FIN 7100 Module 4 Capital Structure Written Assignment Example

Seven Percent Debt Versus Fifty-Five: What the Capital Structures of Johnson & Johnson, Merck and Campbell's Say About Raising Capital

Student Name

Master of Business Administration (MBA), Thomas Edison State University

FIN-7100: Financial Management

Mentor Name

Month Day, Year

Seven Percent Debt Versus Fifty-Five: What the Capital Structures of Johnson & Johnson, Merck and Campbell's Say About Raising Capital

This written assignment compares how three New Jersey companies finance themselves and uses capital structure theory to judge whether their choices make sense. Johnson & Johnson, Merck and The Campbell's Company are the nonfinancial companies from my final project sample; Prudential is left out because an insurer's balance sheet works differently. Debt figures come from each company's latest annual report on Form 10-K, and equity is valued at the September 30, 2026, share price times shares outstanding. The final section applies the theory to a practical question: how Campbell's should raise $1 billion if it needed new capital.

Three Very Different Balance Sheets

Measured at market value, the three companies sit at opposite ends of the range. Johnson & Johnson's equity was worth about $638 billion against $47.9 billion of debt, so debt was 7.0 percent of its total value. Merck, with $49.3 billion of debt and equity worth about $358.5 billion, stood at 12.1 percent. Campbell's carried $7.1 billion of debt against equity worth only about $5.9 billion after a five-year fall in its share price, so debt made up 54.7 percent of its value.

Coverage tells the same story. Johnson & Johnson's earnings before interest and taxes covered its interest expense 34.6 times and Merck's 16.5 times; Campbell's covered its interest only 2.6 times. Campbell's debt was about 5.6 times its operating income plus depreciation and amortization, or about 4.9 times before the year's impairment and restructuring charges.

What Theory Predicts

Modigliani and Miller (1958) showed that in a perfect market, with no taxes, distress costs or information problems, the mix of debt and equity does not change a firm's value: borrowing raises the expected return shareholders require by exactly enough to offset the cheaper debt. Berk and DeMarzo (2020) then relax the assumptions one at a time. Corporate taxes add value to debt, because interest is deductible; if debt is permanent, the present value of the tax shield is roughly the tax rate times the debt. Against that benefit stand the costs of financial distress, which grow as debt rises, and agency costs between managers, shareholders and lenders (Jensen & Meckling, 1976). The trade-off theory says firms should borrow until the marginal tax benefit equals the marginal expected distress cost.

Myers (1984) pointed out that real firms rarely look as though they are pursuing such a target. His pecking order theory, developed with Majluf, holds that because managers know more than investors, issuing equity signals that the stock may be overvalued, so firms prefer internal funds first, then debt, and issue equity only as a last resort (Myers & Majluf, 1984).

Applying the Theories

Johnson & Johnson and Merck look under-levered by the trade-off theory. With enormous coverage, both could borrow much more before distress costs became meaningful, and each forgoes tax shields worth tens of billions. The pecking order offers a better explanation: both generate far more cash from operations than they invest, so they rarely need outside money, and their debt mostly funds acquisitions and share repurchases. Both companies also face large legal and patent risks that make financial slack valuable, which counts as a cost of debt the simple trade-off model leaves out. Graham and Harvey (2001) reported that the finance chiefs they surveyed ranked financial flexibility and their credit rating above tax savings when setting debt policy, which fits these two companies.

Campbell's is the opposite case. Its debt grew mainly to pay for acquisitions, and the fall in its share price has raised its debt ratio at market value further. Its tax shield is worth about a quarter of its equity value, which looks attractive, but with coverage of 2.6 times and declining operating income, the expected costs of distress are rising: lenders charge more, suppliers and customers watch the credit rating, and management has less freedom to invest. Under the trade-off theory, Campbell's is likely past its best debt level, not short of it.

These differences show up in the cost of capital. Using CAPM costs of equity of about 7.9 percent for the two drug makers, an assumed pretax cost of debt of 5.74 percent and a 21 percent tax rate, the weighted average cost of capital is about 7.7 percent for Johnson & Johnson and 7.5 percent for Merck. For Campbell's, the regression beta is too low to trust given its debt load, so I used costs of equity from 9 to 10 percent and a pretax cost of debt of about 6.8 percent, giving a WACC between 7.0 and 7.5 percent. A low WACC for Campbell's is a warning rather than a strength: it reflects heavy reliance on debt whose distress costs the simple formula does not capture.

How Should Campbell's Raise $1 Billion?

Suppose Campbell's wanted $1 billion for a new acquisition. The pecking order would suggest internal funds and then debt. Internal funds are limited: free cash flow of $678 million in fiscal 2026 was mostly paid out as dividends of $470 million. More debt would lift debt to about $8.1 billion, cut coverage to about 2.1 times and risk a downgrade. Issuing equity at a depressed price would dilute shareholders by roughly 17 percent and send the negative signal Myers and Majluf describe.

The best answer is to raise the money without new securities: reduce the dividend, sell a slower-growing brand, or both. Cutting the dividend by a third would free about $157 million a year and could be paired with a brand sale to reach $1 billion while reducing debt at the same time. Managers resist dividend cuts, but for a company with Campbell's debt load, retaining cash is cheaper than either more debt or new equity. The more important conclusion is that Campbell's should not pursue a large acquisition until its debt has fallen.

Conclusion

The three companies show that capital structure is shaped by more than the textbook's tax and distress trade-off. Johnson & Johnson and Merck carry little debt because they generate cash and value flexibility, as the pecking order and survey evidence predict. Campbell's carries too much for its earnings, so its priority should be to reduce debt, and any new capital should come from retained cash and asset sales rather than from borrowing or issuing shares.

References

Berk, J., & DeMarzo, P. (2020). Corporate finance: The core (5th ed.). Pearson.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360. https://doi.org/10.1016/0304-405X(76)90026-X

Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48(3), 261-297.

Myers, S. C. (1984). The capital structure puzzle. The Journal of Finance, 39(3), 574-592. https://doi.org/10.1111/j.1540-6261.1984.tb03646.x

Myers, S. C., & Majluf, N. S. (1984). Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13(2), 187-221. https://doi.org/10.1016/0304-405X(84)90023-0