FHCE 3200 Lecture 2: Professional Exploration 2 (Hiren Patel)

Figuring out Cost of Equity for Ford CO

This weekly puzzle asks you to estimate the Cost of Equity forFord Motor Co (ticker: F) look at how the way that youcalculate 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 forFord Motor Co (ticker: F) look at how the way that youcalculate 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 of2.75%

And the Equity Risk Premium is4% to 5.5 %.

1. Estimating ‘beta’ (using a published source). Let’s startsimple 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 thesource 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 industryon Damodaran’s data page: what is your estimate of the ‘unleveredbeta’?
   
2. In order to calculate the debt/equity ratio, we need to findthe market values of equity and debt:

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

Part 2: What is the balancesheet value of the debt? (Note: just look up thesummary information on FINRA, you don’t need to pull the 10Q forthis.)

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

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

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

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

3. Please list the 4 key supply side growth factors we discussed, and discuss their viability in terms of getting our economy growing again, given that today our economy is not growing.

a. The slides should provide you with what you need here.

b. The issue of viability – if the economy is growing slowly or not at all, do we have any chance of achieving success with each of the 4 growth factors? What will likely cause us problems? What approaches could we use to increase our odds of success? You need to think carefully on this one.

4. Creative problem solving

Scenario #1:

The rate of growth in the US economy is currently 0.5% annually. Your mission is to increase our growth rate to at least 4% annually, without setting off unacceptable levels of inflation. You have the tools of fiscal and monetary policy available.

a. Present your solution to the problem – write it down first.

i. Strategy for creating your solution:

1. First identify a specific natural resource and think through how having more of it or a better quality of it could lead to significantly increasing the GDP growth rate.

2. This will lead you to a general solution to the problem.

3. Write it down! The explanation of the solution should take at least one good paragraph!

4. Determine what will be required to make the solution happen, typically it is money.

5. Think of ways to use your fiscal and monetary policy tools to get the needed money.

6. To attack the problem you must select at least one Monetary Policy tool and one Fiscal Policy tool.

b. Write down the names of the one fiscal policy tool and the one monetary policy tools you picked.

i. Remember – for this question you need one Fiscal Policy tool and one Monetary Policy tool.

c. Explain why you picked the tools that you picked and why you did not select the other choices.

i. Specifically explain what is good about the tool you selected and what is not so good about the tools

you did not select? Do this for

both the monetary and fiscal policy tool that you selected. The key here is to use some decision criteria in making your choice.

d.,Thoroughly and completely explain how your solution would work to solve the problem. You must include and explain the use of your monetary and fiscal policy tools and indicate the impact your solution would have on the key economic variables. Please present your answer using a chain of events format. Be specific. I need to see the detail.

Problem 2 (15 points)

Consider an economy with five assets: 1) Cash 2) Checking Accounts 3) Savings and Money-Market Accounts 4) Bonds 5) Stocks. M1 includes asset classes 1 and 2, and M2 is the sum of M1 and asset class 3. All else being equal, how would each of the following changes affect demand for M1? And for M2? Explain.

a) The stock market crashes, and investors who were previously excited about prospective gains now view it as too risky.

b) Authorities intensify the fight against street crime, leading to more arrests and convictions for robbery. As crime rates fall, people feel safer holding cash.

c) Banks introduce overdraft protection, under which funds are automatically transferred from savings to checking as needed to cover checks.

d) Due to an increase in inflation expectations, the average interest rate on bonds rises from 3% to 6%.

e) The government introduces deposit insurance, guaranteeing checking, and savings deposits in the event that there are depositor runs and banks fail.

Hint: Each change in a-e makes one asset more (less) attractive by raising (lowering) its return, liquidity, safety, or another desirable characteristic of the asset. You need to identify which asset's attractiveness has increased (decreased) and will thus absorb more (less) funds. As agents change their portfolios, there may be several possibilities regarding where funds come from (flow to). Thus, different answers may be correct, as long as you write a sentence explaining the move you have in mind. The emphasis of the question is on demand. That is, you just need to think through how an individual would reallocate funds between different available assets. Do not try to guess further equilibrium effects, i.e., do not worry about what would happen to prices and other behaviors that might follow if everyone in the economy did this move. That is interesting but beyond the scope of this problem. Also, assume that these are ceteris paribus changes, i.e., other factors do not change.