Policy makers have embraced financial analysis to examine and evaluate financial performance of a given firm. A financial statement refers to an organized collection of company data, based on a logical and conceptual framework. This report provides an analysis of the Time Value of Money (TVM) for Johnson & Johnson, an American corporation. Analysis of the company will provide significant insights to investors, managers, shareholders, and other key stakeholders
The calculation of TVM entails a discount factor of the future value of a given set of cash flows. Analyzing financial statements involves processing information to provide data for decision-making (Jurakulovna et al., 2021). Calculating the present value (PV) of Johnsons & Johnsons would help investors make informed decisions. The analysis of Johnsons & Johnsons free cash flows for financial years 2019, 2020, and 2022 represents the most current trading periods. An assumed interest rate of 5% is applied to discount future cash flows. The analysis revealed that Johnson & Johnsons’ PV, given the free cash flows within the three years, is $73.393 billion.
Unprecedented changes in the investment risk levels may significantly impact the company and an increase in the investment risk decreases the present value. Supposing that the risk of investment in the company changes based on an annual 10% decrease in free cash flow within the three years, the PV would decrease to $66.053 billion. The decline in the free cash flow negatively impacts the PV, indicating that financial health is declining steadily. High or rising free cash flow indicates a healthy company is likely to thrive in its business environment.
Implications of Change on Present Value
The company’s financial analysis, based on TVM, has revealed that an increase in investment risks of a company decreases the PV. Internal issues in the firm can create significant investment risks by triggering a reduction in free cash flow. Lai et al. (2020) state that sufficient cash flow enables firms to engage in activities that further maximize shareholders’ value. O’Donoghue and Somerville (2018) found that investor’s preferred lower returns with known risks to high returns with unknown risks. Thus, it is vital to minimize investment risks by aligning the company’s objectives with the organizational strategies and goals. Higher investment risks may be associated with higher returns for investors.
Recommendations
Assuming that the free cash flow would increase annually by three percentage points over the next three years, Johnsons & Johnsons PV would also increase significantly. The company would have a PV of $148.659 billion. To determine the reasonable value of the firm in three years, one must discount the current value of $73.393 billion. The time value of money dictates that the sum of money in the present is worth much more in the future due to its earning potential (Jezkova et al., 2020). Thus, considering the annual increment of 3%, Johnsons & Johnsons’ net present value over the next three years would be $148.659 billion. However, selling the company at that amount would result in undervaluation since there may be a further rise in value over the years subsequently a value of $150 billion would be much more reasonable.
Johnson & Johnson offers a required rate of return of 7% and this rate of return would caution a potential buyer against the perceived risks. Potential investors are risk-averse when they receive more utility from the actuarial value of an investment (Diaz & Esparcia, 2019). Research by Gambeta and Kwon (2020) found that risk-return trade-offs link to higher returns in shareholder value. Thus, the assumption is that investing in Johnsons & Johnsons will yield an efficient frontier for potential shareholders due to the risk-return trade-off.
Stock Valuation
Valuation of stocks is the process of calculating a share’s fundamental or hypothetical worth. The significance of stock valuation stems from the fact that a commodity’s intrinsic worth is unrelated to its current price (Bernardino et al., 2022). The procedure of valuing stocks is exceedingly complex and can be considered a blend of sciences and art. The quantity of knowledge that might conceivably be utilized to value companies may overburden shareholders. The first case is: the new dividend yield if the company increased its dividend per share by 1.75.
A company’s dividend yield is computed using its dividends and prices.
(Kadim et al., 2020). Therefore, the dividend yield for the financial years 2019, 2020, and 2021 are calculated as follows.
The second case is: the dividend yield if the firm doubled its outstanding shares.
(Dividend reduced as the number of shares doubled)
The third case is: the rate of return on equity (i.e., the cost of stock) based on the new dividend yield calculated above:
The current year’s dividend, as well as the stock prices from the past years, are taken into account when calculating the rate of return on equity, or ROI (Hertina & Saudi, 2019).
Dividends are paid from a firm’s retained profits; however, most corporations today give out smaller dividends and reinvest their revenues in the organization. Higher payouts might restrict the corporation’s reinvestment, but investors would be delighted to receive the gains (Michaely et al., 2018). The payout ratio is the profit as a proportion of the institution’s total worth. Higher yield corresponds to greater dividends, which would benefit the creation of shareholder value (Michaely et al., 2018). When shares are doubled, and the dividend stays the same, the payment would be cut in half, which could have a negative effect on investor worth.
Companies use different strategies to distribute their dividend to their stockholders. Firms utilize the cash to issue dividends, subtracted from the business’s interest income. The issuance of bonus shares is another strategy: historically, the dividend payment proportion has been high, but venture capitalists are now more forgiving than in the past when they anticipated higher dividends (Michaely et al., 2018). The dividend methodology of a firm is directly tied to its expansion; the more significant the dividends, the greater the payout, and vice versa.
Bond Issuance
The first case for this task is: the new value of the bond if overall rates in the market increased by 2%.
The second case for this task is: the new value of the bond if overall rates in the market decreased by 2%.
The standard rate was 8%, which would get to 6%.
The third case for this task is: the present value of the bond if overall rates in the market remained the same as at issuance.
Bonds are the firm’s debt securities offered to stakeholders. Bonds are advantageous if interest rates are under control or below normal levels, whereas the expense of borrowing at rising rates is undesirable. Bond borrowing costs and market interest rates have an opposite relation; if one increases, the other decreases, and vice versa. At a 2% rise in the interest rates, the corporation must pay more for the secured loans, resulting in a 7% rise in the expense of financial leverage. Increasing investment in this proportion would be a costly decision (Maltais & Nykvist, 2020). Assuming that the average interest rate is 8%, this would be a typical lending cost. When interest rates decrease by 2% to 6%, this can be an excellent time to raise funds, as this is an inexpensive source of funding.
Capital structure has a significant influence in deciding how much debt finance and equity a business requires. The safety of bonds as a financing option depends on a variety of variables, including maturity, interest rate, and face value (Gilchrist et al., 2021). If a firm is functioning well, it may choose to issue bonds, which can help it retain its ownership and enhance its returns. If the company’s performance fluctuates, owning a large number of bonds increases the strain on interest repayment. It is also essential to consider the duration of the organization’s endeavors and the maturity dates of its bonds in order to ensure prompt payment and efficient use of cash (Gilchrist et al., 2021). Bonds typically assist the company’s objectives because they are adaptable to the company’s demands; nonetheless, unsustainable debt lending is not recommended.
Capital Budgeting
Capital budgeting is a quantitative method of evaluation of investments used by decision-makers to create a portfolio project for the company (Tayler & Warren, 2018). There are several capital budgeting techniques, such as net present value (NPV), internal rate of return (IRR), payback period, and discounted payback period (Tayler & Warren, 2018). This paper part of the capstone project focuses on the analysis of a potential investment in order to make a decision on whether the project should be accepted using IRR and NPV. Moreover, the paper aims and discussing which of the two methods is more appropriate for the situation.
Selecting and Calculating
Project 1 was selected for evaluation out of three possible investment opportunities. The project was associated with a $17 million investment in equipment, which would depreciate on a straight-line basis to zero salvage value in five years. Other assumptions associated with the investment is the weighted average cost of capital (WACC) of 5%, which was used as the minimal expected rate of return, and the effective tax rate of 28%. The results of the calculations demonstrated that the IRR of the project was 5.1%, and NPV was $41,575. The calculations of the project’s cashflows are provided in Table 1 below.
Table 1. Project Cashflows
Implications of the Calculations
The NPV of the project was a positive value of $41,575. NPV is a commonly used appraisal technique that takes into consideration the time value of money. This approach provides a clear signal for investing or not investing in a project. It is calculated by adding all the discounted cash flows (Mclaney, 2017). If the value of NPV is positive, it is clear signal that the project is profitable after incurring the time value of money. If a project has positive profitability after deducting the time value of money, it should be accepted if no better options exist (Mclaney, 2017). The calculations demonstrated that the selected project will have positive profitability of $41,575 with WACC of 5%, which is enough to be accepted.
The IRR approach is another important metric that can be used to measure the profitability of a project. This metric is essentially a return rate (or WACC) that would make NPV of the project be equal to zero (Mclaney, 2017). According to the method, a decision-maker should accept a project of the IRR is higher than the current expected rate of return (WACC). In the situation with the investment described in Table 1, the IRR was 5.1%, which is above the expected minimum rate of return of 5%. Thus, according to the calculations, the investment opportunity should be accepted. However, before making the final decision, the investors should assess the accuracy of the cashflow forecast. The central problem here that the calculations allow a very small margin of error, as if the actual IRR is slightly lower than the estimated IRR, the project should be declined.
Selecting the Best Method
In the situation describe in this case, NPV is the preferred method of project evaluation due to one central benefits of the method. Both NPV and IRR approaches take into account the time value of money or the idea that a dollar today is worth more than a dollar tomorrow (Fool, 2015). This is crucial for assessing the investment decisions as money today is more valuable than money in the future (Merati & Alavi, 2017). However, NPV provides estimation of monetary benefit of the investment instead of giving the percentage value (Fool, 2015). In other words, NPV provides more valuable information and a clearer marker for the decision-makers to accept or decline the investment. IRR is more suitable for comparing investments with different caliber of initial investments (Fool, 2015). Since the proposed project s not compared to any other investment possibilities, the NPV approach is more preferable that IRR. However, since both approaches are based on the same date, it may be beneficial to use both methods to evaluate investment opportunities from different angles.
Macroeconomic Items
Johnson & Johnson researches, develop, manufactures, and sells various hygiene and healthcare products worldwide. It has over 250 subsidiaries in over 60 countries, and products are sold in over 175 countries (James et al., 2019). This paper presents a detailed analysis of the influence of external factors on the company’s activities, its performance on the stock exchange, and the correlation of the influence of interest rate on financial performance. The considered company Johnson & Johnson is presented in modern realities; all information is taken from scientific and news sources. Previously, an experimental calculation was carried out with various interest rates to see in detail the influence of this factor on free cash flow indicators and assess their consequences.
First of all, the calculations showed an inverse relationship between the market interest rate and free cash flows through the present value. The higher rate reduced this financial performance, consequently affecting the company’s current capabilities and partly its liquidity or ability to meet its short-term obligations (Díaz & Escribano, 2020). The smaller one in the market, in turn, allows significantly increasing the present value compared to other indicators, which gives the organization flexibility in planning and potential expansion opportunities. However, a small interest rate has negative consequences: available borrowed money gives similar opportunities to competitors, significantly increasing the need for constant development, often with shrinking margins (Hanzlík & Teplý, 2022). Manufacturing companies like Johnson & Johnson then face the threat of new players in each of their diversified product divisions.
With a growing market and money available, companies are better off short-term at the expense of long-term planning. Investing is no longer a priority due to the low-interest rate on deposits, in connection with which companies allocate more money to circulation. This stage should be seen as an opportunity and a need for potential development paths. A high-interest rate, in turn, forces companies to take a wait-and-see attitude. As a rule, its increase in the market by more than 2% is dictated by external factors, the effect of which, as a rule, cannot be predicted. In this case, the money is taken out of the flows and can be sent to save in deposits or investments as their price rises significantly.
For the market as a whole, this situation is a test of companies’ flexibility, mobility, and reactivity. Johnson & Johnson used the crisis of 2020 to invest in property, plants, and equipment, while in 2017, they sold many investment assets to offset low sales and income (Macrotrends, 2022). Such actions reflect the reactionary and, in some fortunate cases, proactive activity characteristic of a period of high-interest rates. Accordingly, in numerical terms, the average interest rate is a balance between two market conditions, where the assessment already depends on the company’s strengths and the context of the surrounding situation.
Despite the past years’ pandemic and global crises, Johnson & Johnson has consistently paid dividends on shares. At the same time, payments are growing in line with the growth in net income, which was significantly increased in 2021 due to the optimization of production, reflected in gross profit and cost of goods sold (Macrotrends, 2022). Accordingly, the company will work out any problem in the stock market to one degree and overcome it with the most excellent probability due to the long-term history of an impeccable reputation. Moreover, the majority of Johnson & Johnson’s revenue comes from pharmaceuticals and medical devices, which, in the face of the spread of the virus and the increase in public attention to health, allows it to maintain a leading position even in times of crisis (Alhosnai et al., 2021). In the event of a global recession, such a company will be more likely to survive with minimal losses.
The most apparent external factor for the company is the geopolitical situation in the east of Europe, where an armed conflict broke out. As a result, to maintain its reputation, Johnson & Johnson left the Russian market, significantly leading to a drop in revenue and the need to rebuild an established supply chain in this direction (Johnson & Johnson, 2022). The impact on financial indicators can only be predicted so far since the 2022 financial statements will be released only next year. However, it is safe to say that after a successful 2021, maintaining the same level of net income will be highly positive. The company will likely respond to the withdrawal from the market by selling assets, which will affect cash flow statements while possibly increasing operating costs for restructuring logistics routes. At the same time, the drop in the value of a company’s shares may not be due to an increase in reputational and responsible issues as determinants of investor attractiveness in the modern world (Ziyadin et al., 2019). Finally, increasing long-term liabilities through lending is possible if revenues fall significantly. In this case, as discussed above, the macroeconomic indicator of the market interest rate will play an important role, which to a certain extent, can determine the different vectors of the organization’s development.
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