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 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.

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

As the company is privately owned, it is difficult to ascertain the cost of equity for the company. So, it is naturak to want to use the pure play approach to estimate the cost of capital for SMI. The representative company chosen is Tesla.

The pure play approach essentially suggests that we choose a public company which is 'purely' engaged in the kind of work or projects we are going to carry out to ensure as much similarity when it comes to ascertaining the riskiness of the project. AsSMI is working in battery development and is an auto manufacturer, it seems to select Tesla as a representative.

Problems with pure play approach

1)The betas calculated are based on historical data strictly toestimate the betas. These betas are backward looking.

2)The public company chosen , i.e Tesla is not entirely a pure play prospect . It would be an approximation to consider any public company to be pure play in nature.Most public firms use diversification as a strategy now.

3)The beta depends very highly on the market index used to represent the market return

Improvements

1)Choose a suitable pure play company. is difficult in itself. They can identify seperate projects in their portfolio and find appropriate betas for each of their individual projects by then looking for pure play companies who operate those kinds of projects.

2) Forward looking betas can be found out by analysing options and futures on the public company's stock whih is used for pure play. This will citcumven tthe issue of forward looking betas.