Question

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ou have recently been hired by Layton Motors, Inc. (LMI), in its relatively new treasury management department. LMI was founded eight years ago by Rachel Layton. Rachel 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 before requiring a recharge. The cars manufactured by LMI are midsized and carry a price that allows the company to compete with other mainstream auto manufacturers. The company is privately owned by Rachel and her family, and it had sales of $197 million last year.

LMI 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. LMI'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. Rachel 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 Rachel 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. Rachel wants you to use the pure play approach to estimate the cost of capital for LMI, and she has chosen Tesla Motors as a representative company. The following questions will lead you through the steps to calculate this estimate.

QUESTIONS

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 filings are available on the SEC website at www.sec.gov. Go to the SEC website, follow the “Search EDGAR 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?

You now need to calculate the cost of debt for TSLA. Go to finra-markets.morningstar.com/BondCenter/, 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?

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?

You used TSLA as a pure play company to estimate the cost of capital for LMI. Are there any potential problems with this approach in this situation?

Answer 1

Answer: -

As mentioned in the above procedure to get data for 10Q for book value of debt and equity for 31st Mar 2018 :-

• Long term debt outstanding balance is $8761070 Thousand is the book value of debt
• Total shareholders equity is $4450695 Thousand and is the book value of equity.

From given link address we have following information:-

• Recent Stock price of TSLA on Nasdaq at close of 24th Jul 2018 is $297.43
• Market Capital is $50.502 Billion
• Share Outstanding is 169.79 Million
• Annual Dividend is $0.
• With Dividend being $0 and payout ration is 0%,h ence Dividend Discount Model is not applicable.
• Beta Value of TSLA scrip is 0.97

3 Month Treasury Bill is $350.73 as of 24th Jul 2018 Closure.

Cost of Equity = Risk Free Return + Beta (Market Rate of Return - Risk Free Rate of Return)

Risk Free Rate of Return from 3 month Treasury Bond is very stable and is closer to 0% whereas the expected return from the TSLA is 5% by an investor than the cost of equity with Beta at 0.97 would be:-

Cost of Equity = 0% + 0.97 (5% - 0%) = 0.97 x 5% = 4.85%

There are no TSLA bond as searched in given link. Hence Cost of Debt is taken 0% as from the provided link.

WACC, Weighted AVerage of Cost of Capital = Cost of Equity + Cost of Debt = 4.85% + 0% = 4.85%

There are problem in this approach as TSLA is being long in the market and it has huge cash flows and a predictable rate of return that would be helpful to support CAPM and WACC. LML being a starter hence such process applicability is bit risky till they go a long way in their business. CAPM and WACC would be helpful to them for insight in financing but with the help of same amanging business would be bit risky.