Financial Management For Company Capital Budgeting Problem

Financial Managementford Companycapital Budgeting Problemthe Market Va

Financial Management Ford Company capital budgeting problem involves calculating the weighted average cost of capital (WACC) based on given market values of equity, preferred stock, and debt, as well as their respective costs and other relevant financial metrics. The problem provides the market value of Ford's equity, preferred stock, and debt, along with information on beta, market risk premium, risk-free rate, preferred stock dividend, preferred stock price, yield to maturity on debt, and tax rate. The goal is to determine Ford's WACC using these details.

Paper For Above instruction

The weighted average cost of capital (WACC) is a critical metric for firms, representing the average rate it is expected to pay to finance its assets through equity, debt, and preferred stock. It reflects the minimum return that a company must earn on its existing asset base to satisfy its investors or creditors. Calculating Ford’s WACC requires integrating the costs of each component of its capital structure, adjusted for their proportions and the company's tax rate.

1. Market Values and Capital Structure

The given market values are:

- Equity (E): $7 billion

- Preferred stock (P): $3 billion

- Debt (D): $10 billion

Total value (V) = E + P + D = $7B + $3B + $10B = $20 billion

The weights of each component in the capital structure are:

- Weight of equity (E/V): 7/20 = 0.35

- Weight of preferred stock (P/V): 3/20 = 0.15

- Weight of debt (D/V): 10/20 = 0.50

These weights are essential to calculating the WACC, representing the proportion of each type of capital in Ford's total capital structure.

2. Cost of Equity (Re)

The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM):

Re = Rf + β × Market Risk Premium

Where:

- Rf = risk-free rate = 4%

- β = beta = 1.8

- Market risk premium = 7%

Re = 4% + 1.8 × 7% = 4% + 12.6% = 16.6%

3. Cost of Preferred Stock (Rp)

Preferred stock's cost is calculated as:

Rp = Dividend / Price per share

Given:

- Dividend = $3.5

- Price per share = $27

Rp = $3.5 / $27 ≈ 0.1296 or 12.96%

4. Cost of Debt (Rd)

The yield to maturity (YTM) on debt is:

- Rd = 9.5%

Since interest on debt is tax-deductible, the after-tax cost of debt is:

Rd(1 - Tax rate) = 9.5% × (1 - 0.30) = 9.5% × 0.70 = 6.65%

5. Calculating WACC

WACC is computed as:

WACC = (E/V) × Re + (P/V) × Rp + (D/V) × Rd(1 - Tax rate)

Plugging in the values:

WACC = 0.35 × 16.6% + 0.15 × 12.96% + 0.50 × 6.65%

Calculations:

- Equity component: 0.35 × 16.6% = 5.81%

- Preferred component: 0.15 × 12.96% ≈ 1.94%

- Debt component: 0.50 × 6.65% = 3.33%

Total WACC = 5.81% + 1.94% + 3.33% ≈ 11.08%

6. Final Result

Therefore, Ford's weighted average cost of capital is approximately 11.08%. This rate reflects the company's blended cost of financing from equity, preferred stock, and debt, considering the company's capital structure and tax considerations.

In conclusion, understanding and calculating the WACC enables Ford to evaluate investment projects, optimize its capital structure, and ensure value maximization for shareholders by aligning project returns with the company's cost of capital.

References

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