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.

3. you can use other websites such as marketwatch.com, Bloomberg.com, etc. to find the main competitors of Tesla. 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?

Answer 1

From Marketwatch, competitors of Tesla are observed as :

COMPETITORS

NAME : Beta

Honda Motor Co. Ltd. : 0.98

Toyota Motor Corp. : 0.96

Ford Motor Co. : 1.12

General Motors Co. : 1.14

Beta of Tesla: is 1.34

Average Beta of industry : [1.34+0.98+0.96+1.12+1.14] / 5 = = 1.108

Basis for calculating Cost of Equity:

From CAPM Capital Asset Pricing Model framework,

Cost of equity = risk free rate + beta *[market return - risk free rate]

Here Risk free rate = 2.79% (considering US Treasury bond rate for 30 years)

Market Return:

To assess market return, we can use yields offered by above mentioned competitors. Yield rate may not be available for all of above mentioned companies. It is available for older companies which have been steadily publishing their financials.

eg. General motors yield rate : 3.91%; Ford Motor Co. yield rate: 5.31%.

(For Honda, Tesla and Toyota - yield rates are not available)

Based on above : Market return can be taken as an average of Yield rates of FOrd and General Motors, which is = [3.91+5.31] / 2 = 4.61%

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Plugging these figures in the CAPM model:

Scenario 1: Taking Tesla beta, viz., 1.34

Cost of equity = risk free rate + beta *[market return - risk free rate]

= 2.79 + [1.34*(4.61-2.79)] = 2.79 + [1.34*1.82] = 2.79 + 2.438 = 5.228

Cost of equity = 5.228

Scenario 1: Taking Industry beta, viz., 1.108

Cost of equity = risk free rate + beta *[market return - risk free rate] =

= 2.79 + [1.108*(4.61-2.79)] = 2.79 + [1.108*1.82] = 2.79 + 2.016 = 4.806

Cost of equity = 4.806

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Does it matter if you use the beta for Tesla or the beta for the industry in this case?

To answer this question, the above two scenarios are to be revisited.

*Remember Beta indicates a measure of to waht extent your stock fluctuates with comparison to market. if beta is more than 1, it indicates your stock fluctuates more compared to market. Similarly, of beta is less than 1 , it indicates your stock fluctuates lesser than market, or in other words it is considered stable. Based on this understanding, if my beta has direct positive effect on cost of equity.

If beta is more, cost of equity is more.

This can be reconfirmed from above scenarios. When tesla beta(1.34) is taken, cost of equity is 5.228%. When industry beta (1.108) is taken cost of equity is 4.806.

Thus a more representative beta selection helps in better assessment of the cost of equity.

-End of solution-