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%?
|Equity (E)||$7 billion||(7/20) = 0.35|
|Preferred (P)||$3 billion||(3/20) = 0.15|
|Debt (D)||$10 billion||(10/20) = 0.5|
Cost of equity is the Risk free rate + Beta x Market risk premium
4% + (1.8 x 7%) = 0.166= 16.6%
Cost of preferred stock is the Fixed Dividend / Price per share
$3.50/$27 = .1296296296 = 12.96%
Cost of debt = Yield to maturity x (1- Tax rate)
9.5% x (1-30%) = 0.0665= 6.65%
Ford Company has equity, stock and debt in its capital structure. The degree of its debt in the capital structure is about half deemed by value at 35 percent and stock at 15 percent. Taken a toll value is most noteworthy among all another expense of capital. Expense of capital applying the given beta of 1.8 is 16.60 percent, expense of stock is 12.96 percent and expense of debt is considerably lower at 6.65 percent. The Weighted average cost of capital (WACC) for Ford Company is 11.08 percent. The Beta of the company contrasts with time, and are unpredictable. When there have been adjustments in the level of beta, business sector hazard premium, and the danger free rate, causing a significant change in the expense of value for the company. Change in the business sector loan fee may cause changes in regarding development of the bond. Expense of value will be fitting to use a somewhat higher beta when comparing with the normal beta. Chance that profit markdown model has been used for deciding expense of value then there will be an adjustment in the whole estimation of the expense of value.
Another actual reason for fine-tuning the degree of capital is if the company increases the degree of value and decreases the extent of debt then it will build the WACC and the just the opposite the other way. It may expand the degree of debt that will build danger and may promote building the expense of value which may influence the WACC. Undertaking, there must be an adjustments made in the WACC as indicated by the sources and extent of capital used for financing the venture and the expense at which these capitals being brought up in the business sector. WACC is not dependable in all situations because it changes with the sources and amount of capital consumed.
Ross, Westerfield, & Jordan. (2013). Fundamentals of Corporate Finance (10th ed.). New York, NY: McGraw-Hill Irwin.
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M7A1 Mini Case Ford Company Capital Budgeting Project.docx