Capital Budgeting Analysis
Johnson & Johnson manufactures and markets pharmaceuticals for both the health care and consumer markets. They have demonstrated strong financial performance over the past five years, and this has been rewarded in the market with a stable stock multiple. They have strong solvency and reasonable liquidity. They have slow but steady growth, and have been able to maintain consistently high margins. A financial ratio analysis reveals no major weaknesses, although their liquidity could be stronger.
The firm’s capital structure is comprised mainly of equity. Based on market value, equity is 82.15%, short-term liabilities 9.45%, long-term liabilities 8.4%. JNJ has no preferred shares.
We calculated before and after-tax costs of debt, using the after-tax figure in our calculations. The after-tax cost of short-term debt for JNJ is 1.7127% and the after-tax cost of long-term debt is 3.9447%. The cost of equity based on DCF, CAPM, and BYPRP was estimated to be 5.19%. Therefore the WACC was determined to be 4.7568%.
The cash flows included a high initial outlay. However, depreciation costs and strong sales give the project strong positive cash flows in years 1-6. However, operating costs increase more quickly than sales, which means that by years 7 and 8 the cash flows from operations turn negative. Year 8’s present value is only positive because of the $30 million salvage value.
The project yielded a net present value of 11 million dollars, based on the WACC calculated and the cash flow estimates over the 8-year time horizon. The IRR was 9%, and MIRR 5.03%. The payback period, discounted, stretches to the end of the sixth year on an eight-year project.
However, a sensitivity analysis reveals that the project is highly sensitive to the unit price, and to cost factors. The long-term time frame and high degree of sensitivity call into question the risk inherent in the project. So while the NPV and other traditional tools for making capital budgeting decisions point to a decision to undertake the project, this risk of a strong negative downturn in the project causes a recommendation against it.
Financial Ratio Analysis
The I have selected is Johnson & Johnson (JNJ: NYSE), a multinational conglomerate that operates over 250 different companies in 57 countries. JNJ has three main business: consumer health care, medical devices and diagnostics, and pharmaceuticals. Consumer health care is comprised of seven different types of consumer products, sold in over 100 countries. This market is over-the-counter and targeted to the mass market. Medical devices and diagnostics includes surgical equipment, a range of diagnostic products. This group has nine key units the key target market is hospitals, with the exception of Johnson & Johnson Vision Care, which markets contact lens. The pharmaceuticals segment is broken down into three main units. JNJ largely focuses on serious diseases, and the products are targeted at consumers.
Liquidity ratios indicate a firm’s ability to meet its upcoming financial obligations. Johnson & Johnson has a long-term trend of high liquidity. In the last quarter they had a positive income expense due to interest gains from investments. Their current and quick ratios for the past five years are as follows:
Johnson & Johnson’s liquidity is decent, but has seen some erosion over the past five years. The company has seen some growth over the past couple of years, as well as an increase in operating expenses, resulting in the liquidity erosion. Their liquidity ratios have long trailed those of the industry and sector, and this has not changed of late. Their ratios are more in line with those of the S&P 500.
Asset management ratios measure a firm’s ability to generate sales from its asset base. The key asset management ratios for Johnson & Johnson over the past four years are:
Both of these ratios are relatively stable over this time period. There has been, however, a slight deterioration in the past couple of years. Both the receivables turnover and inventory turnover are much higher than the industry and sector averages, which are below zero. JNJ’s asset management ratios are stronger than the S&P average as well.
Debt management ratios measure a firm’s financial leverage. These ratios measure solvency, the long-term version of liquidity. The ultimate goal is to measure a firm’s ability to weather long-term financial distress. For Johnson & Johnson, the debt management ratios over the past five years are as follows:
Johnson & Johnson is not a highly levered firm, having more equity than debt. Their debt-to-asset ratio has remained stable over the past five years, and the debt-to-equity ratio has been almost as stable. This indicates strong financial management and stability in operations. These ratios also compare very favorably with the industry, sector and S&P averages, all of which illustrate that the other firms tend to be more highly levered than JNJ.
Profitability ratios measure a firm’s success at generating income. They can be used to track the flow of revenues down the income statement, to determine at which point profit begins to erode. Because of each firm’s unique circumstances they are best used as an internal measure, on a period-over-period basis. The key profitability ratios for Johnson & Johnson over the past five years are as follows:
JNJ has been able to hold their gross margin steady over the past five years. They have seen some fluctuations in their operating margin, noting a decline in 2007 of 20.5%. The net margin saw a small jump in 2005/2006 but last year returned to the normal levels for the company. Johnson & Johnson’s profitability ratios compare favorably against the industry, sector and S&P. They outscore each of these measures both last year and in terms of five-year moving average.
Market value ratios evaluate the current share price vs. The book value share price. This can be used to measure the improvement in shareholder value that the company has seen. Since the book value is based on issues that may have occurred at different times and for different amounts, this measure holds more value as an internal, period-over-period comparable. One main market value ratio is the P/E ratio. Over the past five years, Johnson & Johnson’s stock has traded in a fairly narrow multiple range, with a low multiple of 16.05 and a high multiple of 24.21. Both of these ratios are much higher than that of the industry and sector as a whole. The high P/E is slightly higher than the high P/E for the S&P 500 over this period, and the low P/E is significantly higher than the same for the S&P 500. This shows that not only is Johnson & Johnson a very stable company, but that they are viewed as a company that consistently outperforms.
All told, the ratio analysis indicates that Johnson & Johnson is a fairly strong company, albeit with some recent weaknesses, particular in terms of liquidity. In all measures except for liquidity, the company outperforms the pharmaceuticals industry. They make better margins at all levels than do their competitors.
Growth rates are also strong for JNJ. The company has grown slowly but steadily over the past five years.
Their five-year sales and EPS growth rates are in line with the industry and sector, which puts them lower than the S&P as a whole. Capital spending growth for JNJ is almost double the industry and sector averages over the past five years.
The company’s success and stability have not gone unnoticed by the market, which has rewarded JNJ with a high degree of share price stability. Their P/E ratio has seen little movement over the past five years, in contrast to much of the S&P. The lack of volatility gives JNJ a beta of just 0.38. Their strong financial management and low debt load allows the market to give them a price-to-sales ratio of 3.02, ten times the industry average and five times the sector average.
In all, Johnson & Johnson has considerable financial strength. The have conservative financial management, which is facilitated by strong margins and healthy cash flows. This may have some interesting implications for their cost of capital. Their lack of leverage may ultimately make them a less efficient company, with a WACC that is higher than it needs to be. However, given their robust performance, it would be hard to argue that they should do anything else.
Estimate of Capital Structure
Capital structure can be measured in a couple of ways – book value and market value – and there are implications for each. Based on the March 30, 2008 interim balance sheet, the book value of JNJ’s equity, short-term debt, and long-term debt are as follows:
The vast majority of the equity is in the form of retained earnings, since the shares in JNJ were issued many years ago. The book value of the shares is $3,120. The company has no preferred stock. Short-term liabilities for JNJ are largely accounts payable and accrued expenses. Approximately 19% of the short-term liabilities in the form of notes payable and other short-term debt.
The long-term liabilities consist of long-term debt and other miscellaneous liabilities. The debt portion of this represents approximately 39% of the total long-term liabilities. Johnson & Johnson has issued notes onto the market that mature in 2017, comprising the bulk of the long-term debt.
The calculate the market value capital structure of JNJ, we need to find estimates of the market value for their long-term liabilities and their equity. For short-term liabilities, we will assume that because the maturity is under one year, the market value and the book value will be sufficiently similar to one another.
As of market close on Friday August 1, 2008, Johnson & Johnson had 2818.19 million shares outstanding. The price of their stock was $68.61. This gives them a market capitalization for their equity of $191,918.91 million.
The market value of their long-term liabilities can be estimated based on the market value of their outstanding long-term debt, the 2017 note. This bond has a coupon of 5.55 and a maturity of 15-Aug-2017. This bond is currently priced at 105.61 on the open market. This price represents the net present value of those cash flows, both the interest and the principle.
JNJ also has another long-term bond on the market. This bond has a maturity of 15-Aug-2037. The coupon on this bond is 5.95%, and the price is 108.90. For the majority of JNJ’s long-term debt, the “other long-term liabilities,” we do not know the structure or nature. Therefore, we shall have to extrapolate the information from the marketed securities and apply it to the other long-term liabilities in order to achieve an estimate of the market value.
To do this, we will average the price of the two bonds on the market, to get an average price of 107.255. The securities would have been issued at par value, which is reflected in the book value. So the average price of the debt currently on the market represents the appreciation over the book value. This gives us a market value for the long-term debt of 107.255 * 18,299 = 19,626.59.
Therefore, the market value capital structure of Johnson & Johnson is as follows:
So we can see that the capital structure based on book value is much more heavily weighted towards equity. This reflects a couple of factors. One is that JNJ is not highly leveraged. They have only a couple of major public debt issues, which means that the majority of their liabilities both short-term and long-term flow from operations.
Another factor at play is the disparity between the balance sheet and the stock market valuation. The balance sheet stock issue is low, with the majority of the equity being retained earnings. The stock market, however, is basing its valuation based on expectations of future performance. Retained earnings only reflects past performance, since the profit needs to be earned before it can be translated to the balance sheet.
Weighted Average Cost of Capital
There are several components to the WACC of Johnson & Johnson. We will first compute the before-tax cost of debt, both short-term and long-term. For the short-term debt, we will use an estimate based on the 3-month non-financial CD rate. This is 2.21%.
We shall base the long-term cost of capital on the average yield to maturity of JNJ’s two long-term debt issues. The 2017 issue has a YTM of 4.831%, and the 2037 issue has a YTM of 5.09%. The average of yield to maturity of these two issues is 5.09%.
Next, we shall determine the tax rate so that we may calculate the after-tax cost of short-term and long-term debt. This is an important consideration because interest expense comes off of the income statement before taxes are applied. Therefore, one must compare after-tax cost of debt vs. The cost of equity, which is not subject to tax deduction.
Corporate tax rates fluctuate each year for a variety of reasons. In the case of Johnson & Johnson, their income tax provision for 2007 was significantly lower than it was in the preceding five years, at 20.3%. This is compared with the provisions from the previous four years ranging from 23.2% to 33.6%. Therefore, it is reasonable to assume that the tax rate for JNJ is typically going to higher than the 2007 number. Since the numbers of 2003 and 2004 are far above what they have paid in the past three years, we will estimate their tax rate based on the past three years only. The average tax rate for the past three years has been 22.5%.
The after tax cost of debt is calculated as After-tax dost of debt = (before tax cost of debt) * (1 – tax rate)
When applied to the before-tax short-term cost of debt, the after-tax cost of short-term debt is 1.7127%. When applied to the before-tax cost of long-term debt, the after-tax cost of long-term debt is 3.944%.
To estimate the cost of equity, we can use several different models. The first we shall use is CAPM. The CAPM formula is as follows:
Ra = Rf + B (Rm-Rf), with JNJ being Ra.
The risk free rate is represented by a one-year government security. That rate is 2.32%. The market rate is represented by the average long-term return on the S&P 500 is approximately 7%. The beta for JNJ is 0.34. This gives us a CAPM calculation of:
Ra = 2.32 + (0.34)(7-2.32), which computes to a cost of equity for Johnson & Johnson of 3.9112%.
Another model is the discounted cash flow model. The DCF calculation is as follows:
(D/P)*(1+g)+g, where k is the discount rate, D is the dividend, P is the stock price, and g is the expected dividend growth rate. The current dividend is $1.84, and the current stock price is $68.61. The dividend growth over the past five years has been 15.3%, so a 3.06% average. Thus the DCF calculation is:
(1.84 / 68.61) * (1 +.0306) +.0306, which gives us a discount rate of 5.82%
The third method for calculating the cost of equity is bond yield plus risk premium. The bond yield we established as 5.09%. The risk premium on JNJ is reflected it its beta, and the risk-free bond rate is 2.21%. With a beta of 0.34, the risk premium is 0.75, so the cost of equity is 5.84% using this method.
The component cost of equity for Johnson & Johnson can be considered an aggregate of the costs of equity determined by these three methods, so 5.19%.
The weighted average cost of capital evaluates the relative costs of capital of short-term and long-term debt and the cost equity. Again, JNJ has no preferred shares. The weightings used are the market value weightings, and the debt costs of capital should be the after-tax costs of capital, since interest expense is a before-tax cash flow.
Therefore the WACC of JNJ is calculated as follows:
This gives us a weighted-average cost of capital for JNJ of 4.7568%.
Cash Flow Estimation
The first step in the cash flow estimation of the project is to calculate the applicable MACRS allowances. The project falls into the 7-year MACRS class, and the initial outlay is $120M. This gives us the following MACRS chart:
Outlay $120-Year 1-2 3-4 5-6 7-8 MACRS 0.1429 0.2449 0.1749 0.1249 0.0893 0.0892 0.0893 0.0446 Depreciation charge 17.15-29.39-20.99-14.99-10.72-10.70-10.72 5.35
The estimate the annualized cash flows, we need to determine the annual revenue stream, the annual variable cost stream, and the annual operating cost stream. These calculations are as follows:
Products Sold 800000 864000 933120 1007770 1088391 1175462 1269499 1371059 Price 200-200 200-200 200-200 200-200 Revenue (millions) 160-172.8 186.624-201.5539 217.6782 235.0925 253.8999 274.2119 VC 120-133.488-148.4921 165.1826 183.7491 204.4025 227.3773 252.9345 NOWC 19.2-20.736 22.39488 24.18647 26.12139 28.2111 30.46799 32.90543 net 20.8-18.576 15.73707 12.18489 7.807768 2.47892 -3.94541 -11.6281 vc increase factor 1.03 baseline vc 150-154.5 159.135-163.9091 168.8263 173.8911 179.1078 184.4811
To this information we then add the initial outlay, salvage value, and then account for the tax. This gives us the final cash flow chart:
Year 0-1 2-3 4-5 6-7-8 Outlay -120 Install -8 Revenue stream 20.8-18.576 15.737 12.184 7.807 2.478 -3.945 -11.628 Salvage 30 Net cash flow -128 20.8-18.576 15.737 12.184 7.807 2.478 -3.945 18.372 Tax 51.2 -8.32 -7.4304 -6.2948 -4.8736 -3.1228 -0.9912 1.578 -7.3488 Tax effect of depreciation 6.8592 11.7552 8.3952 5.9952 4.2864 4.2816 4.2864 2.1408 After tax flow -76.8-19.3392 22.9008 17.8374 13.3056 8.9706 5.7684 1.9194 13.164 tax = 40.00% WACC 4.7568% the timeline representation of these flows is as follows:
Capital Budgeting Analysis
The WACC I have calculated is 4.7568%. Applying this WACC to the cash flows calculated above, the net present value (NPV) of the project is:
After tax flow -76.8-19.33-22.9-17.83-13.3-8.97 5.76 1.91-13.16-Year 0-1 2-3 4-5 6-7-8 WACC 4.7568% Present Value -76.8-18.452 20.868 15.510 11.044 7.110 4.358 1.380 9.074 NPV 10.996
The IRR of the project is:
After tax flow -76.8-19.33-22.9-17.83-13.3-8.97 5.76 1.91-13.16-Year 0-1 2-3 4-5 6-7-8 IRR 9.14%
The MIRR of the project is:
After tax flow -76.8-19.33-22.9-17.83-13.3-8.97 5.76 1.91-13.16-Year 0-1 2-3 4-5 6-7-8 MIRR 5.03%
The profitability index is the present value of the cash flows, divided by the initial investment. The initial investment of the project is $128 million. The present value of the cash flows is $11 million. Therefore the profitability index is 8.5%.
The payback of the project is the time frame that it will take for the investment to be recouped. Based on the cash flows, the payback period is just over five years, meaning the money is recouped just into the 6th year. Using the discounted payback method, the payback period is just less than seven years.
When a sensitivity analysis is performed, we see the following results. We started with a sales growth rate of 8% per year, with a sales starting point of 800,000. This will affect the gross revenues, and also the operating costs and variable costs. An increase in sales growth rate to 10% gives us a slightly improved NPV, up to 11.4. In the later years, the net revenues are negative, due to the fact that operating costs are increasing more than revenues. So while during the earlier years the impact of an increase in sales volume is positive, in those later years each successive sale causes the company to lose more money.
When the sales growth rate is shifted to 6%, we see that cash flows in the last two years improve, due to the abovementioned factor, but that the NPV drops slightly, to 10.61. This is because the impact of lower sales volumes in the first six years is negative. However, because sales volume affects before revenues and costs, the impact of changes in the pace of sales volume growth does not have a significant impact on the worthiness of the project.
The next sensitivity analysis conducted is on the cost of capital. If the cost of capital increases, the values of the future positive cash flows decrease. If there are future negative flows, the impacts of those flows are diminished. We shifted the discount rate to 5.5%, and this gave us an NPV on the project of 8.9. A decrease in the cost of capital, to 3.5%, gave us an NPV of 14.69. Therefore, a significant change in the cost of capital does not rule out this project.
The sale price will affect the revenue streams. Unlike the unit volume growth, the sale price does not have an impact on the cost structure of the project. Therefore, if sale price is increased to $210, the project becomes more valuable. The NPV of the project becomes 47.012. If the sale price decreases to $190, the NPV of the project becomes -24.9. Therefore, the project is highly sensitive to the sale price. The ramifications of this are that the company needs to develop an acute understanding of the market before they accept this project. Many factors can result in price pressures, such as market maturation, the emergence of low-cost competitors, or economic downturn. The firm must carefully weigh the risk of such eventualities, because the price point at which the NPV equals zero is just $197, which represents a price decline of just 1.5% over the sale price they are presently expecting. Any amount of downward price pressure will make this project a money-loser.
Fixed costs are presently 12% of sales. If the fixed costs increase to 13% of sales, the NPV becomes 2.857. If fixed costs decrease to 11% of sales, the NPV becomes 19.211. This illustrates a strong sensitivity for this project to fixed costs. This is especially important considering that the last two years represent a loss because of the escalating fixed costs. Therefore, it is important that JNJ carefully manage its fixed costs with regards to this project. They can still proceed with the project, should their fixed costs start to run out of control, the project will quickly become unprofitable. Still, with sound cost control, they can improve their NPV significantly.
The final sensitivity analysis conducted was with regards to unit cost. If the rate of variable cost increases moves to 3.5% annually, the project’s NPV becomes -1.776. If the rate of variable cost increases moves to 2.5%, the NPV becomes 23.586. Therefore there is a strong sensitivity to the rate of variable cost increases. This shows that the company must control their variable costs very carefully. They must forge strong supplier relationships, since any upward shift in variable cost growth rate will render the project unprofitable. if, however, they are able to control their variable costs, or better yet lock in a lack of growth rate entirely, they would have a very profitable project on their hands.
The other unit cost factor that was tested was the baseline cost. This was thought to be $150 per unit. If that can be reduced to $149 per unit, the NPV of the project increases to 15.41%. But if the baseline costs increase to $151 per unit, the NPV decreases to 6.926. This means that there is some significant sensitivity on the baseline price side as well. JNJ will need to make certain, before they undertake the project, that they have accurate estimates as to their costs, or that if they do not they are going to be able to increase the unit price in order to compensate.
The project appears to be a money maker. The NPV is strong, the IRR and MIRR are also healthy. Better, the project’s profitability is not overly sensitive to shifts in the sales growth rate or the cost of capital.
However, there is serious cause for concern given the projects sensitivity to shifts in cost and unit price. This is due largely to the high volumes that are predicted. If the initial volumes do not meet expectations, for example 650,000 units, then the project becomes only marginally profitable.
The time frame for profitability is also fairly long. On a machine with a life span of eight years, it takes almost 6 full years to realize a payback. Remember that the profitability is highly sensitive to shifts in unit cost and unit price. Six years is a long time for the cost structure of the investment to change. If price pressures are felt, the project would become unprofitable almost immediately if they are unable to squeeze a corresponding cost decrease from their suppliers. For example, if at year three the unit price is squeezed, down to $195, and the suppliers cannot or will not adjust their prices to JNJ accordingly, the project’s NPV becomes -106.48. This illustrates the real risk that price pressures have, even halfway through the project’s life span.
The unit price and unit costs are two variables that are highly sensitive to external factors. These factors may not manifest until several years into the project, and are largely out of JNJ’s control. The results of a negative movement would be catastrophic. Therefore, because of the lack of control over the possibility of strong negative externalities, I recommend that JNJ not accept this project.
JNJ financial statements and key ratios from Reuters, retrieved August 2, 2008 at http://www.reuters.com/finance/stocks/overview?symbol=JNJ.N
JNJ long-term bond information and pricing from Yahoo, retrieved August 2, 2008 at http://reports.finance.yahoo.com/z1?so=a&sf=m&is=johnson
3-Month CD rate obtained August 2, 2008 at http://www.economagic.com/em-cgi/data.exe/fedbog/cp3m
Johnson, Steven H. (2005). Common Sense on Social Security. CSSS. Retrieved August 2, 2008 at http://www.sscommonsense.org/page04.html
Johnson, Steven H. (2005). Common Sense on Social Security.
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