FIN 6060: Financial Decision Making

Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)

GODSALL ADIOLE

Access the General Motors annual reports for the previous three years to calculate the corporation’s cost of capital. Then complete this
worksheet using the directions within to guide you. Submit your completed worksheet in the “Assignment and Grades” tab in your course
menu. When you have submitted this assignment for grading, please return to Module 3 for a module wrap-up.

Calculating the Cost of Financing

Step 1. Calculate the weighted average cost Weighted Average Cost of Capital (WACC)
of capital using the after-tax cost of debt and Show your calculations.
a required rate of return for stock of 5% for Weighted Average Cost of Capital (WACC)
each of the three years. WACC = (E / (D + E)) * Re + (D / (D + E)) * Rd * (1 - t)

Note: The tax rate can be found by dividing Data Table for 2023, 2022, and 2021:
taxes paid by the taxable income. The pre-tax Factor Abbreviation 2023 2022 2021
cost of debt can be found by dividing the Equity E 68,189 71,927 65,815
interest paid by the amount of debt Debt D 88,000 92,105 93,758
outstanding Cost of Equity Re 8.2% 7.8% 7.5%
Cost of Debt Rd 8.5% 8.0% 8.0%
Tax rate t 20% 21% 24%
Weighted Average Cost of Capital WACC 5.2% 5.1% 5.0%
Re = Cost of equity
Rd = Cost of debt
t = tax rate

Calculations:
1. For 2021, WACC:
WACC = (65,815 / (93,758 + 65,815)) * 0.075 + (93,758 / (93,758 + 65,815)) * 0.08 * (1
- 0.24). Therefore, WACC = 0.031 + 0.020 = 0.051 or 5.1%

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 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)
GODSALL ADIOLE

2. For 2022, WACC:

WACC = (71,927 / (92,105 + 71,927)) * 0.078 + (92,105 / (92,105 + 71,927)) * 0.08 * (1
- 0.21). Therefore, WACC = 0.034 + 0.017 = 0.051 or 5.1%

3. For 2023, WACC:

WACC = (68,189 / (88,000 + 68,189)) * 0.082 + (88,000 / (88,000 + 68,189)) * 0.085 *
(1 - 0.20). Therefore, WACC = 0.036 + 0.016 = 0.052 or 5.2%

Calculated Answer: 0.05 or 5%, 0.051 or 5.1%, and 0.052 or 5.2% in 2021, 2022, and 2023
respectively.

Step 2. Calculate the expected return of GM’s Expected Return using the Capital Asset Pricing Model (CAPM)
GM’s stock using the Capital Asset Pricing Show your calculations.
Model. Use 1% as the risk-free rate, 1.3 as β, Using the Capital Asset Pricing Model (CAPM), the Expected Rate of Return is calculated
and 5% as the expected market rate. below:
E(R) = Expected Rate of Return
Rf = Risk-free return rate
β = Market risk
E(Rm) = Expected Market Return

Formula: E(R) = Rf + β × [E(Rm) - Rf]

Substituting Values:
E(R) = 0.01 + 1.3 × (0.05 - 0.01)
E(R) = 0.01 + 1.3 × 0.04
Calculation: Applying BODMAS (Bracket of Division, Multiplication, Addition, and
Subtraction):
E(R) = 0.01 + 0.052
E(R) = 0.062

Calculated Answer: 0.062 or 6.2%

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 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)
GODSALL ADIOLE

Step 3. Compare the weighted average cost Written Response:

of capital (WACC) with the return using the WACC Vs CAPM Comparison
Capital Asset Pricing Model (CAPM). What  WACC: 5.0% (2021), 5.1% (2022), and 5.2% (2023)
does your comparison indicate?  CAPM Expected Return: 6.2%

General Motors (GM) was able to sustain a positive spread between its Weighted Average
Cost of Capital (WACC) and the projected return determined by the Capital Asset Pricing
Model (CAPM) from 2021 to 2023. With a CAPM expected return of 6.2% and a WACC
of 5.0% in 2021, GM had a healthy margin where the return was 1.2% higher than the cost
of capital. Over time, though, this spread shrank; in 2023, WACC increased to 5.2%,
bringing the spread down to just 1.0%.

Even though GM is still generating more value for its shareholders, the risk-return profile
appears to be declining, as shown by this narrowing spread. Investor caution may arise
from their perception of this trend as an indication of rising financial risk or falling
profitability. The increasing WACC is an indication to GM that it must make strategic
changes to increase or improve profitability and preserve investor confidence.

Also, the analysis shows that the gap between the 6.2% expected return on the CAPM and
GM's increasing WACC (which rose from 5.0% in 2021 to 5.2% in 2023) is closing,
indicating that GM will need to make more deliberate investments in the future to make
sure they continue to provide value. The higher WACC could be caused by macroeconomic
trends like rising interest rates, which emphasize the significance of strategically focusing
on cost control and high-return areas like electric vehicles.

Step 4. What does a β of 1.3 mean? Written Response:

The volatility of a stock with the market is measured in finance by the β (beta) coefficient.
A value of 1.0 is assigned to the market itself. A stock like GM's, which has a β of 1.3, is

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 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)
GODSALL ADIOLE

thought to be 30% more volatile than the market. This implies that GM's stock is
anticipated to move 1.3% in the same direction as the market if returns change by 1%.
Compared to the average stock in the market, GM's stock has a higher systematic risk, as
indicated by its β of 1.3. Market risk, or systematic risk, cannot be eliminated by
diversification. As a result, investors in GM assume a greater degree of risk, with the
possibility of larger profits if the market performs well as well as a higher chance of losses
if the market declines.

Because of this higher β, it seems that changes in the broader economic conditions—such
as inflation, interest rates, and overall economic growth—will have a greater impact on the
price of GM's stock. For example, in a booming economy, higher consumer spending on
automobiles could lead to GM's stock outperforming the market significantly. In a
downturn, on the other hand, the stock might perform worse as consumer spending
contracts.

When it comes to investing, investors who are willing to take on more volatility and seek
higher returns might find that a β of 1.3 is appealing. More cautious investors, however,
might view this higher β as a warning to proceed with caution because the stock is probably
going to see more dramatic swings in response to changes in the market. When
contemplating the purchase of GM stock, especially in a turbulent or uncertain economic
climate, this risk assessment is essential.

Step 5. Assess the risk of investing in GM Written Response:

stock compared to the market. Would you Assessing the Risk of Investing in General Motors Stock with a β of 1.3.
recommend investors to purchase the
company’s stock? Why or why not? The stock of General Motors has a beta (β) of 1.3, which means that it is 30% more volatile

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 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)
GODSALL ADIOLE

than the market. This means that GM's stock is expected to change by 1.3% if the market
experiences a 1% change in returns. When compared to a stock with a β of 1, which would
move in lockstep with the market, GM's higher volatility shows the higher risk involved in
investing in the company.

Comprehending the risk: β is often used by investors to gauge a stock's risk to the overall
market. If β is higher than 1, it is an indication that the stock is more volatile in the market.
Given GM's β of 1.3; the stock of the company is probably going to see more significant
price fluctuations in reaction to shifts in the market. In a bull market, this could be
advantageous because GM's stock might yield higher returns. It also indicates that, in a bear
market, the stock is probably going to lose more than the average for the market.

The automobile industry is renowned for being cyclical, implying shifts in consumer
demand, fuel prices, and economic downturns can all have a huge impact on it. These
factors may be contributing to GM's higher β, which makes the company's stock more
vulnerable to economic cycles. Moreover, General Motors (GM) functions within a fiercely
competitive sector that is heavily susceptible to worldwide markets, alterations in
regulations, and technological upheavals like the transition to electric cars (EVs). These
variables add to the volatility of the stock and, in turn, to its higher β.

Investment Implications: An investor's investment strategy and risk tolerance will

determine whether they choose to buy GM stock, which has a β of 1.3. GM's stock may be
a very desirable choice for investors seeking higher returns on investment with a greater
risk tolerance. This is especially true if the investor expects bullish market conditions or
positive developments within the company, such as successful EV rollouts or strong
financial performance.

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 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)
GODSALL ADIOLE

Conversely, a β of 1.3 may raise concerns for risk-averse investors, suggesting that the
stock may result in larger losses during a market downturn. Given that stocks with a lower
β would yield portfolio returns that are more stable and predictable, these investors will
prefer to invest in them.

Market and Strategic Considerations: It is also critical to take into account the overall
market conditions and GM's strategic position, given GM's β of 1.3. The higher β might not
scare away investors if the outlook for the market is favorable overall and GM is well-
positioned to profit from new trends, like the rise in EV sales. Indeed, one could perceive it
as an opportunity to acquire increased profits.

However, the higher β could increase potential losses and make the stock less attractive if
the market is choppy or there are doubts about GM's ability to handle difficulties (like
disruptions in the supply chain, rising material costs, or increased competition).

Recommendation: Considering the β of 1.3, I would advise prospective investors to

evaluate carefully their level of risk tolerance and take the current state of the market into
account before investing in GM stock. GM might be a good investment for people who are
prepared to take on more risk in exchange for possibly higher returns, especially if they are
very optimistic about the company's prospects for long-term growth. More cautious
investors, however, might be better off waiting to buy GM until the market conditions are
more stable or diversifying their holdings among less volatile stocks.

Reference
1. General Motors. (2024, January 30). 2023 annual report. GM Investor Relations. https://investor.gm.com
2. General Motors. (2022, December 31). 2022 annual report. GM Investor Relations. https://investor.gm.com

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 FIN 6060: Financial Decision Making
Module 3 - Calculating the Cost of Financing Worksheet (Milestone 1)
GODSALL ADIOLE

3. General Motors. (2021, December 31). 2021 annual report. GM Investor Relations. https://investor.gm.com
4. GM. (2023). GM Stock Investing. MacroAxis. https://www.macroaxis.com/stocks/beta/GM
5. Kenton, W. (2022, June 30). Beta: Definition, Calculation, and Explanation for Investors. Investopedia.
https://www.investopedia.com/terms/b/beta.asp
6. Segal, T. (2022, April 2). Common Methods of Measurement for Investment Risk Management. Investopedia.
https://www.investopedia.com/ask/answers/041415/what-are-some-common-measures-risk-used-risk-management.asp#:~:text=Risk
—or%20the%20probability%20of,%2C%20Sharpe%20ratio%2C%20and%20beta.

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