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Case Solutions

Fundamentals of Corporate Finance

Ross, Westerfield, Jordan, Lim and Tan


2nd Asia Global
Edition
CHAPTER 14
This is an alternative case for chapter 14.
USE TESLA MOTORS AS A PURE PLAY
COMPANY FOR SWAN MOTORS

Question
You have recently been hired by Swan Motors that sells mid-priced cars, and have been tasked to
determine its cost of capital. Because the company is privately owned, you decided to use the pure play
approach. You have identified Tesla Motors as a representative company in this industry. The following
questions will lead you through the steps to calculate this estimate.

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 filings are available on the SEC Web site at www.sec.gov. Go to the SEC Web site;
follow the Search for Company Filings link and the Companies & Other Filers link; enter Tesla
Motors; and search for SEC filings made by Tesla Motors. 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.
2. To estimate the cost of equity for Tesla Motors, 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 Tesla Motors? What is the market value of equity, or market capitalization? How many shares of
stock does Tesla have outstanding? What is the most recent annual dividend? Can you use the
dividend discount model in this case? What is the beta? 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 Tesla Motors using CAPM?
3. You now need to calculate the cost of debt for Tesla Motors. Go to finra-markets.morningstar.com,
enter TSLA to get company information, and click bond issues. Under bond issues, click for more
bond information to find the yield to maturity for each of Teslas bonds. What is the weighted
average cost of debt for Tesla Motors 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
Tesla Motors. Calculate this using book value weights and market value weights, assuming a 35
percent marginal tax rate. Which number is more relevant?
5. You used Tesla Motors as a pure play company to estimate the cost of capital for Swan Motors. Are
there any potential problems with this approach in this situation?

NOTE: The solution shows the results during April 2014. The actual answer to the case will change
based on current market conditions.
1. The book value of the companys liabilities and equity can be found from a number of sources.
When we calculated the WACC, the book value of debt was not shown on the 10K or 10Q.
Therefore, we used the values reported on finra-markets.morningstar.com.

2. We need various pieces of information to estimate the cost of equity. We can use the dividend
growth model or the CAPM, so we will attempt to use both. The following information is necessary
for our calculations. We gathered all the information from finance.yahoo.com.

Market price = $198.12


Market capitalization = $24.41 billion
Book value per share = $5.42
Shares outstanding = 123.19 million
Most recent dividend = $0
Beta = 1.32
3-month Treasury bill rate = 0.02%

Tesla has never paid a dividend so we cannot use the dividend growth model to estimate the cost of
equity. We do have the information to estimate the cost of equity with the CAPM. Using the market
risk premium of 7 percent from the textbook, we get:

RE = Rf + [E(RM) Rf]
RE = .0002 + 1.32[.07]
RE = 9.26%

3. To get the yield to maturity on Teslas bonds, we went to finra-markets.morningstar.com. We


gathered the following information:

Ignoring the convertible bond due in 2018, the weighted average cost of debt for Tesla using both
the book value and the market value is:

Book value Percent Market value Percent Yield to Book Market


Maturity Year (millions) of total (millions) of total Maturity values values
2019 $920 0.40 836.64 0.40 2.229% 0.89% 0.90%
2021 1,380 0.60 1,243.79 0.60 2.845% 1.71% 1.70%
Total $2,300 1.00 $2,080.43 1.00 2.60% 2.60%

It is irrelevant whether we use book or market values to calculate the cost of debt for Tesla since
they are the same.
4. Using book value weights, the total value of Tesla is:

V = $2.300B + $.668B
V = $2.968B

So, the WACC based on book value weights is:

WACC = RE(E/V) + RD(D/V)(1 TC)


WACC = (.0926)($.668/$2.968) + (.0260)($2.300/$2.968)(1 .35)
WACC = 3.39%

Using the market value weights, the total value of Tesla is:

V = $2.080B + $24.410B
V = $26.4904B

So, the WACC based on market value weights is:

WACC = RE(E/V) + RD(D/V)(1 TC)


WACC = (.0926)($24.410/$26.490) + (.0260)($2.080/$26.490)(1 .35)
WACC = 8.67%

The cost of capital for Tesla using book value weights and market value weights are dramatically
different because the market-to-book ratio is over 36 for Tesla.

5. The biggest potential problem with Swan Motors using Teslas cost of capital is that Swan Motors is
a mid-priced car, while Tesla manufactures and sells at the high end of the automobile market,
although Tesla has announced plans for a lower priced model. Another factor that could affect the
cost of capital is Teslas access to capital since it is a public company, while Swan Motors is private.