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Research Paper: Ford Motor Company Timothy Gnadt GB550.02 Financial Management 22 February 2011 Professor Dr. Geoffrey VanderPal Ford 2 Table of Contents Abstract ……………………………………….………………………………………...…...............................… 3 Ford’s History of Capital Structure …………………………………………………………………….... 3 Recent Capital Structure Issues at Ford ………………………….……………….…………………... 4 Profitability and Ford’s Current Capital Structure …………………..……………..…………….. 5 The Modigliani and Miller Theory of Capital Structure ………………………………………… 6 Application of Capital Management Theory and he Path for the future of Capital Structure at Ford …………………….….……………………..…………………………………..… 7 Enclosure 1 …………………………………………………………………………………………………….... 10 References ………………………………………………………………………………………………………. 13 Ford 3 Abstract Ford Motor Company has had its share of debt problems in recent history. Compared to the rest of the U.S. Auto Industry, however, it came out of the economic downturn of the later part of the first decade of the 21st century in a relatively good position. Being the only major automaker that did not come under government control does not mean it was, or is yet, in a good financial position though. Ford is still carrying a great deal of debt and this paper proposes how that that debt should be serviced. The company has restructured its business and CEO, Alan Mulally, has implemented the ONE Ford plan to bring the company back to profitability with resounding success thus far. The company’s capital structure has been analyzed and been combined with forecasts about the auto industry and current trends in financial management. Along with that is a through analysis of Ford’s financial structure using traditionally accepted capital management theory. This paper culminates with recommendations for how Ford can bring itself out of the economic downturn financially stronger and with a more secure future. Ford’s History of Capital Structure Ford is a company whose past goes far back into American History. Still known today as the company that created assembly line manufacturing, the company is well respected and has a deep heritage. Its financial history goes as far back, but this report is going to begin looking at the company’s financial reports starting in 2005. The reason for this is because the recent financial crisis that hit the American Auto industry had not yet developed in 2005 and by observing the Ford 4 company’s performance starting at this point one can get a good sample of before during and after the company’s recent turmoil. Ford was the only one of the Big Three U.S. Automakers – Ford, General Motors and Chrysler - that did not need government assistance during the most recent economic downturn. This was due mostly to CEO Alan Mulally’s decision to borrow $23.6 billion against the company’s assets in 2006, sensing an impending recession (Taylor, 2009). This turned out to be a well-timed strategic decision. Mulally’s anticipation of a recession was correct and because if his swift action Ford had enough cash on hand to survive a downturn. This turned out to be even more important than even Mulally could have guessed due to the fact that capital was extremely hard to come by during the recession and other automakers had to turn to the federal government. With out knowing it, Ford had positioned itself in the best place to gain share in the auto market when consumers were ready to buy cars again, but its long term health as a company could been jeopardized by the amount of debt it had to take on to do so. In essence, it was the best-positioned automaker but also the one that needed a spectacular performance the most. Recent Capital Structure Issues at Ford The cash that Ford had on hand to get through the recession would only be sufficient if the company was also able to cut its costs as well. The company had essentially gotten too large with too many different product lines that operations needed to be trimmed in order for the company to survive. Ford had increased its liabilities to gain cash order to survive; now the company was in a position where it needed to remove many its assets that were not producing a return in order to Ford 5 generate positive income form its revenue streams. (See Enclosure 1 for the total debt to equity ration for the year ending 2006). Ford had taken on a great deal of debt and while this was a well-timed strategic maneuver the company had assumed a great deal of risk by doing so. Both business and financial risks are assumed by taking on debt. The auto industry itself was on shaky ground at this time. Cars are large expenses and the threat of falling demand and falling prices meant that continued sales for the company were anything but assured. Also, if raw materials rose in cost do to reduce production during a recession this could jeopardize Ford’s ability to pay its debt. Being leveraged as much at it now was, if Ford was unable to pay of its debt the company risked bankruptcy. This risk was assumed by not only the company but also every shareholder it had. Profitability and Ford’s Current Capital Structure The major capital structure advantage Ford had over its competitors at the time was that because it did not require government assistance, it was able to do all of its restructuring on its own terms. Mulally had a plan for this as well, he called it ONE Ford. In short ONE Ford was Mulally’s plan to align the goals of every division of the company to the goal of servicing the debt while managing each of the business and financial risks the company encountered while taking it on. ONE Ford required the company to use its already in place distribution network – the largest in the auto industry – to expand operations in the Brazilian, Indian and Chinese markets – the fastest growing auto markets. It also required the Ford 6 company to cease production of non-profitable product lines – Ford soon shed Volvo, which had not made money since it was acquired several years earlier. Ford also had to redesign all of its other product lines to appeal to a consumer that was now focused on hybrid technology and gas mileage – Ford now has the most hybrid vehicle options of any car company. The Modigliani and Miller Theory of Capital Structure The Modigliani and Miller theory of capital structure has to propositions: 1) A firm’s total value is independent of its capital structure, and 2) the return on equity will rise and the debt to equity ration rises in order to compensate investors for the additional financial risk. The first proposition relies on the assumptions that before tax-operating profits are not affected by capital structure neither are taxes themselves, and the firm’s capital structure choices do not convey important information to the market. What the Modigliani and Miller means to the Ford and its investors is that since the company was able to get a large amount of cash through taking on debt, to increase the value of the company it needs to use this capital to generate more revenue. Investors will not respond to a rise in the debt levels of the company until they become excessive, what will increase the value of the company is a rise in sales revenue. This is not to say that there is no adverse effects of the company taking more debt and the shareholders will not be any worse off as debt levels go up. There is considerably more risk as the company becomes more and more leveraged. This is Ford 7 the basis for the second proposition to Modigliani and Miller’s theory, which says that as risk increases the investor’s expected return also rises to compensate for the additional exposure to risk. The second thermo is what dictates that Ford use its additional capital to generate more income. Without a significant rise in demand for automobiles, Mulally’s only choice was to shed assets that were costing too much money and take market share. Application of Capital Management Theory and The Path for the future of Capital Structure at Ford Mulally was able to realize this and combine that into the ONE Ford operations plan. Modigliani and Miller told Mulally that the investors would not be concerned with the amount of debt the company had as long as the revenue was rising as well. Due to the ONE Ford implementation Ford’s revenue for FY 2010 rose to $129 Billion from 116.3 Billion in 2009. Mulally had this to say in the Company’s FY09 year-end financial statement: We reported full year 2009 net income of $2.7 billion, which was the company’s first full year of positive net income since 2005 and a $17.5 billion improvement over the previous year (2009). During the same time, 2008 – 2009, the return on asset ratio rose from -3.40 to 3.51. This shows that the firm was able to use the assets it had more efficiently and get rid of those that were unprofitable. Ford Since the value of the company is independent of its capital structure, the question still remains, what is the optimal capital structure. The answer to this question is the debt to equity ratio that allows for the lowest cost of capital. According to the trade off theory, there is rage or debit to equity ratios that will allow for the weighted average cost of capital (WACC) to be at or very near its lowest point and deviation form this will result in significant changes in the WACC. This is due to the fact that the cost of debt is weighted differently than the cost of equity when calculating the WACC and the fact that debt is tax deductable so financing with debt will be lower than financing with equity, after taxes. Figure 1. (Guin, n.d.) Now that the firm has been able to survive the economic down turn and use the opportunity it created to capture market share and return to profitability, the 8 Ford 9 next step is to finally service the debt. With the positive income the company is generating it can either do that or reinvest in more assets. Paying off debt would mean reducing the risk it is exposing itself and its investors to. Since the company has already claimed market share from competitors, changed its image from that of the primary large truck and SUV manufacturer to a hybrid and high efficiency automaker as well, the best capital structure policy Ford can set for itself is a cash positive company. The company is well positioned to reduce its cost of capital while lowering it risk do to being as leveraged at it is. The shareholder’s who have stuck with the company this far now know the value of a sound operational strategy and they know they can trust Mulally, what the shareholder’s need at this point is a financial policy that reduces the risk they are being exposed to. What the company needs is to be able to borrow money for the lowest cost possible. Ford 10 Enclosure 1 Financial Ratios for Ford Motor Company from FY 2006 to Present. (Thomson One, 2011) Ford 11 Ford 12 Ford 13 References Ford Motor Company. (28 JAN 2011). 2010 Fourth Quarter, Full Year Earnings Review and 2011 Outlook. Dearborn Michigan. Ford Motor Company. (28 JAN 2011). 2010 Fourth Quarter, Full Year Earnings Review and 2011 Outlook. Dearborn Michigan. Graham, J. & Campbell, H. (Spring 2002). How Do CFOs Make Capital Budgeting and Capital Structure Decisions? Journal of Applied Corporate Fianace Guin, L. (n.d.) Optimal Capital Structure. Murrasy StateUniversity. Retrieved from http:www.murrstate.edu. Kiley, D. (2009). The Debt Specter Haunting Ford. BusinessWeek, (4142), 51. Retrieved from EBSCOhost. N., C. C. (2011). In the New Financial Markets, Securitization Loses Its Appeal. Asset Securitization Report, 11(1), 16-17. Retrieved from EBSCOhost. Securities and Exchange Commission. (2011). Ford Motor Company 2010 Fourth Quarter Full Company Report. Washington, D.C. Taylor III, A. (2009). Fixing Up FORD. (Cover story). Fortune, 159(11), 44-52. Retrieved from EBSCOhost. Thompson Financial Services. (2011). Ford Motor Company 2010 Fourth Quarter Full Company Report.