Mini Case - Cost of Capital for Swan Motors PDF

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You have recently been hired by Swan Motors, Inc. (SMI), in its relatively new treasury management department. SMI was founded eight 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 b...

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Cost of Capital for Swan Motors You have recently been hired by Swan Motors, Inc. (SMI), in its relatively new treasury management department. SMI was founded eight 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 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. 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 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 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 10-Q (quarterly) and 10-K (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 "Company Filings" link, and search for SEC filings made by Tesla. Find the most recent 10-Q and 10-K 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 "LongTerm Debt" or "Long-Term Debt and Interest Rate Risk Management" that will list a breakdown of Tesla's long-term debt. Our search in Tesla’s 10-K report showed a book value of debt of $9,556 and a book value of equity of $22,225.

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 "Markets" and "U.S. Treasury Bonds Rates" links. What is the yield on 3-month Treasury bills? Using a 7 percent market risk premium, what is the cost of equity for Tesla using the CAPM? Stock price Market capitalization Outstanding shares of stock Beta Yield on 3-month Treasury bills Cost of equity with CAPM

$577.98 $542.79 $939,308,14 9 1.98 1% 14.86%

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? Industry average beta Cost of equity (using industry average beta)

1.066 8.46%

Yes, it matters. It is important to be considered over Tesla’s beta because the industry average beta can give us a better look to the stock volatility. 4. You now need to calculate the cost of debt for Tesla. Go to finramarkets.morningstar.com/Bond Center, 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? Weighted Average Cost of Debt (Book Value)

1.26%

Weighted Average Cost of Debt (Market Value)

0.09%

Yes, it makes a difference. The book value weight is 30% and the market value weight is 2%, so the weighted average cost of debt is 0.09% if market value is used, and 1.26% if book value is used. 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 21 percent marginal tax rate. Which cost of capital number is more relevant? WACC (Book Value Weights)

11.65%

WACC (Market Value Weights)

14.62%

Is more important the WACC (Market Value Weights) because it includes current market situation. 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? Potential Problem: A very important factor that can possibly affect the cost of capital is the access of Tesla to capital by being a public company. SMI being private, can have more regulated prices. Improvement: It would be better to use the industry average because Tesla showed a higher cost of equity and also beta, compared to the industry average.

Cost of Equity Market Risk Premium 3-month Treasury Bill Rate Beta Cost of Equity

0.07 0.01 1.98

Market Risk Premium 3-month Treasury Bill Rate Beta Cost of Equity

0.07 0.01 1.066

14.86%

Industry Average

Cost of Debt (Book Value Weight) Pre-Tax Effective Interest Rate (YTM) Marginal Tax Cost of Debt Book Value of Debt Weight of Debt Weighted Average Cost of Debt

Cost of Debt (Market Value Weight) Pre-Tax Effective Interest Rate (YTM) Marginal Tax Cost of Debt Book Value of Debt Weight of Debt Weighted Average Cost of Debt

8.46%

0.053 0.21 0.04187 9,556.00 0.30 1.26%

0.053 0.21 0.04187 12,510,000,000.00 0.02 0.09%

Calculation of WACC (Book Value Weights) Cost of Debt (Book Value Weight) Pre-Tax Effective Interest Rate (YTM) Marginal Tax Cost of Debt Market Value of Debt

0.053 0.21 0.04187 9,556.00

Weight of Debt Weighted Average Cost of Debt

0.30 1.26%

Cost of Equity Market Risk Premium 3-month Treasury Bill Rate Beta Cost of Equity Book Value of Equity Weight of Equity Weighted Average Cost of Equity WACC

0.07 0.01 1.98 14.86% 22,225.00 0.70 10.39% 11.65%

Calculation of WACC (Market Value Weights) Cost of Debt (Market Value Weight) Pre-Tax Effective Interest Rate (YTM) Marginal Tax Cost of Debt Market Value of Debt Weight of Debt Weighted Average Cost of Debt

0.053 0.21 0.04187 12,510,000,000.00 0.02 0.09%

Cost of Equity Market Risk Premium 3-month Treasury Bill Rate Beta Cost of Equity Book Value of Equity Weight of Equity Weighted Average Cost of Equity WACC

0.07 0.01 1.98 14.86% 542,798,000,000.00 0.98 14.53% 14.62%...