Question

You 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.

7. 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 and why?

Please provide steps.

Answer 1

Pure play approach is when a similar company in the same industry is used as a benchmark to determine the cost of capital.

Yes, there are potential problems with this approach :

• TSLA is a listed, public held company whereas LMI is a privately held company. This is an issue when it comes to liquidity of the company shares. TSLA shares are highly liquid, whereas LMI shares are illiquid. Hence LMI would have a liquidity premium added to its cost of capital. Determining the liquidity premium may be a complex task
• TLSA is a much larger company in terms of market value and revenue. Hence the risk associated with TSLA may be lower than LMI. Determining the cost of capital after considering this risk factor is a complex exercise
• TSLA has a high amount of debt in its capital structure, which increases its financial leverage, and therefore increases the risk of capital. Its cost of capital may be higher as a result. LMI on the other hand has funded its growth through profits, and has no debt. Determining the cost of capital with these differences is a potential problem with the pure play approach