Question

You have recently been hired by Swan Motors, Inc. (SMI), in its relatively new treasury management department. SMI was founded 8 years ago by Joe Swan. Joe found a method to manufacture a cheaper battery with much greater energy density than was previously possible, giving a car powered by the battery a range of 700 miles before requiring a charge. The cars manufactured by SMI are midsized and carry a price that allows the company to compete with other mainstream auto manufacturers. The company is privately owned by Joe and his family, and it had sales of $97 million last year. SMI primarily sells to customers who buy the cars online, although it does have a limited number of company-owned dealerships. Most sales are online. The customer selects any customization and makes a deposit of 20 percent of the purchase price. After the order is taken, the car is made to order, typically within 45 days. SMI’s growth to date has come from its profits. When the company had sufficient capital, it would expand production. Relatively little formal analysis has been used in its capital budgeting process. Joe has just read about capital budgeting techniques and has come to you for help. For starters, the company has never attempted to determine its cost of capital, and Joe would like you to perform the analysis. Because the company is privately owned, it is difficult to determine the cost of equity for the company. Joe wants you to use the pure play approach to estimate the cost of capital for SMI, and he has chosen Tesla Motors as a representative company. The following questions will lead you through the steps to calculate this estimate.

1. Most publicly traded corporations are required to submit 10Q (quarterly) and 10K (annual) reports to the SEC detailing their financial operations over the previous quarter or year, respectively. These corporate filings are available on the SEC website at www.sec.gov. Go to the SEC website, follow the “Search for Company Filings” link and the “Companies & Other Filers” link, enter “Tesla,” and search for SEC filings made by Tesla. Find the most recent 10Q and 10K and download the forms. Look on the balance sheet to find the book value of debt and the book value of equity. If you look further down the report, you should find a section titled either “Long-Term Debt” or “Long-Term Debt and Interest Rate Risk Management” that will list a breakdown of Tesla’s long-term debt.

2. To estimate the cost of equity for Tesla, go to finance.yahoo.com and enter the ticker symbol “TSLA.” Follow the various links to find answers to the following questions: What is the most recent stock price listed for Tesla? What is the market value of equity, or market capitalization? How many shares of stock does Tesla have outstanding? What is the beta for Tesla? Now go back to finance.yahoo.com and follow the “Bonds” link. What is the yield on 3-month Treasury bills (https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield)? Using a 7 percent market risk premium, what is the cost of equity for Tesla using the CAPM?

3. Go to www.reuters.com and find the list of competitors in the industry. Find the beta for each of these competitors, and then calculate the industry average beta. Using the industry average beta, what is the cost of equity? Does it matter if you use the beta for Tesla or the beta for the industry in this case?

4. You now need to calculate the cost of debt for Tesla. Go to finra-markets.morningstar .com/BondCenter/Results.jsp, enter Tesla as the company, and find the yield to maturity for each of Tesla’s bonds. What is the weighted average cost of debt for Tesla using the book value weights and the market value weights? Does it make a difference in this case if you use book value weights or market value weights?

5. You now have all the necessary information to calculate the weighted average cost of capital for Tesla. Calculate the weighted average cost of capital for SMI using book value weights and market value weights assuming SMI has a 35 percent marginal tax rate. Which cost of capital number is more relevant?

6. You used Tesla as a representative company to estimate the cost of capital for SMI. What are some of the potential problems with this approach in this situation? What improvements might you suggest?

Answer 1

Solution:

1)

Book Value of debt	11313000000	$
Book value of equity	6040000000	$

2)

Most recent share price (previous close)	352.7	$
Market capitalization	6483000000	$
Shares outstanding	180.24	million
Beta	0.58
Yield on 3-months T-bills	1.57%
Market Risk Premium	7%
CAPM formula:
Cost of equity, Re = Risk free rate + Beta * Market Risk Premium = 1.57% + (0.58 * 7%)	5.63%

3)

Main competitors in auto industry:	Beta
Ford motor company	1.06
General motors	1.39
Honda motor company	1.27
Toyota motor corp.	0.88
Hyundai	0.4
Average	1.00
Cost of equity, Re = Risk free rate + Beta * Market Risk Premium = 1.57% + (1* 7%)	8.57%
It does not matters to use industry beta in this case because SMI is into electric vehicles and Tesla is into the same sub-category out of the whole automobile industry which have various diversified players.

4)

	Market Value	YTM	Weighted average yield
TSLA4103351	1,38,00,00,000	1.25%	2.88%
TSLA4474416	97,75,00,000	2.38%
TSLA4530906	1,80,00,00,000	5.30%
TSLA4830349	1,84,00,00,000	2%
Sum	5,99,75,00,000
	Book Value	YTM	Weighted average yield
TSLA4103351	1,20,00,00,000	1.25%	2.98%
TSLA4474416	85,00,00,000	2.38%
TSLA4530906	1,80,00,00,000	5.30%
TSLA4830349	1,60,00,00,000	2%
There is difference if we use book or market value. If we use market value then cost of debt before any tax benefits is lower by 0.10%.

5)

Given tax rate	35%
Cost of capital using book value weights = Weight of debt *cost of debt * (1- tax rate) + Weight of equity * cost of equity	3.22%
Cost of capital using market value weights = Weight of debt *cost of debt * (1- tax rate) + Weight of equity * cost of equity	3.82%
The market value cost of capital of 3.82% is more relevant as it captures the current capital structure.

6)

Potential problems with this method is that the capital structure of SMI may be different than the capital structure of Tesla which will change the cost of capital. The improvements that can be made is by using the target capital structure of the SMI in the above cost of capital calculation. First beta for SMI should be found using beta of Tesla and capital structure of SMI and then this beta should be used to calculate cost of equity for SMI. Also in the final WACC formula weights should be corresponding to the target capital structure of the SMI.