1

Financial Management

Ford Company

Capital Budgeting Problem

Q1) Given values:

i) Equity = $ 7 billion
ii) Preferred Stock = $ 3 billion
iii) Debt= $ 10 billion
iv) Beta value= 1.8
v) Market risk Premium = 7%
vi) Risk Free Rate Of Interest = 4%
vii) Ford's preferred stock pays a dividend = $3.5 each Year
viii) Trading price = $27 per share
ix) Ford's debt trades with a yield to maturity of= 9.5%
x) Tax rate = 30%

Market Capitalization Weight

Equity(E) $7 billion 7/20 = 0.35
Preferred (P) $3 Billion 3/20= 0.15
Debt(D) $10 Billion 10/20 = 0.5
Total $ 20 billion

Cost of Equity = Risk-Free Rate of Return + Beta of Asset * (Expected Return of the Market -
Risk-Free Rate of Return)

= 4% +1.8*7% = 16.6%

Cost Of Preferred Stock= (Dividend)/ Price *100 = 3.5/27 *100 = 12.96%

Cost of Debt = Cost of debt is generally equal to the value of debt shares with a yield to maturity
= 9.5%

After tax Cost of Debt = 9.5(1-t) = 9.5(1-0.3) = 6.65%

 2

Weighted Average Cost Of Capital:

= [(Weight of equity) × Cost of Equity] + [(Weight of debt) × Cost of Debt after Tax] + [(Weight
of Preferred stocks) × Cost of Preferred Stocks]
= [0.35 ×16.6] + [0.5+ 6.65] + [0.15×6.65] = 11.079 %

Weight Cost After Tax Marginal

Weight
Equity (E) 0.35 16.6 5.81
Preferred (P) 0.15 12.96 1.944
Debt (D) 0.5 6.65(After Tax) 3.325
Total 1 11.079 11.079

The weighted average cost of capital (WACC) for the ford company is around 11.079 %. This
shows that if for example the company is getting 20% in return, then the company is generating
approximately 9% return on every dollar that is invested. The weighted average cost of the
capital of the company shows the minimum rate of return that the company must obtain in order
to remain profitable or to generate value as the company grows. When the company tries to
invest in high risk project it has to keep in mind that the discount rate of the investment should
be Higher than WACC value while if the company decides to invest in a lower risk project than
it has to look that the discount rate of the project is less than the WACC value of the company.
The risk that is associated with the calculation of the WACC value is that even though the
calculation of the weight of the debt and the weight of the cost is relatively but for calculation of
the cost of debt and the cost of equity there are various options like Dividend growth model,
capital assets pricing model and the bond yield risk premium method and all these options have
at least one variable which is derived on the basis of assumptions. Thus on the basis of the
different values the value of WACC may vary according to the methods used. The calculations
of the WACC is based on the risk free rates which are evaluated from the treasury bills which are
issued in the terms of 2,3,5,10 and 30 years thus in future the company should keep in mind that
the terms of debt of the company also may not match with the treasury terms.