. Johnson and Johnson reported earnings per share of $6.400 in 2013 and paid div

Question

. Johnson and Johnson reported earnings per share of $6.400 in 2013 and paid dividends per share of $3.40 in that year. The firm reported depreciation of $630 million in 2013 and capital expenditure of $950 million. There were 320 million shares outstanding, trading at $102 per share. The working capital needs are negligible. The firm has debt outstanding of $3.2 billion and intends to maintain its current financing mix of debt and equity to finance future investment needs. The firm is in steady state, and earnings are expected to grow 7% per year. The stock had a beta of 1.50. The Treasury bond rate is 4%. The market rate of return is 8.25%.

Estimate the value per share, using the dividend discount model

Estimate the value per share, using the FCFE model.

Explain the difference in your price

Explanation / Answer

Part A)

To determine the value per share with the use of dividend discount model, we need to calculate the cost of equity with the use of following formula:

Cost of Equity = Risk Free Rate + Beta*(Market Return - Risk Free Rate)

The value per share can be calculated as follows:

Value Per Share = Dividend*(1+Growth Rate)/(Cost of Equity - Growth Rate)

___________

Using the information provided in the question, we get,

Cost of Equity = 4 + 1.5*(8.25 - 4) = 10.375%

Value Per Share = 3.40*(1+7%)/(10.375% - 7%) = $107.79

___________

Part B)

To calculate the value per share using the FCFE model, we need to determine the value of Free Cash Flow to Equity with the use of following formula:

Free Cash Flow to Equity = Current EPS - (1-Desired Debt Percentage)*(Capital Spending - Depreciation)/Outstanding Shares - (1-Desired Debt Percentage)*Change in Working Capital

___________

Using the information provided in the question, we get,

Desired Debt Percentage = 3,200,000,000/(3,200,000,000 + 320,000,000*102) = 8.93%

Change in Working Capital = 0

Using these values in the above formula for FCFE we get,

FCFE = 6.4 - (1-8.93%)*(950 - 630)/320 - (1-8.93%)*(0) = $5.4893

The value per share has been calculated as follows:

Value Per Share = FCFE*(1+Growth Rate)/(Cost of Equity - Growth Rate) = 5.4893*(1+7%)/(10.375% - 7%) = $174.03

___________

Part C)

The difference in price is on account of higher FCFE when compared to dividend per share. FCFE accounts for the total cash value derived by the firm. Therefore, it is more appropriate to use FCFE as the basis for determining value per share.

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