)(1 - .240) 2796.8 2796.8

Return on Capital = = = = 22.47%
(57 + 98 + 1210) + 11081 1365 + 11081 12446

2693
Return on Equity = = 24.30%
11081

EBIT equals Gross Profit less total selling and administrative expenses, or
12446 - 8766 = 3680. The debt used for the ROC calculation includes all short-term and long-
term debt, including the current portion of long-term debt and notes payable. As noted above, for
the ROE and ROC where we compare an income statement number to a balance sheet number, I
am using the beginning of period balance sheet value. It would also be acceptable to use the
average of the beginning and ending period balance sheet values. Using average debt (1369.0)
and average equity (10952.5) gives ROC=22.70% and ROE=24.59%.

The comparable values for Home Depot are 36.4%, 7.40%, 6.83%, 20.40%, and 30.29%,
respectively. Nike's profit margins and ROC are significantly higher than those for Home Depot
and the firm's effective tax rate is lower. By these measures, Nike is more profitable and has
lower costs than Home Depot. However, Nike’s ROE is lower than that for Home Depot. As
shown on the next page, this is driven primarily by Home Depot’s use of leverage.

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b. Show the decomposition of Nike’s Return on Capital (ROC) into After-tax Operating Margin and
Capital Turnover. Show the decomposition of Nike’s Return on Equity (ROE) into Net Profit
Margin, Capital Turnover, and Financial Leverage. What do these decompositions suggest about
the performance of Nike relative to Home Depot's performance, as discussed in class?

As shown in part (a), the ROC for Nike is 22.47%, which is significantly higher than what we
calculated for Home Depot (20.40%). Nike's ROC can be decomposed into an after-tax operating
margin and capital turnover ratio as follows:
(12446 − 8766)(1 − .240)  2796.8   27799 
Return on Capital (ROC) = = × 
(57 + 98 + 1210) + 11081  27799   12446 

= 22.47% = 10.06% × 2.234

Nike's capital turnover (2.23) is slightly lower than Home Depot's (2.76), while its operating
margin (10.06%) is significantly higher than Home Depot’s (7.40%). Thus, Nike's higher ROC
appears to be driven by Nike's higher operating margins (lower costs), rather than by Nike's
ability to generate sales (capital turnover).

As shown in part (a), the ROE for Nike is 24.30%, which is lower than what we calculated for
Home Depot (30.29%). Nike's ROE can be decomposed into net profit margin, capital turnover
ratio, and financial leverage, as follows:

2693  2693   27799   12446 

Return on Equity (ROE) = = × × 
11081  27799   12446   11081 

= 24.30% = 9.69% × 2.234 × 1.123

As in part (a), Nike's capital turnover ratio (2.23) is slightly lower than that of Home Depot
(2.76). In addition, Nike’s net profit margin (9.69%) is significantly higher than Home Depot’s
(6.83%). Nonetheless, Home Depot’s ROE is higher than Nike’s. This can be explained by the
fact that Home Depot's ROE is driven up by its use of leverage, which is much higher than that of
Nike. Without this leverage, Home Depot's ROE would look much worse relative to that of Nike.

We can also decompose ROE as a function of ROC, as follows:

Return on Equity (ROE) = ROC − (ROC − i (1 − T ) )
D
E
= .2247 +
1365
(.2247 − (.0996)(1 − .240) )
11081
= .2247 + (.1232)(.2247 − .0757) = .2247 + .0184 = 24.30%
(33 + 103)
where i = = 9.96%
1365

This breakdown illustrates the large leverage effects in the ROE for Home Depot in comparison
to Nike. Note that in order for this decomposition to work, we must use Nike’s “net interest
expense” rather than actual interest expense. The “net interest expense” includes both interest
expense and “other” income or expense that is listed on the income statement below operating
income. This issue is discussed in more detail below.

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Additional Comments on the Effects of Non-Operating Income and Expenses:

In the analysis above, calculations for net profit margin and ROE are based on the Net Income as listed on
the income statement. One issue that we have ignored in these calculations is the effect of investment and
“other” income/expenses. To perform the valuation carefully, we should remove these non-operating
income and expense items from Net Income.

The income statement lists “interest expense (income), net” of $33 million and “other expense (income),
net” of $103 million. Both income items are added before arriving at the Net Income number of $2,693
million. Although it is not completely clear, note 6 to the financial statements suggest that “interest
expense (income), net” includes $5 million in income related to available-for-sale securities. Recognizing
the inclusion of this $5 million investment income, suggest that the firm’s actual interest expense was
approximately $38 million (resulting in the $33 million net figure). The $103 million expense listed in the
“other expense (income)” line item also appears to be related primarily to derivatives positions (see note
17). Together with the non-operating income included in net interest expense, this gives a total non-
operating expense of $98 million ($103 – $5).

To perform a careful analysis of net income and free cash flow to equity, we should attempt to eliminate
the effects of investment income and expenses. We can then value the firm’s investments and derivatives
positions separately and adjust the valuation to account for these investments. To be more specific we
should subtract from Net Income the after-tax value of non-operating income and add back to Net Income
the after-tax value of non-operating expenses. As noted above, this would leave $38 million in interest
expenses on the income statement. Note that adjustments to income should be made based on the
marginal tax rate. As we will discuss in the question 5 of the Nike Case Study, the marginal tax rate for
Nike is 24.4%.

The adjusted values of Net Income and ROE would then be calculated as follows:

(Adjusted) Net Income = 2693 + (103 − 5)(1 − .244) = 2693 + 74.09 = 2767.09

2767.09
(Adjusted) Return on Equity = = 24.97%
11081

In subsequent Case Study questions, I will use this adjusted measure of Net Income as my starting point
for any analysis of Free Cash Flow to Equity (FCFE) or fundamental growth in Net Income.

Related highlights from the financial statements and notes are provided in the appendix.

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 Appendix:

Question 1:
Balance Sheet Information:

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Income Statement Information: