Question

1. Ford Motor Company is considering an investment in a software company in India. Since the software company is not of the same risk as Ford, Ford has found a similar software company in India to use as a proxy. The proxy firm’s levered beta is 1.4, its D/E ratio is 40%, and the proxy firm’s marginal tax rate is 30%.

The U.S. risk-free rate is 2% and the expected return on the market is 8%. Ford Motor Company’s (unlevered) beta is 1.05. What unlevered cost of equity capital should Ford Motor Company use to discount after-tax operating cash flows for this project?  

Answer 1

- Calculating the Unlevered Beta of the Proxy:-

Unlevered Beta = Levered beta/[1+(1-Tax Rate)*Debt/Equity]

= 1.4/[1+(1-0.30)*0.40]

= 1.09375

So, Unlevered Beta of the Proxy is 1.09375

His unlevered beta will be used to calculate the unlevered cost of equity capital of Ford Motors which will be used as the discount rate for this project:-

As per CAPM,

Cost of Equity = Risk-free Rate + Unlevered Beta(Market Return - Risk-free Rate)

= 2% + 1.09375(8% - 2%)

= 8.5625%

So, the Unlevered Cost of equity is 8.5625%

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