Corporate Finance

Estimation of Cost of Capital 
 99

Johnson & Johnson has 198 operating companies in 54 countries around the world employing 108,300

employees and selling products in more than 175 countries.

Stock Information

Industry: Pharmaceuticals

Common stock quote (March 28, 2003): $56.96

Price/earnings ratio: 24.21

Earnings per share: $2.18

Indicated annual dividend: 0.82

Yield (percent): 1.55

Beta coefficient: 0.47

Market cap (billion): 174.248

Shares outstanding: 2,969,972,000

J&J’s marginal tax rate is estimated to be 28 percent. This calculation is based on the average effective tax

rates for J&J between 1996 and 2002.

J&J’s cost of debt can be estimated by the average effective interest paid on its debentures and notes

payable, which is calculated to be 5.85 percent before taxes.

To calculate J&J’s cost of equity we will use as the risk-free rate rf = 3.907, the prevailing yield on long-

term bonds (i.e., US 10-year bonds), the latest value of the firm’s beta = 0.47, and the market risk

premium (rm – rf) = 5.9 percent, which is the geometric mean of historical risk premiums (for the period

1926–99).

Thus, Ke= 3.907 + 0.47(5.9)

= 6.68 percent.

J&J’s market value of debt as per its December 29, 2002 balance sheet includes (in millions) loans and

notes payable of US$ 2,117 and long-term debt of US$ 2,022, for a total of US$ 4,139 million.

The market value of equity can be calculated by multiplying the current share price times the number of

current shares outstanding,

or US$ 56.96 × 2,969,972,000 = US$ 169,169.6 million.

Thus, we find that Wd = 2.38 percent and We = 97.62 percent.

J&J’s WACC can be determined by using the WACC formula:

WACC = (1 – .28)(2.38 percent × 5.85 percent) + (97.62 percent × 6.68 percent)

= 6.62 percent

Some companies use a single company wide discount rate for all projects and divisions even though the
divisions have different risk complexion. Obviously, this leads to inappropriate investment decisions.