Ford Motor Company - Case Study Example

FORD MOTOR PROJECT The Problem A project model with determinate projected cash flows but without the amount of required capital and type of industryhas been presented to me as possible project funding. In my capacity as Ford CFO, I would choose a project that can earn a return above the opportunity cost of equity capital and which would help improve the profitability of the corporation. Ford Motor Company has been in the red since 2006 when it lost $12.6 billion after having been profitable in the previous years (Annual Report; Stock quotes). Although average revenues for 2006 and 2007 had only slightly dipped below the average of the previous two years, the global recession hit the company particularly hard in 2008 when revenues dropped 15 percent to $146 billion and losses mounted to $14.7 billion from a low of $2.7 billion in 2007. All of the companys assets in 2008 were funded by debt, while equity is negative. I find that although the company raised some equity in 2009, the demand for automobiles in general and for Ford models in particular has yet to recover from the recession. Raising capital in the automotive industry would be difficult. I would therefore consider a project only if it is shielded from the impact of the current recession and which is within our organizational capability to carry out and manage. Risk-free capital and risk premium. In order to determine whether investors would be willing to put up investment money for the project, I would have to look for market criteria that they would normally consider as part of their evaluation. The risk-free rate of return is a theoretical return on investment that has an absolute zero risk. In the United States the common benchmark used is the 3-month Treasury bill which has been holding at 6 per cent per annum. Although bonds recently have dropped temporarily below 1 per cent, this has no relationship to T-bills for our purpose because we have to consider what is the standard rate that is expected to remain in the next months or years (Risk-free rate of return). The risk premium is the return in excess of the risk-free rate that investors expect to receive. It is a sort of compensation for the risk they take. Equities carry a larger risk premium compared to government bonds because of the greater risk of failure inherent in common stock investments compared to the default risk on bonds. Investment alternatives and/or mix A new project always requires equity because of the risk that must be borne as well as the potential for making substantial profits. A common stock represents ownership of a business enterprise denoting certain rights such as setting policy. In the event of liquidation, however, the common shareholder have rights to the corporations assets subordinate to those of the debtors and preferred stockholders. For new projects, venture capitalists may be asked to participate to provide capital funds, particularly for start-up and small firms with above-average long-term growth potential. This is a good source of investment funds for a business with limited operating history and with limited ability to raise debt capital. A preferred stock is a class of ownership that receives dividends with higher priority compared to common stockholders. Owners of preferred stocks have a higher claim on the companys assets in case of liquidation than common shareholders but cannot participate in the profits. Long-term debt or bondholders are paid a fixed interest and have a prior claim to a firms assets than the preferred and common stockholders. On the other hand, a commercial loan, with characteristic maturities of one year or less, may also be considered for financing operational needs, but they are not appropriate where funds are needed for the purchase of fixed assets. Thus only long-term debt and equity (preferred and common) can constitute the capitalization of a business or project. Seeking investment capital Ford cannot use its financial record as obtained through its financial statements (balance sheet, income statement, and cash flow statement) because they are quite dismal at this point in time. Cash flow from operating activities is negative ($179 million in 2008 ) even after adding back substantial depreciation. Google finance lists the companys Beta as 2.63, indicating huge volatility compared to the equity market in general. The risk premium in the automotive industry is listed as 4.89. Using the CAPM formula for deriving the required risk of return and inputting this beta, we would have the following return profile for Ford: Rds = Rfr + Rp (beta) = 6 + 4.89 (2.63) = 6 + 12.9 = 18.9 The desired rate of return for the recession-buffeted automotive company would therefore be a very high 18.9 per cent. This computation is valid only if the project that I choose is in or is somehow linked to the same industry. Capital structure and the WACC Ford Motors capital structure at the end of 2008 consisted only of long-term debt, equity being negative. This does not mean that the project now under consideration should be financed purely through debt. I would proposed a capital structure that represents a going concern under normal conditions. However, Keat and Mathis (2003) maintain that capital structure varies among different industries, with those having low-growth and high fixed assets showing higher leverage (debt/asset) ratios than fast-growing high-tech industries. A companys cost of capital as a whole is the weighted average of the returns expected by debt and equity investors. This is expressed by the following expression. where W1 is the weight of each type of capital, Ki is the cost of that capital component, and n the number different sources of capital. According to Brigham and Gapenski (1998), the primary use of WACC is to establish a firms cost of capital for capital budgeting purposes. It is also used as a hurdle rate when evaluating projects with similar risks. One uses the discounted cash flow method, bond-yield plus risk premium approach, or the capital asset pricing model. It is not within the scope of this paper to discuss the latter concept, although the the formula for the required rate of return is derived from it. Evaluation of the proposed project. The project has some some data provided by the proponent but has no specific amount required as capital to be employed (which could consist of debt or venture capital/ equity). It was therefore necessary to assume $3 million and $4 million as possible numbers. Using the discounted cash flow method, we have devised the following tables and computations. a. $3 million capital with the following assumptions Assumptions: Capital employed is $3 million (tentative capital amount) Operating expenses is 40 percent including depreciation Opportunity cost of capital is 12 percent Tax rate is 35 percent Fixed asset is depreciated on a straight-line basis for a period of 4 years. Cash inflow is $2m in year1, $3m in year2, $4m in year 3, and $5m in year 4 There is no terminal value. Table 1 I t e m s ($000) Year 0 Year 1 Year 2 Year 3 Year 4 Cash flow -3000 2000 3000 4000 5000 Operating expenses 1550 1950 2350 2750 Operating profit 450 1050 1650 2250 Income tax 35% 157 367 577 787 Net profit after tax 293 683 1073 1463 Add back Depreciation 750 750 750 750 Net cash flow 1043 1433 1823 2213 Present value at 12 per cent 1.00 0.89 0.80 0.71 0.64 Present value 931 1142 1298 1407 Total present value -3000 4478 Net present value 1478 At the opportunity cost of equity capital of 12 per cent, the net present value is $1478, which means that the true Internal Rate of Return is substantially higher than this percentage. One has to compute via trial and error in order to arrive at the IRR, which is beyond the scope of this paper. b. $4 million capital, with other assumptions remaining the same. Table 2 I t e m s ($000) Year 0 Year 1 Year 2 Year 3 Year 4 Cash flow 4000 2000 3000 4000 5000 Operating expenses 1800 2200 2600 3000 Operating profit 200 800 1400 2000 Income tax 35% Net profit after tax 130 390 910 1300 Add back Depreciation 1000 1000 1000 1000 Net cash flow 1130 1390 1910 2300 Present value at 12 per cent 1.00 0.89 0.80 0.71 0.64 Present value 1006 1112 1356 1472 Total present value -4000 4946 Net present value 946 With an increased investment outlay of $4,000,000, the projects net present value is $946,000 which means that even with this increase, the rate of return is still above 12 percent. Computing for the Hurdle Rate (Using Ford Motor beta) a. Hurdle rate for $3 million If we assume that the hurdle rate is 20% (rounded off from 18.9, for ease of computation), the following computations for $3 million capital will yield: Table 3 I t e m s ($000) Year 0 Year 1 Year 2 Year 3 Year 4 Cash flow -3000 2000 3000 4000 5000 Operating expenses 1550 1950 2350 2750 Operating profit 450 1050 1650 2250 Income tax 35% 157 367 577 787 Net profit after tax 293 683 1073 1463 Add back Depreciation 750 750 750 750 Net cash flow 1043 1433 1823 2213 Present value at 12 per cent 1.00 0.83 0.69 0.58 0.48 Present value 865 989 1057 1062 Total present value -3000 3973 Net present value 973 A net present value of $973 shows that the project is a good one because of its net present value at 20% hurdle rate.Hurdle Rate for $4 million With an investment of $4 million the following results. It also passes the test but the net present value at 20 percent has dropped to $108 Table 4 I t e m s ($000) Year 0 Year 1 Year 2 Year 3 Year 4 Cash flow 4000 2000 3000 4000 5000 Operating expenses 1800 2200 2600 3000 Operating profit 200 800 1400 2000 Income tax 35% Net profit after tax 130 390 910 1300 Add back Depreciation 1000 1000 1000 1000 Net cash flow 1130 1390 1910 2300 Present value at 12 per cent 1.00 0.83 0.69 0.58 0.48 Present value 937 959 1108 1104 Total present value -4000 4108 Net present value 108 Conclusion It was difficult to use the historical financial data of Ford Motor for the purpose of formulating the capital structure for a new venture or project because of the unfortunate events that befell the automotive industry and the company in the past year or so. Nevertheless, I decided to use the hurdle rate of 20 percent derived from computing the desired rate of return, using the high beta for Ford Motor. The expected returns on capital employed for the project exceeded the hurdle rate for investments of $4 million and below. I would therefore invest in this project provided the required capital does not exceed $4 million, assuming the projected cash flows to be correct. REFERENCES Annual Report, Ford Motor. Retrieved December 7, 2009 http://www.ford.com/about-ford/investor-relations Brealey, RA, Myers, SC & Marcus, AJ, (1995). Fundamentals of Corporate Finance, , Boston, Mass: McGraw-Hill Brigham, E.F. (1996). Intermediate Financial Management (5th ed.). Orlando, FL: The Dryden Press Financial statements, Ford. Retrieved December 7, 2009 http://www.reuters.com/finance/stocks/companyProfile?symbol=F.N Keat, P.G. & Mathis, F.J. (2003). Financial Management. New York: Simon & Schuster Prime rates. Retrieved December 7, 2009 http://www.finaid.org/loans/prime_libor.phtml Risk-free rate of return. Retrieved December 7, 2009 http://financial-dictionary.thefreedictionary.com/Risk-Free+Rate+of+Return Stock quotes, beta. Retrieved December 7, 2009 http://moneycentral.msn.com/detail/stock_quote?Symbol=F Read More