Cost of Capital for Swan Motors You have recently been hired by Swan Motors, Inc
ID: 2821128 • Letter: C
Question
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 that will hold a larger charge giving a car powered by the battery a range of 700 miles be fore requiring a charge. The cars manufactured by SMI are midsized and carry a price that allows the company to com- pete with other mainstream auto manufacturers. The company is privately owned by Joe and his family, and it had sales of $97 million last ycar filings are available on the SEC website at www.sec.gov Go to the SEC website, follow the "Search for Company Filings" link, and search for SEC filings made by Tesla Motors (TSLA). Find the most recent 10Q or 10K, and download the form. Look on the balance sheet to find the book value of debt and the book value of equity To estimate the cost of equity for TSLA, go to finance yahoo.com and enter the ticker symbol TSLA. Follow the links to answer the following questions: What is the most recent stock price listed for TSLA? What is the market value of equity, or market capitalization? How many shares of stock does TSLA have outstanding? What is the most recent annual dividend? Can you use the dividend discount model in this case? What is the beta for TSLA? Now go back to finance.yahoo.com and follow the "Bonds" link. What is the yield on three-month Treasury bills? Using the historical market risk premium, what is the cost of equity for TSLA using CAPM? 2. 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 pur chase 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 analy- sis. 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 3. You now need to calculate the cost of debt for TSLA Go to finra-markets.morningstar.com, enter TSLA as the company, and find the yield to maturity for each of TSLA's bonds. What is the weighted average cost of debt for TSLA using the book value weights and using the market value weights? Does it make a difference in this case if you use book value weights or market value weights? 4. You now have all the necessary information to calculate the weighted average cost of capital for TSLA. Calculate this using book value weights and market value weights assuming TSLA has a 35 percent marginal tax rate Which number is more relevant? steps to calculate this estimate QUESTIONS 1. Most publicly traded corporations are required to submit quarterly (10Q) and annual reports (10K) to the SEC detailing the financial operations of the company over the past quarter or year, respectively. These corporate 5. You used TSLA as a pure play company to estimate the cost of capital for SMI. Are there any potential problems with this approach in this situation?Explanation / Answer
1) Book Value of Long Term Debt = 9,418,319
Book Value of Equity = 4,237,503
Book Value of Debt = 10,314,868
2) Market Capital = 50.78 Billions
Current Stock Price = 300.37
Beta = 0.96
Share O/s= 168.922 million
Treasury Rate = 1.7%
Ke as per CAPM :
= 1.7% + 0.96(7%)
= 8.42%
3)
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 realistic
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 appropriate.
4)
Following are the figures for Tesla from Yahoo! Finance
Book Value of Debt
= 9,418,319,000
Book Value of equity =4,237,242,000
Total = 13,655,561,000
Book value weight of debt = 9,418,319,000/13,655,561,000 = 0.6897
Equity weight = 1-0.6897 = 0.3103
Cost of debt = Interest expense/ Total debt
= 471,259,000/9,418,319,000 =0.05 = 5%
assumed corporate tax rate to be 21%
After tax cost of debt = 0.05*(1-0.21) = 0.0395 = 3.95 %
Cost of equity = rf +beta*(Rm-rf)
= 2.5 +0.96*(10-2.5)% (assumed risk free rate =2.5% and market return to be 10% which are long term averages)
= 9.70%
WACC using book value weights = 0.6897*3.95% +0.3107 *9.70% = 5.74%
WACC using book value weights = 5.74%
Market value of debt = 9,418,319,000
Market value of equity = 50.37 Billion = 50,370,000,000
Total = 59,788,319,000
Market value weight of debt = 9,418,319,000/59,788,319,000 = 0.1575
Marekt value weight of equity = 0.8425
WACC with market value weights = 0.1575*3.95 + 0.8425*9.7 = 8.79%
WACC with market value weights= 8.79%
5)
When book values are used, the incorrect information is presented since these represent the values at the issue of the equity and not the value of the current share price.
So, using market value weights is more efficient.
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%