Nike Contingent Claim and Timing Option

Assume that you are a consultant to Nike Corporation.  As a consultant, you are to advise the Vice President for Planning, regarding the two projects below.  The officer has no knowledge of finance and your expertise is the area of capital budgeting and, in particular, options analysis of strategic investment decisions.  Within your analysis you need to accomplish several very general goals: First, you need to convince the officer that the options approach is the right approach and superior to straight NPV analysis.  Second, you must clearly lay out the steps in the analysis and why they are required.  Finally, an interpretation of the results is necessary. 

There are two investment opportunities that Nike is considering.  The first involves investment in a new proprietary technology that the firm must decide on quickly or the opportunity will disappear.  This is referred to as the contingent claim.  The second involves deciding on whether a current investment opportunity should be undertaken now or later.  Competition is not knocking on the door so immediate investment in not required.  This is referred to as the timing option.  The risk-free rate of interest is 3.3% and the cost of capital is 12%. 

The Contingent Claim

Nike can invest in a proprietary technology now to produce an alloy metal tennis racket.  The project will require an investment of $50 million and produce cash flows over the next 10 years of $8 million annually, after taxes, expenses and depreciation.  However, it was pointed out by one manager, that there is another very interesting side benefit of this technology, which may be applied in the baseball market, from tee-ball to college baseball. 

Currently there is an interest in baseball to move away from metal bats due to the dangerous exit speed of the ball when hit.  However, there is still the concern that wood bats are very expensive for teams to adopt since they are much less durable than a metal bat.  This proprietary technology would enable Nike to produce a metal bat that is in every way like a wood bat except that these bats would be as durable as current metal bats.  However, it is uncertain whether this market will develop.  Metal bat producers have large investments in their own technology and have lobbied heavily to retain the current metal bat.  If a new standard for metal bats is to develop, it will happen in 4 years. 

The new project will require additional investment in equipment listed below.  The following data should be considered in your analysis:

                        Equipment                               $42 million

                        Equipment life                                     8 years

While the marketing department thinks that the cash flows could be as high as $16 million (estimated probability of 60%), they could also be as low as $2 million (estimated probability of 40%).  Given these probabilities the expected cash flow today would be $10,400,000.  These percentages relate to expectations concerning the industry as a whole.  Clearly, this is a very risky venture, however, if the company does not move now Nike will be absolutely precluded from this market.  What would you advise upper management to do?

The Timing Option

Nike has the opportunity of investing in a plant and equipment capable of producing a new very lightweight running shoe.  There is some additional uncertainty as to how the market will develop given the current state of the economy.  This uncertainty suggests the possibility of delaying the project for several reasons: First, competition is not coming out with any new products that would force Nike to need to be in the market first.  Second, if the market goes up, this project could pay off nicely, but if not, it could spell disaster.  It is estimated that the company has a window of opportunity two years out. 

It is expected that the initial cash flow will be $8.231 million.  The standard deviation of the cash flows is estimated to be 30% per year.   The total investment will be $60 million.  Assume that the project has an infinite life.  When should Nike invest?