Research Proposal on "Cost of Capital Structure and Capital Budgeting Analysis"

Research Proposal 15 pages (4128 words) Sources: 15 Style: APA

[EXCERPT] . . . .

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,

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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:

Quick ratio

Current ratio

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:

Receivables Turn

Inventory Turn

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:

Debt ratio

Debt/Equity ratio

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:

Gross margin

Operating margin

Net margin

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:

Equity

Short-Term Liabilities

Long-Term Liabilities

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… READ MORE

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Quoted Instructions for "Cost of Capital Structure and Capital Budgeting Analysis" Assignment:

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We will pay $300.00 for the completion of this order.

Dear students,

In this project, you are supposed to be a financial manager to apply the financial knowledge obtained from the course to estimate the cost of debt, cost of preferred stock, cost of common equity, capital structure, and the weighted average cost of capital (WACC) for a publicly-traded company of your choice. Then you are required to use the WACC as the discount rate to perform capital budgeting analysis of a project that the firm is considering.

(1) Read the Instructions for the Final Project carefully. Please let me know if you have any questions.

(2) You should inform the instructor of the company you choose before your formally start the project. Students should analyze different firms. If several students happen to select the same company, the first student who informs the instructor has the priority, so other students have to change their company selections.(Therefore, do not do a company that is too common)

(3) Financial data and industry ratios are available in the UHV online library.

(4) Your project should be well-organized and typed in a WORD file (Office 2003 version). Attach the necessary tables and/or worksheets with your report. The style and organization of the project accounts for 10 points. List the references that you cited or used in your project. The Final Project Grade Sheet may help you understand the contribution of each part of the project to your overall grade.

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INSTRUCTIONS TO THE PROJECTS:

Cost of Capital, Capital Structure,

and Capital Budgeting Analysis

1. Purpose of the project:

In this project, you are supposed to be a financial manager working for a big corporation and you have to apply the knowledge obtained from the financial management (FIN6352) course to determine the cost of debt, cost of preferred stock, cost of common equity, capital structure, and the weighted average cost of capital (WACC) for a publicly-traded company of your choice. You will use the WACC as the discount rate to conduct capital budgeting analysis for a project that the firm is considering and then decide whether it should be accepted or not.

2. Outline for the project:

(1) Executive Summary (10 points)

- Summarize the results and analysis of the report.

(2) Financial Ratio Analysis (40 points)

- Perform trend analysis of the key financial ratios (i.e., liquidity ratios, asset management ratios, debt management ratios, profitability ratios, market value ratios) of the company.

- Perform industry (or benchmark companies) comparison analysis of the key financial ratios of the company.

- Based on the financial ratio analysis results, evaluate the financial performance of the company.

(3) Estimate Capital Structure (25 points)

- Estimate the firmÂ¡Â¯s weights of debt, preferred stock, and common stock using the firmÂ¡Â¯s balance sheet (book value).

- Estimate the firmÂ¡Â¯s weights of debt, preferred stock, and common stock using the market value of each capital component.

(4) Compute Weighted Average Cost of Capital (WACC) (35 points)

- Estimate the firmÂ¡Â¯s before-tax and after-tax component cost of debt;

- Estimate the firmÂ¡Â¯s component cost of preferred stock;

- Use three approaches (CAPM, DCF, bond-yield-plus-risk-premium) to estimate the component cost of common equity of the firm.

- Calculate the firmÂ¡Â¯s weighted average cost of capital (WACC) using market-based capital weights.

(5) Cash Flow Estimation (40 points)

- We assume that the company you selected is considering a new project. The project has 8 yearsÂ¡Â¯ life. This project requires initial investment of $120 million to purchase land, construct building, and purchase equipment, and $8 million for shipping & installation fee. The fixed assets fall in the 7-year MACRS class. The salvage value of fixed assets is $30 million. The number of units of the new product expected to be sold in the first year is 800,000 and the expected annual growth rate is 8%. The sales price is $200 per unit and the variable cost is $150 per unit in the first year, but they should be adjusted accordingly based on the estimated annualized inflation rate of 3%. The required net operating working capital (NOWC) is 12% of sales. The company is in the 40% tax bracket. The project is assumed to have the same risk as the corporation, so you should use the WACC you obtained from prior steps as the discount rate.

- Compute the depreciation basis and annual depreciation of the new project. (Please refer to table 12-3 MACRS allowances)

- Estimate annual cash flows for the 8 years.

- Draw a time line of the cash flows.

(6) Capital Budgeting Analysis (40 points)

- Using the WACC you obtained for the publicly-traded company as discount rate, apply capital budgeting analysis techniques (NPV, IRR, MIRR, PI, Payback, Discounted Payback) to analyze the new project.

- Perform a sensitivity analysis for the effects of key variables (e.g., sales growth rate, cost of capital, unit costs, fixed costs, sales price) on the estimated NPV or IRR in order to demonstrate the sensitivity of the model.

- Discuss whether the project should be taken and summarize your report.

3. Other information regarding the project:

(1) Avoid firms in the financial sector. Their financial statements are not compatible with the type of model we study in this class. Generally, financial firms have 4-digit SIC codes 6000s.

(2) You will inform the instructor of the company you choose. Students have to choose different companies. If several students want to use the same company, the first student to inform the instructor will have priority; the others will have to pick another company.

(3) Your project should be well-organized and typed in a Word document and attach the necessary Excel worksheets with your report. The style and organization of the project is important.

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Financial Data and Industry Ratios Resources

(1) In the database D&B Key Business Ratios, you can find some key industry & business ratios. Other books, reference & print resources include 1) Almanac of Business and Industrial Financial Ratios 2) Industry Norms and Key Business Ratios 3) Robert Morris Associates (RMA) Annual Statement Studies.

(2) In the database Mergent Online, you can find financial data and information for most U.S. publicly-traded firms.

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FIN6352-Financial Management

Individual Term Project Grade Sheet

Category

Possible Points

Actual Points

Executive Summary

10

Final Ratio Analysis

40

Estimate Capital Structure

25

Compute WACC

35

Cash Flow Estimation

40

Capital Budgeting Analysis

40

Style and Organization

10

Total

200

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PROJECT RUBIC:

Perform capital budgeting analysis for a publicly traded company

1. Estimate the component cost of capital: Student applies capital asset pricing model to estimate cost of equity component. Can correctly estimate cost of debt and cost of equity. Students use various methods for each component cost.

2. Obtain the capital structure and calculate the weighted average cost of capital: Student must correctly estimates weights on capital components using book values and market values. Student correctly estimates cost of capital.Student researches financial reports and finds the target capital structure. Student presents a comparison against other firms in the industry.

3. Calculate net cash flows for an expansion project:Student correctly estimates Operating Cash Flows (OCF), correctly uses the adjustments to Net Operating Working Capital (NOWC) and calculates the Salvage Cash Flows. Student uses models that consider inflation rates, multiple depreciation schedules and different salvage values.

4. Evaluate an expansion project: Student correctly calculates NPV and IRR in order to evaluate the project. Student documents his/her conclusion. Student applies other tools to evaluate the project. Student includes results for scenario analysis and uses sensitivity analysis for the main input variables.

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