Investment Appraisal Project: Ford Motor Company Limited - Research Paper Example

? INVESTMENT APPRAISAL PROJECT Ford Motor Company Limited ___________ Contents Introduction to the company 3 Relevant Financial Data 5 Mathematical Analysis of the Project 9 Financing Plan for the Project 11 References 14 Ford Motor Company Limited Introduction to the company Ford motors - an internationally recognized name which is considered analogous for state of the art automotive designs and high efficient luxurious cars. Ford Motors is regarded as the premier automotive company in the global automotive industry catering the diverse range of consumers all around the globe. Keeping in pace with the globalization, the company has expanded into a giant multinational by launching its business in other frontiers. As per the latest audited financial statement of the company (for the financial year ended 201), the company employees more than 164,000 and has more than 70 operational plants worldwide in six continents. Ford Motors well established business attracts a great deal of consumer base irrespective of demography. The primary business of the company comprises of high end state of the art cars both for the individual as well as for the industrial use. The company, through its resilient and effective marketing tactics, has able to capture significant market shares in the automotive industry worldwide. Following is an extract from the financial statement of the company which presents the movement in the market share of the company for the current financial year of 2011 The company divides its revenue into two broad segments which are through automotive and through financial services. The automotive structure is further divided into four segments of 1) Ford North America, 2) Ford South America, 3) Ford Europe, and 4) Ford Asia Pacific Africa. Whereas, the ford financial services are divided into 1) Ford Credit, and 2) Other Financial Services. The company has improved its asset allocation strategy and has also rejuvenated its business strategy and global competitive strategy. The proactive approach has resulted in an increase of 5.7% in sales revenue from the automotive and financial services business. The financial year 2011 proved to be another progressive year for Ford Motor Company. During the current year, the company’s revenue increased by 5.7% during the current year to an impressive $136,264 million which has caused the operating profit to increase by a staggering 21%. The company, following its growth strategy, aspires transform its operation into multi channel business. The company has taken major steps in investing its direct sales business which enhanced the revenue during the current financial year. In addition, the company is actively following its strategy of refurbishing its plants and giving them a new and improved look. The refurbishment has resulted in an increased production capacity and has created a more opportunities for the company. The following table compares the financial results of Ford Motor Company, for the financial year 2011 with that of the year 2010. As quite evident from the above comparison, the financial outlook of the company has improved. The increase in group revenue primarily pertains to the increase in like-for-like sales as well as the addition of new plants and outlets, both in and outside of North America. Since Ford Motor Company do a significant number of its sales overseas, the company’s revenue is majorly increased due to the fluctuation in exchange rate. Although the recent credit crisis and global economic meltdown proved to be a hurdle, but the impact was offset by prudent risk management and apt allocation of capital investment. The gross profit to sales ratio for the year ended December 31, 2011 was 6.37% which has decreased by notably during the current year. The increase in the profit is due to the fact that during the current year the company did not spend any exceptional cost which it incurred during the prior year on strategic restructure. In addition, the company took strong measures to control its finance cost during the current year and curtailed it by $4,431 million as compared to the prior year figure of $6,152 million. Relevant Financial Data The company is currently considering a project in which requires an initial investment of $ 10 million in preliminary funding. In order to evaluate the financial feasibility of any company, the Net Present Value (NPV) or IRR (internal rate of return) of the project is calculated by using the company’s cost of capital. The company’s cost of capital is basically the weighted average cost of capital which is calculated through the following formula WACC=wdkd(1-T)+wpkp+wsks Where  Kd = interest on debt  Kp = cost of preference shares  Ks = cost of shares and retained earnings.  WACC is calculated by multiplying the cost of equity by the market value of the equity and cost of debt by the market value of the debt. Cost of equity can be defined as the minimum rate of return that a company must generate and offer to their investors in order to provide a return on their investment and for assuming some level of risk. If the company does not offer this risk to the investors, there is a chance that the shareholders might sell these shares in the market. Selling of the company shares can be interpreted as a negative sign for the financial outlook of the company and will put a downward impact on the market value of the company. Cost of debt is actually the rate at which the present value of the interest payments and redemption amounts equals the current market value of the debt. The following formula further clarifies. Where M is the market value of the bond currently on which it is being traded in the market, i is the interest payment and kd is the rate of return required by the debt holder. From the formula it can easily be deduced that the market value of any bond is the present value of the interest payment. But the above formula is only applicable in the case of debt having maturity till perpetuity. In case tax is involved, the interest is taken after tax. Cost of debt is basically the internal rate of return. The cost of equity, Ke can be calculated through the CAPM formula which is stated as: Where ‘Ke’ is the cost of equity, ‘Rf’ is the risk free rate, ‘Rm’ is the market rate of return and B is the beta of the company. The risk free rate is usually taken to be the rate on the 52-week discount rate for United States treasury bills for all the companies operating in the United States. The rationale behind using this rate as the risk free rate is that US Treasury bill, like any other government issued security is backed by the government security and there is no fear of default. As per the rates issued by the US Treasury Department, the interest rate on 52-week discount rate is 6% For investment appraisal decision, the company should use project specific beta. This can further be explained as the systematic risk associated with the project or the equity beta of a company involve in the similar project. The above calculated project of the company can only be applied on the projects which pertain to automotive industry since it represents the systematic risk of that particular industry. However, for example if the company decides to diverse its operations and decides to start a project which involves designing operating system software for desktop computers, it would be required to recalculate its WACC as the project specific beta would be different. Since the company is appraising a project which belongs to the automotive industry, to which it belongs, therefore the company’s beta can be used in determining the cost of equity of the Ford motor company limited. As per yahoo finance the beta factor of the ford motor company limited is 2.32. Another factor which is required for the calculation of the cost of equity is the market rate of return. This can be further defined as the average return of the stock market in which the share of the company under consideration is listed. Being an American based company, the stock exchange on which the shares of the Ford Motor Company is listed is the New York Stock Exchange (NYSE). The annual market return for the NYSE index remained on average 14% for the financial year ending 2011. In most situations, any project is financed through debt that is acquired from banks or any other financial institution. These banks and financial institution usually screen the credentials of the entity requiring the loan in order to ensure that the company will be able to pay back the loan under the stipulated terms along with the interest charge. Ford Motor Company Limited is well established organization portraying sound financial outlook and strong financial ratios. The best way to determine the average interest rate at which loan will be sanctioned to the company is by analyzing the current outstanding debts of the company and at what interest rate is being charged on these loans. Considering this factor, it is likely that the interest rate on the loan will range from 5% to 6% annual. Investment appraisal through NPV method and IRR method are both very useful in order to financially attractive prospective of any investment decision. A good financial analysis is based on the tradeoff between these two methods. However, practically the IRR method is used widely in investment appraisal decision. The prime reason behind selecting the IRR method of appraisal is it is comparatively straight forward and can be used without having a prior experience in capital budgeting. NPV method has certain drawbacks and limitations. Different projects must be assessed at different discount rates because the risk for each project is generally different. The reliability of the NPV based investment appraisal can be as reliable as the discount rate itself. However, in practice, it is very unrealistic to determine different discount rate for different investment proposals. Whereas, IRR uses a single discount rate to evaluate every investment, due to which it is used extensively among the financial analysts. The IRR of a company cannot be evaluated however; the IRR of a project of the company can be evaluated by considering the expected future cash inflows and out flows. Mathematical Analysis of the Project In order to evaluate whether the company should undertake the project the company should first calculate the WACC. The following table represents the calculation of WACC of the company for the appraisal of the project. Cost of equity B 2.32 Rf 6% Rm 14% Ke 24.56% Cost of debt of the company is taken to be the weighted average interest rate that the Ford Motor Company Limited paid on its debts in the financial year 2011. The cost of debt thus is taken to be 5%. The market value of the debt, for the purpose of simplicity is assumed to be equal to be the book value of the debt as presented in the balance sheet of the company. WACC Ke 24.56% Kd 5% Market Value of E 39,697 Market Value of D 98,656 WACC 11% Thus based on the above calculation, the company will discount its project using the discount of 11%. The company can calculate the Net Present Value (NPV) of the project by utilizing the discount rate of 11%. If it is assumed that the project will continue for an infinite period (as no time limit for the project is given), the NPV of the project can be calculated by using the following formula for infinite annuity Whereas, R is the annual benefit that will accrue to the company due to the implementation of the project. The value of R can be calculated as follows Benefit likely to accrue per car 2,500 Total number of cars sold in 2011 5,695,000 Number of cars likely to utilize the facility (90%) 5,125,500 Total annual benefit 12,813,750,000 Total annual benefit 116,488,636,364 Initial Cost (10,000,000) NPV 116,478,636,364 The above calculations present that the project will yield a positive NPV, and thus it would be financially viable for the company to enter into the project. However, the result of the NPV would change if the project is for a certain period of time. Then the present value of the benefit will be calculated by using the following formula The above mentioned formula is termed as the formula for ‘annuity’ in which “P” is the present value of the cumulative amount, “R” is the period payments, “I” is the period interest rate and “n” is the number of period for which the funds were borrowed. Financing Plan for the Project In order to finance any project, a company needs to raise capital in the form of revenue funds, short term finance, long term finance, running finance etc. Raising capital can be a significant and crucial task for any company as several technicalities and procedures are involved. It is generally observed in an economic scenario that the company with a good credit history and uplifted financial outlook is likely to raise funds easily as compared to the otherwise. Raising capital significantly affect the gearing of a company. Both modes of financing i.e. equity and debt, comes with their advantages and disadvantages. Several factors, such as statutory rules and requirements, terms and conditions imposed by the counter party and general economic conditions are analyzed before selecting one of the options. The downside of acquiring financing through issuance of equity is that the procedure is quite complicated as compared to acquiring funds by approaching any bank. In most cases, a loan is acquired from any bank o financial institution by filing an application for the sanctioning of the loan. The bank or any other financial institution, after evaluating the necessary details such as credit history, financial outlook for assessing the ability of the entity to repay the loans in future, and the purpose of the project for which the loan application was filed, sanctions the loan. Whereas in the case of raising finances through issuance of equity shares, the company has to fulfill several requirements such as issuing a pre defined number of shares, issuing shares to the existing shareholder in proportion to their existing shares and appointing a financial advisor for conducting a due diligence of the entity’s operations. Although these statutory rules and requirements are enforced by the relevant authorities in order to safeguard the interest of the organization and general public, complying with them can be quite troublesome when the requirement of the fund is urgent. There is another drawback of raising finances through issuance of equity. There is always an uncertainty that the shares will not be completely subscribed by the public, whenever they are floated in the market, and thus the company would not be able to raise the required funds. Whereas, in the case of loan, the financer usually communicates to the organization about the sanctioning of the loan. In contrast, in equity financing, the company has to wait for a considerable longer period of time for the funds to become available for their utilization. The cost of acquisition of funds, in the form of loan, is quite less if compared to the cost of raising financing through shares or bonds. Initial cost pertaining to the raising of equity financing includes printing of shares, cost of listing of shares on the stock market and professional charges paid to financial advisor for conducting the due diligence of the issuance of shares. Whereas, no or very minimal cost is expended in the acquisition of short term or long term financing. The biggest advantage of financing through shares or bonds is that no subsequent cost arises after the issuance. In case of debt financing, subsequent cost arises in the form of interest payments which is spread over the period of the term of the loan. Although, initially the cost of raising equity financing would be much higher, but the burden put on by the debt financings, in the form of interest payments, would significantly affect the net earnings of the company for a longer period. Moreover, if a company finds itself in a stringent economic condition and the repayment of interest charges and principal becomes difficult for it, the credit rating of the company would be adversely affected which in turn would affect its financial outlook. Thus based on the above discussion it would be in the best interest for the company to issue equity shares in order to raise the funds for financing the project. References Ezinearticles.com (2007). Randika Lalith Abeysinghe - EzineArticles.com Expert Author. [online] Retrieved from: http://ezinearticles.com/?expert=Randika_Lalith_Abeysinghe [Accessed: 14 Oct 2012]. Finance.yahoo.com (2012). F: Summary for Ford Motor Company Common Stock- Yahoo! Finance. [online] Retrieved from: http://finance.yahoo.com/q?s=f&ql=1 [Accessed: 14 Oct 2012]. Financialmodelingguide.com (2007). Capital Budgeting and the Advantages and Disadvantages of IRR and NPV | Financial Modeling Guide. 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