Cost of Capital for Layton Motors

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. LMIs 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.

3) You now need to calculate the cost of debt for TESLA. Go to finra-markets.morningstar.com/BondCenter/ , enter TSLA as the company, and find the yield to maturity for each of TSLAs 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?

4) 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 21 percent marginal tax rate. Which number is more relevant?

5) 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?