You have recently been hired by Swan Motors, Inc. (SMI), in its relatively new t
ID: 2788031 • Letter: Y
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.
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?
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?
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?
Explanation / Answer
Bonds
Book Value
Book Value Weight
Market Value
Market Value Weight
Yield to Maturity
1.
$3 B
$2.6 B
4.35%
2.
$1 B
$0.92 B
3.92%
3.
$2 B
$2.14 B
2.25%
4.
$2 B
1.86 B
2.86%
Book Value of Equity
$4,711,480
Stock Price
310.11
Market Value of Equity (market Capitalization)
52.119B
Number of Shares Outstanding
168.07M
Stock Beta
0.73
3-month T-bill rate
1.06
Cost of Equity
6.17%
Cost of Debt
Based on Book Values=3/(3+1+2+2)*4.35%+1/(3+1+2+2)*3.92%+2/(3+1+2+2)*2.25%+2/(3+1+2+2)*2.86%=3.3988%
Based on Market Values=2.6/(2.6+0.92+2.14+1.86)*4.35%+0.92/(2.6+0.92+2.14+1.86)*3.92%+2.14/(2.6+0.92+2.14+1.86)*2.25%+1.86/(2.6+0.92+2.14+1.86)*2.86%=3.3313%
Market value is more appropriate
Cost of equity=6.17%
Market Value of Equity=52.119B
Book Value of Equity=4.71148M
WACC based on Book value=(3+1+2+2+2)/(3+1+2+2+2+4.71148/1000)*3.3988%*(1-35%)+4.71148/1000*6.17%/(3+1+2+2+2+4.71148/1000)=2.2111%
WACC based on Market Value=(2.6+0.92+2.14+1.86)/(2.6+0.92+2.14+1.86+52.119)*3.3313%*(1-35%)+52.119*6.17%/(2.6+0.92+2.14+1.86+4.71148/1000)=4.30088%
WACC Based on Market Value is more relevant
Potential problems: Seeing that the business of both the firms is same because the company might be having different lines of business with different risks and characteristics
Bonds
Book Value
Book Value Weight
Market Value
Market Value Weight
Yield to Maturity
1.
$3 B
$2.6 B
4.35%
2.
$1 B
$0.92 B
3.92%
3.
$2 B
$2.14 B
2.25%
4.
$2 B
1.86 B
2.86%
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.