Chapter 9, Problem 1OR

In the chapter opener you learned that Johnson & Johnson’s weighted average cost of capital was around 6% but its investments were earning returns closer to 17%. In 2016, J&J invested about $3.2 billion in capital expenditures. Suppose J&J spends the same amount this year to expand its manufacturing facilities, and that investment produces a net cash flow of $544 million (17% of $3.2 billion) every year in perpetuity. Calculate the NPV of that investment using a 6% discount rate. How much value does the $3.2 billion investment create or destroy? Does it seem that J&J should be pursuing growth in this market?

Summary Introduction

To discuss:

To calculate the NPV.

Introduction:

The difference among the present value of cash inflows and the present value of cash outflows for a period of time is known as the Net Present value. NPV is utilized in capital budgeting as a criterion to analyze the profitability of projects.

Explanation of Solution

The NPV can be calculated as follows,

$\begin{array}{c}{\text{NPV}}_{\text{1 year}}=\frac{\text{Net cash flow}}{\text{Discount rate}}\\ \text{=}\frac{\text{544}}{\text{0}\text{.06}}\\ =9,066.67\end{array}$

Since the NPV value is positive the projects creates a value worth $9,066.67 million.