Text = Ross, Westerfield & Jordan. (2013). Fundamentals of Corporate Finance (10
ID: 2650078 • Letter: T
Question
Text = Ross, Westerfield & Jordan. (2013). Fundamentals of Corporate Finance (10th ed.). New York, NY: McGraw-Hill/Irwin
Analysis needed on the below to provide a brief summary (approximately 200 to 300 words) to the CFO
A) summarizing the weighted average cost of capital you determined for Ford,
B) where there may be risks in the calculation (how the calculation may change over time),
C) how the weighted average cost of capital you calculated should be applied when making cost of capital project decisions,
D) and some scenarios that the CFO should be aware of that may change the weighted average cost of capital at some future point.
Financial Management
Ford Company
Capital Budgeting Problem
The market value of Fords' equity, preferred stock and debt are $7 billion, $3 billion, and $10 billion, respectively. Ford has a beta of 1.8, the market risk premium is 7%, and the risk-free rate of interest is 4%. Ford's preferred stock pays a dividend of $3.5 each year and trades at a price of $27 per share. Ford's debt trades with a yield to maturity of 9.5%. What is Ford's weighted average cost of capital if its tax rate is 30%?
Ford Company
Market Capitalization
Weight
Equity (E)
7
35%
Preferred (P)
3
15%
Debt (D)
10
50%
Total
20
100%
Ford Company
Weight
Cost
After-tax
Marginal Weight
Equity (E)
35%
X
16.60
=
5.81%
Preferred (P)
15%
X
12.96
=
1.94%
Debt (D)
50%
X
6.65
=
3.33%
Total
100%
X
=
11.08%
Details:
Step 1:
1) Cost of Equity = Rf + (Rm-Rf)*Beta
Cost of Equity = 4+ 7*1.8
Cost of Equity = 16.60
2) Cost of Preferred Stock = 3.5/27
Cost of Preferred Stock = 12.96
3) Before Tax Cost of Debt = 9.50 %
After Tax Cost of Debt = 9.50*(1-30%)
After Tax Cost of Debt = 6.65
Step 2:
Market Value of Equity = 7 Million
Market value of Preferred Stock = 3 Million
Market Value of Debt =10 Million
Total Market Value = 7 + 3 +10 = $ 20 Million
Weight of Common Stock = 7/20 = 35%
Weight of Preferred Stock = 3/20 = 15%
Weight of Debt = 10/20 = 50%
Step3:
WACC = Weight of Equity * Cost of Equity + Weight of Preferred Stock* Cost of Preferred Stock + Weight of Debt* After Tax cost of Debt
WACC = 35%*16.60 + 15%*12.96 + 50%*6.65
WACC = 11.08%
Ford Company
Market Capitalization
Weight
Equity (E)
7
35%
Preferred (P)
3
15%
Debt (D)
10
50%
Total
20
100%
Explanation / Answer
A) Weighted avarge cost of capita or WACC is the average cost of capital for FORD using weighted average method for its different sources of capital. Ford has 3 sources - equity, preferred stock and debt. Equity has the highest cost at 16.6% and debt has the lowest tax of 6.65%. Since total capital consists of 50% debt, the overall cost of capital is 11.08%, due to the highest weightage of debt.
B) The calculation may change over time, with changing interest rates. With any change in interest rates the YTM of the debt will also change, changing the cost of debt. This can change the overall cost of capitak or WACC.
C) For capital project decisions, WACC is used to discount the future cash flows in order to calculate the present value of these cash flows. Suppose Ford is looking at an investment of $100 million in a new project, which will give annual inflows of $18.5 million over the next 25 years. So, the present value of the $18.5 million inflows for the next 25 years, will have to found, using a discount rate equal to WACC.
D)Some scenarios that may change the WACC - (1) if Ford issues new equity, its WACC will rise from the current levels. (2) If Ford retires some of its debt, its WACC will rise. (3) If Ford issues new debt its WACC will fall from the current level.
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