# Economic paper online: Calculation of cost of capital and NPV for FedEx investment project

Investment decisions should be done basing on the analysis of industry and company data. In particular, decisions regarding investment projects with predictable cash flows are evaluated using the company’s cost of capital, duration of the project and other parameters. With the help of such techniques as NPV, IRR and payback period, feasibility of the project’s can be estimated and management can decide whether the project corresponds to the chosen financial strategy and its limitations. The purpose of this paper is to determine the cost of capital for FedEx Corporation, using industry and company data (part 1), and to determine NPV of the proposed investment project using the pre-calculated cost of capital (part 2).

Estimation of the company’s weighted average cost of capital

For evaluating investment projects, the figure which is most frequently chosen as capital cost, is weighted average cost of capital (WACC), which is defined by the following formula: , where E is the market value of the company’s equity, D is the market value of the company’s debt, Re denotes cost of equity, Rd denotes cost of debt, and Tc is the effective corporate tax rate (Brigham & Daves, 2009).

Thus, in order to determine weighted average cost of capital for FedEx Corporation, it is necessary to determine book and market value of equity and debt financing for the company, to determine the proportion of debt and equity financing according to the market estimates of debt and equity financing. The cost of debt can be determined using short-term interest rates applicable to FedEx Corporation, long-term debt interest rates and corporate tax rate. The cost of equity can be determined using CAPM equation: , where Rm is expected market return, Rf is risk-free rate of return, the difference Rm-Rf is referred to as the market premium, and beta is the coefficient measuring the stock’s volatility with regard to market volatility (Brigham & Daves, 2009).

Table 1 shows the prerequisites for calculating the WACC for FedEx Corporation.

 Source of Finance Balance sheet value as of: (in millions, except proportion) 1.1. Debt \$11,091 1.2. Equity \$13,811 Market value as of: 2.1. Debt \$11,210 2.2. Equity \$27,265 Proportion debt 29% equity 71%

Table 1. Book and market values of debt and equity for FedEx Corporation

Book values of debt and equity were exported from FedEx 2010 report, and market values were calculated in the following way. Market value of debt was determined using supplementary information in Table 2 showing the details of long-term debts of FedEx Corporation.

 Senior unsecured debt (millions) Interest rate of 5.50%, due in 2010 – Interest rate of 7.25%, due in 2011 \$250 Interest rate of 9.65%, due in 2013 \$300 Interest rate of 7.38%, due in 2014 \$250 Interest rate of 8.00%, due in 2019 \$750 Interest rate of 7.60%, due in 2098 \$239

Table 2. Details of long-term debt for FedEx Corporation (FedEx Corporation, 2012)

Market value of debt was re-estimated using the interest rate of 7.25% actual for the current portion of debt payable in 2011. Book value of long-term debt was \$1,668m, and market value of long-term debt was \$1,787m. Book value of other long-term liabilities is supposed to be similar to market value, since appropriate recalculations are listed in FedEx 2010 report (FedEx Corporation, 2012). Thus, market value of debt for FedEx Corporation is estimated as \$11,210m.

Market value of equity was calculated as the number of shares outstanding (\$314m) multiplied by market value of FedEx stock (\$86.83, as to July 6, 2012) (FedEx Corporation, 2012). Estimated market value of FedEx equity is \$27,265m. Thus, according to market values of debt and equity, FedEx Corporation uses 29% of debt financing and 71% of equity financing.

For FedEx Corporation, beta equals to 1.55, and risk-free rate which is equal to one-year T-bill return is 0.18%. Market premium is supposed to be 6%, so the cost of equity for FedEx is:

The cost of debt will be calculated in the following way. Short-term interest rate is 0.25%, and long-term interest rate can be determined as the average interest rate for long-term loans basing on the data of Table 2. The cost of long-term debt for FedEx is estimated as 8.03%. The value of short-term debt is \$4,645m, and the value of long-term liabilities is \$6,446m; thus, averaged value of the cost of debt is 4.77%. Effective tax rate in 2010 for FedEx was equal to 37.50% (FedEx Corporation, 2012).

Using the data calculated above, it is now possible to determine WACC:

Capital budgeting decision for FedEx

The data for the supposed investment project are listed in Table 3. Supplies, labor and marketing expenses and revenues are expressed in Canadian dollars, investments in machinery and equipment are expressed in US dollars.

 `Year` `Investment in Machinery and equipment` `Purchase of office supplies` `Direct and indirect labor` `Marketing expenses` `Revenues` `0` `8,000(1)` `0` `0` `400` `0` `1` `8,000(2)` `20` `4,800` `800` `8,000` `2` `4,000(3)` `10` `5,600` `690` `13,000` `3` `0` `10` `5,600` `690` `13,000` `4` `0` `10` `5,600` `690` `13,000` `5` `0` `10` `5,600` `690` `13,000` `6` `0` `10` `5,600` `690` `13,000` `Equipment 1 = \$8,000(1)` `Equipment 2 = \$8,000(2)` `Equipment 3 = \$4,000(3)`

Table 3. Costs and revenues of new investment project

First of all, it is necessary to convert the data for project costs and revenues to US dollars instead of Canadian dollars. For this, interest rate parity equation will be used:  (Brigham & Daves, 2009), where  is the expected exchange rate,  is the current exchange rate (1 CAD = S0 USD), RLT is the yield to maturity of U.S. government bonds maturing in T years, and RFOREIGNT is the yield to maturity of Canadian government bonds. These supplementary values are listed in Table 4.

 YTM US Canada S0 EST 1 0.17% 0.99% 0.976963 0.969030436 2 0.26% 0.99% (USD per 1 canadian \$) 0.969901083 3 0.36% 1.07% 0.970099997 4 0.53% 1.18% 0.9706868 5 0.69% 1.25% 0.97155955 6 0.88% 1.36% 0.972336498

Table 4. YTM of US and Canadian government bonds (Bloomberg.com, 2012), exchange rate of CAD and USD (x-rates.com, 2012), and EST calculation

Using EST exchange rate estimates, all investment estimates for the project were converted into US dollars. Depreciation values were calculated using salvage value of all three investments and 4-year direct depreciation for each investment. Table 5 shows the results of conversion, calculation of pre-tax revenue, tax values provided that effective tax rate fro FedEx Corporation is 37.5%, and the value of after-tax income.

 Year Investment in Machinery and equipment (USD thousands) Purchase of office supplies (USD thousands) Direct and indirect labor (USD thousands) Marketing expenses (USD thousand) Revenues (USD thousands) Depre–ciation Pre-tax revenue less depreciation Tax After-tax income 0 \$8,000.00 \$0.00 \$0.00 \$390.79 \$0.00 \$0.00 (\$390.79) \$0.00 (\$390.79) 1 \$8,000.00 \$19.38 \$4,651.35 \$775.22 \$7,752.24 \$1,250.00 \$1,056.29 \$396.11 \$660.18 2 \$4,000.00 \$9.70 \$5,431.45 \$669.23 \$12,608.71 \$2,500.00 \$3,998.34 \$1,499.38 \$2,498.96 3 \$0.00 \$9.70 \$5,432.56 \$669.37 \$12,611.30 \$3,250.00 \$3,249.67 \$1,218.63 \$2,031.04 4 \$0.00 \$9.71 \$5,435.85 \$669.77 \$12,618.93 \$3,250.00 \$3,253.60 \$1,220.10 \$2,033.50 5 \$0.00 \$9.72 \$5,440.73 \$670.38 \$12,630.27 \$2,000.00 \$4,509.45 \$1,691.04 \$2,818.41 6 \$0.00 \$9.72 \$5,445.08 \$670.91 \$12,640.37 \$750.00 \$5,764.65 \$2,161.75 \$3,602.91

Table 5. Calculations of pre-tax and after-tax income

Using the after-tax value of revenue, free cash flows (FCF) were calculated as the sum of after-tax income plus depreciation plus salvage value of M&E in the end of year 6, and less the values of investments during years 0-2. Estimates of present values for resulting cash flows were done using the 8.11% cost of capital for FedEx corporation obtained in Part 1. Present value of every cash flow was calculated in the following way: , where CFi is the cash flow for year i, and r is the cost of capital (). NPV is determined as the sum of present values of all cash flows. Supplementary values used for calculating NPV and NPV value are shown in Table 6.

 Year FCF Cost of capital (r) Factor (1+r)^i PV(CF) 0 (\$8,390.79) 8.11% 1.00 (\$8,390.79) 1 (\$6,089.82) 1.08 (\$5,632.98) 2 \$998.96 1.17 \$854.71 3 \$5,281.04 1.26 \$4,179.48 4 \$5,283.50 1.37 \$3,867.75 5 \$4,818.41 1.48 \$3,262.68 6 \$11,352.91 1.60 \$7,110.69 NPV \$5,251.54

Table 6. NPV calculation for the project

Since NPV value is greater than zero, the project can be evaluated as profitable. Moreover, the value of NPV is significantly above zero, which means that the project will yield revenues, and will have certain protection against risks (a �cushion pad�� against losses and unexpected situations).

Conclusion

The cost of capital for FedEx Corporation, estimated using WACC model and CAPM model, was equal to 8.11% in 2010-2011 year. Using this cost of capital, the proposed investment project was analyzed, using NPV method. NPV equal to \$5,251,540 shows that the project is profitable and should be accepted by FedEx Corporation as a perspective investment.