In this post several calculations and analysis will be examined. Specifically, the Weighted Cost of Capital (WACC) will be calculated and considerations of capital budgeting analysis. Ford’s financials will be examined in finding the most effective budget analysis. National trends toward capital risks will also be discussed in reference to the Ford’s WACC. Lastly the capital requirements of Ford will discussed.
Weighted Average Cost of Capital
The weighted average cost of capital (WACC) is the “Expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments” (Brealey, Myers, & Marcus, 2007, p. 327). The calculation of the WACC takes into account the firm’s capital structure as well as the amount of return required from shareholders for debt and for equity or any other class of security that is part of a company’s capital structure. The cost of capital is the weighted average of the required returns and the WACC uses the same calculations but accounts for the tax discount on interest paid for debt. In order to calculate the WACC the company must first calculate the expected rate of return based on the level of risk that an investor is taking on.
The required rate of return on common stock can be calculated using the capital asset pricing model (CAPM) which measures the rate of return required by investors based on risk as well as current market expected return on risk-free assets. The WACC is used to determine the necessary cash flows that an investment must produce in order to generate enough income to give investors a fair return on their investment. Ford Motor Company has a complex capital structure involving outstanding debts as well as equity, preferred stock and other classes of security. In order to measure the WACC the CAPM model is used to derive a beta for debt and equity and from there the WACC can be calculated.
WACC is an excellent tool to evaluate a project. However, using this method for Ford Motor Company can provide both positive analysis and problems. First of all, as mentioned WACC is helpful in deciding if a project offers a return that shareholders find acceptable. Obviously, Ford needs to evaluate individual projects to see if the project matches up with Ford’s goals. However, applying WACC to a whole company can be difficult. For one, the process gets much more complicated. As mentioned earlier WACC calculated required rate of return for each class of security and debt. For example, Ford has long term debt, minority interest, redeemable preferred stock, non-redeemable preferred stock, common stock, and treasury stock just to name a few (MSN money, n.d.). Each one of these debts or equity is a portion of WACC. Inherently, more variables makes calculation more difficult.
Another point is that changing capital structure of the company will change WACC. Many companies change capital structure and Ford may possibly do so as well. Logically, this means one needs to readjust the WACC whenever capital structure changes. The problem is forecasting the outcome of changing capital structure is difficult. One reason for example, is when a company decides to take on more debt this most likely means shareholders will ask for higher returns. In this case, calculating Ford’s WACC if it decides to take on more debt will prove hard. Plus, not only will the required return on equity increase, but most likely debt will as well. The reason is creditors will ask for a higher return since the company is more leveraged. In this instance WACC debt and equity required return needs to be increased (Brealey, Myers, & Marcus, 2007).
Using WACC on Ford is both complicated and may not yield accurate results. Since, Ford has a variety of debt and equity the rate of return for each needs to be figured. Plus, WACC readjustment would be done every time the capital structure is modified. However, WACC is a way for Ford to benchmark and is a tool for Ford to use in financial analysis.
The calculation of WACC for Ford is based on the 2008 Form 10-k (2008) filed with the SEC. Debt rates were calculated using interest expense as a percentage of total debt value. For equity, shares from the financial statements were used, but matched to market value based on the current share price as quoted at $7.75 (Yahoo Finance, 2009). Convertible preferred stock values were also included in the calculation of WACC. The expected equity returns were calculated using the CAPM with a risk-free rate of 4.5% and an assumed market risk premium of 4%, for a total expected return of 8.5%.
Figure 1. WACC Calculation
The calculated WACC is 5.43% given the stated assumptions. This may be used as a discount factor for internal analysis of new investments, given that it represents the average cost of raising capital for a new project. The expected return rate of the project must cover this weighted average return value with margin above it so that a profit may be made. A project with a return value less than WACC will not yield returns after accounting for cost of capital. This is therefore a hurdle rate and not a target return, as ideally the firm will produce returns in excess of the cost of capital.
It must be noted that Ford is showing a rising value of equity. Over the last year, the stock price has risen over three times from $2 to over $7 (Yahoo Finance, 2009). A forward looking calculation of WACC could take this into consideration. This would increase the proportion of monies calculated for equity in a future WACC calculation, which would increase the cost of capital as equity does not receive the benefits of the tax shelter that debt carries. However, as funds for a project may be required today rather than a year later, the current WACC would be used as a it represents the cost of raising funds at that point in time.
Recommendations for Ford Company would be to continue to use the WACC as a tool to allow them to assess what projects would add value to its shareholders and company with a high return. If they decide not to use this tool it can in ongoing efforts with future projects they could hurt them in the long term. They must take a risk in creating more capital to gain more cash flow to balance their debt ratio. There is a need to make sure that all of their projects are on point and following their timelines and expense. They must comply with all the necessary steps in obtaining their project goal and staying within budget. The last thing the company and its shareholders would want is that the project costs more than their return. Example: If they chose to develop a new make/model car and is projecting the project to cost $4 million dollars but they end up spending $8 million on project. Then when the cars are released for sale, they only make sold $2.6 million in cars which results to a $6.2 million loss. So they must be careful as to how they determine as to what type of project they decide to implement and try their very best to save money as much as possible but yet be able to seek positive and high returns.
After careful analysis, Ford’s WACC is extremely complicated given the company’s structure and national trends. Ford has a required rate of returns for each class of security and debt. For a company such as Ford, this can further complicated the measure. To further complicate the calculations, many companies have been restructuring their capital in light of recent developments. The WACC is 5.43% and includes discount rates and internal analysis. However, the most impressive and shocking thing is the stock’s movement. In the last year it is has gone from $2 and risen to $7. This has to be a disturbing because it doesn’t support our analysis. However, this can be dismissed as fluke in the market, rather than the financials of the company. Ford should use WACC as a tool to measure its effectiveness of the financials and how to structure its debt and capital.
Brealey, R.A., Myers, S.C., Marcus, A.J. (2007). Fundamentals of Corporate Finance, 5e. New York: The McGraw-Hill Companies, Inc.
Ford (2008). Form 10k-k, 2008. Retrieved on November 8, 2009 from http://edgar.sec.gov
MSN money. (n.d.). Retrieved November 2, 2009, from http://moneycentral.msn.com/investor/research/welcome.asp
Yahoo Finance (2009). Stock quote for F. Retrieved on November 8, 2009 from http://finance.yahoo.com.