If Johnson & Johnson at its internal growth rate, increasing assets only with it

Question

If Johnson & Johnson at its internal growth rate, increasing assets only with its retained earnings, how will this likely affect its WACC? Show calculations.

If Johnson & Johnson grows at its sustainable growth rate with increases in both its retained earnings and debt, maintaining a constant debt ratio, how will this affect its WACC?

If Johnson & Johnson attempts to grow faster than its sustainable growth rate with modest increases in its debt ratio, how will this likely affect its WACC? What about very large increases in its debt ratio? Explain.

Explanation / Answer

WACC is calculated as = (Cost of Equity) / (Total Value of Equity and debt)+ (Cost of Debt * (1-T) ) / ( Total Value of Equity and debt)

WHERE T IS TAX RATE

If Johnson and Johnson increase assets only with retained earnings then value of equity will decline and the proportion of debt in capital structure will increase which will result in decreasing the WACC because cost of debt is lower than the cost of equity

For ex Let Initially debt=1000 and Equity=1000 Cost of debt= 5% Cost of Equity= 12% TAX RATE 30%

WACC= 1000/2000*(.12)+ 1000/2000*(.05*(1-.30)

WACC= (.50*.12)+( .50*.70*.05)= .06+.0175

WACC= 7.75%

B) If the company is growing at its sustainable rate with increse in both retain earnings and debt and maintaining the s=constant ratio then WACC will not change because with constant growth in equity and debt there is no change in ratio and also the coapny grows so shareholders are not afraid to put their money and hence not charging higher return

c) According to MM proposition if company attempts to grow faster than the sustainable rate with help of debt then the benefits of debt being a cheper cost of financing and tax advantage provided by it will be outweighed by the cost of default that shareholders assume due to increase in the leverage of the the firm. Hence the WACC of the company will increase as Ke i.e. cost of equity will increase which will result in increasing cost of capital for the company.

Imagine if this is not true then any company can decrease its WACC by simply increasing the value of debt but since debt holders have a prioity over equity shareholders in the claims of a company, so increase in debt results in equityholders fear that they will not get anything due to increase in debt level and hence they want higher return and hence cost of equity increases and so WACC

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