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On August 3, 2007, Nike opened its first flagship store in Beijing. The calculated NPV250, as shown in the table below, was $1.6 million. The total present value of the cash flow projection was $** million over a period of ** years, with $**

million upfront investment. This investment is only for the construction and fixture costs to set the store251.

Table 22: NPV Calculation for NTB

Total Investment Construction Cost plus Fit-out $ **

PV of Projected Cash Flows252 $ **

Lease Term: * year with renew option

NPV253 $ 1.61

Viewed from the standpoint of financial return, this investment would be considered acceptable as project acceptance would provide an expected present value of $1.61 million. The measurement of return nevertheless does not consider the value associated with externalities, or the embedded option value in the investment.

In the RO methodology we use the same data for the present value of the

underlying asset (S) and the present value of the committed investment (X) which is also 250

The NPV here calculated is based on a five-year lease term, using the liquidation of the inventory at the end of the lease term to represent (partially) the termination values.

251 _{Much of the other R&D investments are already occurred as “sunk costs.”} 252

The NPV is calculated to include the final year’s working capital liquidation.

the strike price as in the NPV calculation. The tables below show the values of the six variables required to calculate the call option value of the investment in NTB.

As in previous NikeTown investment cases, the Nike Town Beijing is expected not only to generate commercial profits, but also to generate external benefits. These benefits may include the synergistic effects NTB will have on general sales in the region and the strategic values arising from Nike’s major presence in the regional and national retail segment of China. We have further proposed that using the standard deviation of the monthly rate of change of LiNing closing stock price from 2004-2011 is more appropriate for the analysis than using Nike’s stock price return. On an annualized basis, the standard deviation of sigma is 45.1% , compared to sigma of 33.8% used in previous three cases.

Table 23: Inputs for Option Valuation Variables in NTB Calculation – 5 Year (S): Present value of underlying asset - the

present value of cash flows expected from the investment opportunity.

$**

(X): the option strike price- The present value

of total committed investment $**

(r): risk-free rate 5%

(t): the period for which the investment

opportunity is valid ** Lease term

(σ): Sigma - Std_Dev Nke Qty Stock 1995-

2010 annulized 45.1%

Annualized LiNing Monthly Std_Dev LiNing Mthly Stock 2004-2011 (δ): Dividend payouts -when applicable cost of

delay – Annual cost of delay 1/n 0.00% Annual cost of delay = 1/n

Table 23 above lists the values of the six variables in the call option equation and the resulting call option value of $2.06 million. The positive value indicates that there is some additional embedded option value in the investment project, which reinforces the result from the NPV analysis. The primary contribution of the use of RO in the NTB case is to be found in the evaluation of the staging opportunity, as described next.

As an aside, we note that some analysts may argue that investment in the rapidly growing economy of China may introduce considerably more risk and uncertainty than are typically present in developed countries. Thus, they might want to adjust upward the hurdle rate to accommodate the higher risk and uncertainty. These risks could also include currency and political risks in addition to the risk associated with higher growth of an emerging economy. On the other hand, one might also argue that the low

correlation of China’s securities markets with the more developed securities markets of the Western industrialized economies may be indicative of diversification possibilities that can decrease systematic risk as well as provide better diversification of unsystematic risk. This latter argument could result in a lower the cost of capital of the multinational firm254.

In normal practice, a retail store of such size and scale would expect to remain in operation between 10-30 years. This is particularly the case in China, where the market is seen as a strategically important market for the company in the long term. It is very likely

254 _{See for example, Rene M. Stulz, “Globalization of Capital Markets and the Cost of Capital: the case of}

Nestle”, Journal of Applied Corporate Finance, Fall 1995, pp 30-38, and Ali Fatemi, “Shareholder Benefits from Corporate International Diversification, Journal of Finance, Dec. 1984, pp. 1325-1344.

that the company will exercise its option to extend the lease for an addition ** years at the termination of the initial ** year lease term. The reasons why the company only entered a **-year lease have not been publicly disclosed. Although it is possible that the **-year lease term could simply be due to local real estate regulations or have been unilaterally imposed by the landlord, we believe one of the key reasons could be the unique market risk posed by China at the beginning of the 21st Century.

As 2012 is a year of major political leadership change for China255, the decision by the company to sign a **-year lease with an option to renew for an additional ** year term appears to be a very shrewd way to hedge its bet in China. The short-term renewable lease provides an example of a “staging investment” experiment conducive to the

application and understanding of embedded option value. In other words, by holding the short-term renewable lease, the lessee has the option to plan a second stage of investment based upon uncertain events unfolding. That option has value and is embedded in the initial renewable lease.