Johnson and Johnson has two independent projects in which it can invest. One is

Question

Johnson and Johnson has two independent projects in which it can invest. One is in Washington D.C(designated project W); the other is in New York (designated Project NY). The initial cost of the Washington D.C project is $26,000, and the initial cost of the New York project is $63,000. The expected income streams from these projects are found in the table below. The risks of both projects are similar to the risks of current company projects. The current risk-free rate is 0.57% and the market risk premium (return to the market minus the risk-free rate) is expected to be 6.00% per year. The company's beta is 1.55. The company will be raising all cash for these projects through debt. The company expects to pay 1.03% for any debt used in the project(s). The target capital structure for the company is 40% equity and 60% debt. The marginal tax rate is 40%.

Year............................Project W.......................................ProjectNY

1................................7,500................................................14,282

2..................................6,614...............................................5,526

3..................................3,110...............................................9,072

4..................................5,498................................................17,918

5.................................7,394...............................................10,140

6.................................1,528...................................................8,320

7..................................4,704................................................17,696

8..................................5,220..................................................14,988

Requirement

a) What is the firm

Explanation / Answer

Cost of Equity Ks = Krf + beta*MRP = 0.57% +1.55*6% =9.87%
Costof debt = Kd=1.03%
Tax rate T = 40%
Wd = 60%
We = 40%

We have
WACC (Ka)= Wd*(Kd)*(1-t) + (We)*(Ke)
where Wd= The proportion of the financing taken on by debt
We= The proportion of the financing provided by equity
ie wacc = 60%*1.03%*(1-40%) + 40%*9.87%
ie WACC = 4.32% ..........Ans (A)

COmpany should use WACC as it gives weighted avge cost of capital. Cost of equity ignores cost of debt & hence should not be used. ....Ans (b)

Ans (C):
NPV (W) = -26000 + 7500/(1+4.32%)^1+ 6614/(1+4.32%)^2 + 3110/(1+4.32%)^3 + 5498/(1+4.32%)^4 + 7394/(1+4.32%)^5 + 1528/(1+4.32%)^6 + 4704/(1+4.32%)^7 + 5220/(1+4.32%)^8 = $9,039.14

NPV(NY) = -63000+14282/(1+4.32%)^1+ 5526/(1+4.32%)^2 + 9072/(1+4.32%)^3 + 17918/(1+4.32%)^4 + 10140/(1+4.32%)^5 + 8320/(1+4.32%)^6 + 17696/(1+4.32%)^7 + 14988/(1+4.32%)^8 =$17,398.38

Ans (d):
Proj (W) : During 1st 4 Yrs, Cumulative CF=7500+6614 + 3110 + 5498 =$22,722
Payback period = 4 + (26000-$22,722)/7394 =4.44 Yrs

Proj (NY): During 1st 5 Yrs, Cumulative CF =14282+5526+9072+17918+10140=$56,938
Payback period = 5 + (63000-56938)/8320 = 5.73 yrs

Ans (e)
IRR(W) = IRR(-26000,7500,6614,3110,5498,7394,1528,4704,5220) = 10.32%
IRR(NY) =IRR(-63000,14282,5526,9072,17918,10140,8320,17696,14988) = 7.02%

Ans (f)
Proj NY is better as it has Higher NPV & IRR is greater than WACC

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