Here, we want to work through a proforma income statement to determine the cash flows from the project. Below are some estimates that the marketing department has determined. Other assumptions necessary for completing the proforma income statement can be found by looking at some of the historical average values in Johnson & Johnson’s financial statements. Suppose Johnson & Johnson (ticker symbol - jnj) has decided to introduce a new heart stent, the Heart Flow. Before they launched the Heart Flow, they analyzed it to see if it would be a desirable investment. The company estimated that it would sell 950,000 Heart Flow’s per year at a price of $75,000 for the next six years. After the first year of sales, the quantity sold will increase by 2% per year for the remaining life of the project.The initial capital outlay is determined to be $15 billion and a $2.0 billion outlay in net working capital (NWC) would also be required. Assume that there is a one-time investment in NWC and that this will be recovered at the end of the project.Assume that the equipment used will be depreciated using the MACRS 7 year schedule and that the equipment has a salvage value of zero. At the end of year 6, the equipment will be sold for 120% of its book value. Also, assume that the tax rate is 25%. Use a fixed 60% as the SGA percentage. SAGs = 32% Calculate cost of Equity risk free rate+Beta*market risk premium beta 0.52 risk free rate 5.10% market risk premium 8.50% 9.5200% Calculate cost of debt 3.5%*(1-25%) 2.63% debt to equity ratio 0.5:1 weight of equity 67% weight of debt 33% WACC = (Weight of debt * Cost of debt) + (Weight of equity * Cost of equity) * (1 - Tax rate) ((0.33*2.63%))+((0.667*9.52%))*((1-25%)) = 5.64% Use the following capital budgeting techniques. 1. Payback period 2. Net present value 3. Internal rate of return Now let’s test the sensitivity of the project to some changes in the assumptions. 4. Take the cost of capital you previously computed (in week 8) and add 2% to the value (for example, if WACC was 12%, make it 14%) and recalculate NPV. What happens to IRR? Is the project still desirable? 5. Suppose the cost of goods sold percentage rises by 2.5%. Compute the payback period, NPV and IRR. Use the original WACC you computed. 6. How sensitive is NPV to the changes made in 4 and 5?
Here, we want to work through a proforma income statement to determine the cash flows from the project. Below are some estimates that the marketing department has determined. Other assumptions necessary for completing the proforma income statement can be found by looking at some of the historical average values in Johnson & Johnson’s financial statements.
Suppose Johnson & Johnson (ticker symbol - jnj) has decided to introduce a new heart stent, the Heart Flow. Before they launched the Heart Flow, they analyzed it to see if it would be a desirable investment. The company estimated that it would sell 950,000 Heart Flow’s per year at a price of $75,000 for the next six years. After the first year of sales, the quantity sold will increase by 2% per year for the remaining life of the project.
The initial capital outlay is determined to be $15 billion and a $2.0 billion outlay in net working capital (NWC) would also be required. Assume that there is a one-time investment in NWC and that this will be recovered at the end of the project.
Assume that the equipment used will be depreciated using the MACRS 7 year schedule and that the equipment has a salvage value of zero. At the end of year 6, the equipment will be sold for 120% of its book value. Also, assume that the tax rate is 25%.
Use a fixed 60% as the SGA percentage. SAGs = 32%
Calculate
risk free rate+Beta*market risk premium
beta 0.52
risk free rate 5.10%
market risk premium 8.50%
9.5200%
Calculate cost of debt
3.5%*(1-25%)
2.63% debt to equity ratio
0.5:1
weight of equity 67%
weight of debt 33% WACC = (Weight of debt * Cost of debt) + (Weight of equity * Cost of equity) * (1 - Tax rate)
((0.33*2.63%))+((0.667*9.52%))*((1-25%)) = 5.64%
Use the following capital budgeting techniques.
1. Payback period
2.
3.
Now let’s test the sensitivity of the project to some changes in the assumptions.
4. Take the cost of capital you previously computed (in week 8) and add 2% to the value (for example, if WACC was 12%, make it 14%) and recalculate NPV. What happens to IRR? Is the project still desirable?
5. Suppose the cost of goods sold percentage rises by 2.5%. Compute the payback period, NPV and IRR. Use the original WACC you computed.
6. How sensitive is NPV to the changes made in 4 and 5?
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