Download 1 Ford Research Paper: Ford Motor Company Timothy Gnadt GB550

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.