Cost of Capital, Capital Structure, and Capital Budgeting Analysis
Choose a publicly traded company- Johnson & Johnson (JNJ)
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
- Summarize the results and analysis of the report.
(2) Financial Ratio Analysis
You are supposed to be a financial analyst covering a firm in particular. You are expected to apply the knowledge obtained in the Financial Statement Analysis (ACC6351) course and determine the firm's strengths and weaknesses relative to its peers and to describe historical growth of key variables.
- 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 firm's weights of debt, preferred stock, and common stock using the firm's balance sheet (book value).
- Estimate the firm'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)
- Estimate the firm's before-tax and after-tax component cost of debt; (Note: If the information about the current corporate tax rate is not available, you need to estimate the tax rate based on its historical tax payments).
- Estimate the firm'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 firm's weighted average cost of capital (WACC) using market-based capital weights.
(5) Cash Flow Estimation
- We assume that the company you selected is considering a new project. The project has 8 years' life. This project requires initial investment of $195 million to purchase land, construct building, and purchase equipment, and $15 million for shipping & installation fee. The fixed assets fall in the 7-year MACRS class. The salvage value of fixed assets is $38 million. The number of units of the new product expected to be sold in the first year is 880,000 and the expected annual growth rate is 9%. The sales price is $266 per unit and the variable cost is $179 per unit in the first year, but they should be adjusted accordingly based on the estimated annualized inflation rate of 2.8%. The required net operating working capital (NOWC) is 15% of sales. The company is in the 35% 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 of 3 years MACRS allowances)
- Estimate annual cash flows for the 8 years.
- Draw a time line of the cash flows.
(6) Capital Budgeting Analysis
- 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. The Scenario analysis of several variables simultaneously is encouraged, but not required.
- Discuss whether the project should be taken and summarize your report.
3. Other information regarding the project:
Your project should be well-organized and typed in a Word document and attach the necessary Excel worksheets.