Cost of Capital

On another day, your team had a working lunch with Jack and Mark. During lunch, you talked about the second aspect of the consulting project. Your team were told that the Tuxedo Corporation has developed a new method to manufacture cheaper battery that will hold a larger charge for use in the automobile industry. The idea is for the Tuxedo Corporation to start the manufacturing of its own brand of automobiles. The newly discovered battery cell is more powerful than what is currently available in the market. It will give a car powered by the battery a range of 1000 miles before requiring a charge. The Tuxedo Corporation is now planning to manufacture and sell its own Electric Vehicles powered by its newly discovered battery pack. The cars manufactured by the Tuxedo Corporation will be midsized and sold at a price that allows the company to compete with other mainstream auto manufacturers.

The company expects that most sales will be online. The customer will be able to select any customization and make a deposit of 20 percent of the purchase price at the time of placing the order. After the order is taken, the car is made to order, typically within 45 days. Jack and Mark indicated that the company would start production as soon as it can raise the required capital. You were also told that relatively little formal analysis has been done in its capital budgeting process. Jack and Mark 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, Mark and Jack would like your team to perform the analysis for them to know the cost of Capital that should be used by the Tuxedo Corporation in its capital budgeting analysis of the new EV automobile production project. Since the companys main activity is airplane manufacturing, it has no idea of what the risk analysis of the new project will be and therefore does not know what the cost of capital for the new EV automobile production project should be. Your team leader indicated to Jack and Mark that the cost of capital for a new business venture can be determined through the pure play approach. He explained that the pure play approach is a method that allows the calculation of cost of capital for new project by using a representative company that specialize on the same venture as the new project. Since the new project for the Tuxedo corporation is the manufacturing and sale of EV automobiles, Jack and Mark wants you to use the pure play approach to estimate the cost of capital for the Tuxedo Corporation. They have chosen Tesla Motors as a representative company.

You all agreed with Jack and Mark that TESLA is a pure play representative of the new venture. One of your team members specializes in the pure play approach to calculating cost of capital for new venture. He presented the following steps to Jack and Mark as what your team will follow in order to calculate the cost of capital for the company using TESLA as the pure play representative company.

5. You can use TSLA cost of capital as the discount rate for the Tuxedo Corporations Electric Vehicle capital investment projects. This is the pure play approach as Tesla is a pure electric vehicle company. Are there any potential problems with this approach in this situation?