Assessed blog 7- The application of capital structure

• ·         Capital Structure

Capital structure refers to the make up a firm’s capitalization. It represents the mix of different sources of long term funds in the total capitalization of the company like equity shares, preference shares, retained earnings, long-term loans etc. In other words it can be precisely told as financing plan of the company.

The cost of capital is the rate of return that the enterprise must pay to satisfy the providers of funds. The cost of equity is the return that ordinary stockholders expect to receive from their investment. The cost of loan stock is the rate, which the company must provide its lenders. The weighted average cost of capital (WACC) firm’s capital structure is the average of the cost of its equity, preferred stocks and loan stocks. (Aghion, 2006) An ideal mix of debt, preference stocks and common equity can maximizes the share prices. Debt capital is regarded, as cheap source of finance to the business but will also increase the finance risk of the company. Common stocks regarded as less risky but might lead to loss of voting rights if bought by outsiders. (Aghion, 2006)

In the following analysis, the Ford Motor Company will be chosen as the example to analyse Ford Motor Company’s capital structure to understand the financial risks and companies financial make up.

• ·         Ford Motor Company Capital Structure

In the beginning of 2013, with automotive gross cash of $24.3 billion, exceeding debt by $10 billion. A strong liquidity position of $34.5 billion, an increase of $2.1 billion over 2011. In 2012, pre-tax operating profit excluding special items, was $8 billion, or $1.41 per share. Record results of $8.3 billion in North America, continued solid performance from Ford Credit of $1.7 billion, positive results in South America, continued investment in Asia Pacific Africa and began a challenging transition in Europe. With an eye to the future, Ford continued the largest and fastest manufacturing expansion in more than 50 years, adding capacity to support growth plans in North America and Asia Pacific Africa. (Ford, 2012) Although Ford has debt of over $14 Billion they are still positioned to continue to be the top automotive maker in the US. Their debt can be attributed to the decision made by CEO Alan Mulallys decision to borrow $23.6 Billion in 2006 to avoid the recession and ultimately causing others to require government assistance (Taylor, 2009). This decision has afforded Ford the room to make decisions to better their market share in the future.

Below is the capital structure as of September 2013. Equity is represented by the Orange equalling 20.5 Billion, with company debt of over 110 Billion.

What the Modigliani and Miller theory of capital structure 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 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 theorem 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.

·         Optimal Capital Structure at Ford

Ford Motor Company has seen a large increase in their debt to equity ratio since their decision in 2006 to borrow against their assets. Currently they are seeing a decrease in that ratio to 5.4 as of Sept 2013. According to company disclosure Ford Motor Co has Debt to Equity of 5.4 times. This is 550.0% higher than that of Consumer Goods sector, and 355.56% higher than that of Auto Manufacturers - Major industry (axis, 2014).

Date	debt to equity ratio %
Sept. 30, 2013	5.405
March 31, 2013	6.102
Sept. 30, 2012	4.586
March 31, 2012	6.051
Sept. 30, 2011	15.06
March 31, 2011	39.71
Sept. 30, 2010	-65.94
March 31, 2010	-23.84
Sept. 30, 2009	-15.29
March 31, 2009	-8.303

Figure: debt to equity ratio of Ford from 2009 to 2013

Source: annual report of Ford 2013, 2011, 2009

Ford Motor Company has multiple revenue streams including Ford Motor Company as well as Ford Financial services. Ford Motor can be impacted not only by economic recession or the public’s review of American made vehicles including trucks that have high gas mileage. With the current increasing gas prices Ford must ensure they are investing in the development of the cost and gas efficient vehicles within its portfolio. Fords decision toincrease debt may have given them positive public relations but has put them in a difficult position with limited cash flow needed to continue to grow products. 

References

Aghion. P., & Patrick B. (2006) An Incomplete Contracts Approach to Bankruptcy and the Financial Structure of the Firm

Axis, M. (2014). Ford Debt to Equity. Retrieved from macro axis: http://www.macroaxis.com/invest/ratio/F--Debt-to-Equity Ford. (2012).

Annual Report, 2013, 2012. Retrieved from Corporate.ford.com: http://corporate.ford.com/doc/ar2012-2012%20Annual%20Report.pdf Taylor III,