Question

Johnson & Johnson, the world’s leading and most diversified healthcare corporation, serves its customers through specialized worldwide franchises. Each of its franchises consists of a number of companies throughout the world that focus on a particular healthcare market, such as surgical sutures, consumer pharmaceuticals, or contact lenses. Information related to its property, plant, and equipment in its 2014 annual report is shown in the notes to the financial statements below.

1.Property, Plant and Equipment and Depreciation Property, plant and equipment are stated at cost. The Company utilizes the straight-line method of depreciation over the estimated useful lives of the assets: Building and building equipment 20–40 years Land and leasehold improvements 10–20 years Machinery and equipment 2–13 years 4. Property, Plant and Equipment At the end of 2014 and 2013, property, plant and equipment at cost and accumulated depreciation were: (dollars in millions) 2014 2013 Land and land improvements \( 833 \) 885 Buildings and building equipment 10,046 10,423 Machinery and equipment 22,206 22,527 Construction in progress 3,600 3,298 36,685 37,133 Less accumulated depreciation 20,559 20,423 \(16,126 \)16,710 The Company capitalizes interest expense as part of the cost of construction of facilities and equipment. Interest expense capitalized in 2014, 2013 and 2012 was \(115 million, \)105 million and \(115 million, respectively. Depreciation expense, including the amortization of capitalized interest in 2014, 2013 and 2012, was \)2.5 billion, \(2.7 billion and \)2.5 billion, respectively.

Johnson & Johnson provided the following selected information in its 2014 cash flow statement.

Johnson & Johnson 2014 Annual Report Consolidated Financial Statements (excerpts) Net cash flows from operating activities \(18,471 Cash flows from investing activities Additions to property, plant and equipment (3,714) Proceeds from the disposal of assets 4,631 Acquisitions, net of cash acquired (2,129) Purchases of investments (34,913) Sales of investments 24,119 Other (primarily intangibles) (299) Net cash used by investing activities (12,305) Cash flows from financing activities Dividends to shareholders (7,768) Repurchase of common stock (7,124) Proceeds from short-term debt 1,863 Retirement of short-term debt (1,267) Proceeds from long-term debt 2,098 Retirement of long-term debt (1,844) Proceeds from the exercise of stock options/excess tax benefits 1,782 Net cash used by financing activities (12,260) Effect of exchange rate changes on cash and cash equivalents (310) Increase in cash and cash equivalents (6,404) Cash and cash equivalents, beginning of year (Note 1) 20,927 Cash and cash equivalents, end of year (Note 1) \)14,523 Supplemental cash flow data Cash paid during the year for: Interest $ 603 Income taxes 3,536

Instructions

1. What was the cost of buildings and building equipment at the end of 2014?
2. Does Johnson & Johnson use a conservative or liberal method to depreciate its property, plant, and equipment?
3. What was the actual interest paid by the company in 2014? ‘
4. What is Johnson & Johnson’s free cash flow? From the information provided, comment on Johnson & Johnson’s financial flexibility.

Short answer

1. Cost of buildings and building equipment: $10,046.
2. Straight-line depreciation provides a lower charge of depreciation.
3. The cash flow statement reports $603 of interest.
4. Free cash flow is $7,259.

Step-by-step solution

Meaning of Depreciation

Depreciation is the accounting practice of assigning the cost of tangible assets to expenses systematically and sensiblyto the periods in which the asset is expected to be used.

(a) Determining the cost of the building and building equipment.

The building and building equipment cost end of 2014 was $10,046.As stated in the information of Johnson & Johnson, the value of the building in 2014 is more than the year 2013.

(b) Determine the method that should be used by Johnson & Johnson.

For financial statement purposes, the firm uses the straight-line approach for all additions to property, plant, and equipment, as stated in footnote number 1 to the financial statements. Because straight-line depreciation generates a lesser charge for depreciation in the early years of an asset's life than an accelerated approach, the accounting looks to be less cautious.

(c) Determining the actual interest paid by the company.

The cash flow statement reports the interest paid in cash ($603) as stated in the financial report of Johnson & Johnson that cash paid during the year for interest was $603.

(d) Explaining Johnson & Johnson’s free cash flow.

Net cash flows from operational operations fewer capital expenditures and dividends equal free cash flow.

The amount of discretionary cash flow available to a corporation for making extra investments, paying down debt, buying treasury shares, or simply increasing liquidity is known as free cash flow. In the case of Johnson & Johnson, free cash flow is calculated as follows:

Net cash flows from operating activities	$18,741
Less: Additions to property, plant, and equipment	3,714
Dividends	7,768
Free cash flow	$ 7,259

Johnson & Johnson has a lot of free cash flows, as the preceding calculation shows. The company's financial flexibility is exceptional.

The corporation, for example, can pay its dividends without relying on outside funding. Second, even if operations drop, the corporation looks to be able to pay for property, plant, and equipment upgrades. Finally, the corporation is using its free cash flow to acquire other businesses in order to grow its operations.