Question

Figuring out Cost of Equity for Ford CO

This weekly puzzle asks you to estimate the Cost of Equity for Ford Motor Co (ticker: F) look at how the way that you calculate it can affect your estimate of value.

The questions below:

1. Estimating the Cost of Equity (using CAPM)

Reference Formula: Cost of Equity = Risk Free Rate + (β x Equity Risk Premium)
[Note: we refer to β as ‘beta’)

This weekly puzzle asks you to estimate the Cost of Equity for Ford Motor Co (ticker: F) look at how the way that you calculate it can affect your estimate of value.

The questions below:

1. Estimating the Cost of Equity (using CAPM)

Reference Formula: Cost of Equity = Risk Free Rate + (β x Equity Risk Premium)
[Note: we refer to β as ‘beta’)

I Have the risk free rate of 2.75%

And the Equity Risk Premium is 4% to 5.5 %.

1. Estimating ‘beta’ (using a published source). Let’s start simple and simply look up an estimate of beta online!
   1. What is your estimate of beta?
      
   2. Where did you find that information, and why did you choose the source that you did?
      
      
2. Estimating ‘beta’ (using fundamentals). Now let’s estimate a ‘fundamental beta’ using Damodaran’s methodology:

Reference Formula (simple form): β_Levered = β_Unlevered x (1 + Debt/Equity))

1. Look up the unlevered beta for this company’s industry on Damodaran’s data page: what is your estimate of the ‘unlevered beta’?
   
2. In order to calculate the debt/equity ratio, we need to find the market values of equity and debt:

Part 1: What is the market value of equity, and where did you find this information?

Part 2: What is the balance sheet value of the debt? (Note: just look up the summary information on FINRA, you don’t need to pull the 10Q for this.)

Part 3: What is your estimate of the market value of debt, and how did you calculate it?

Part 4: What is the Debt/Equity Ratio for this Company, and how different would your answer be if you’d just used the balance sheet value of debt?

3. You should now have all the data that you need to produce a fundamental estimate of this company’s ‘levered beta’: do the calculation and write your answer below.

2. 4. How does the value of ‘beta’ that you looked up online compare with the value that you just estimated?
      
   5. If you want to think about how this company’s Cost of Equity would change if it chose to use a different financing mix (ie, more debt, less equity), which of these approaches would be more useful to you?
3. Estimating the Cost of Equity:
   1. Use your answers to the questions above to estimate the Cost of Equity.
      You should find more than one answer, as you calculated ‘beta’ in two different ways: what is your range of estimates for the Cost of Equity?
      

Answer 1

Part A - Estimating Beta , we can use the Beta provided by Reuters site URL-https://www.reuter.com/finance/stocks/overview/F.N

Beta of Levered firm = 0.71

Beta of Unlevered Firm = Beta Levered firm / (1+ Debt/Equity)

= 0.71 / (1+2.89)

Beta of Unlevered Firm = 0.18

Part B - Calculating Cost of Equity as per CAPM

Assuming Cost of Equity for UnLevered Beta

Cost of Equity = Rf + Beta ( Rf - Rm)

= 2.75 + 0.18 (4.75)--------------taking the average of Risk free premium (4+5.5)/2

=3.605 %

Assuming Cost of Equity for Levered Beta

Cost of Equity = Rf + Beta ( Rf - Rm)

= 2.75 + 0.71 (4.75)

= 6.1225 %

Therefore Cost of Equity Ranges from 3.605 - 6.1225%