Date: August 21, 2019.
To: The Chief Executive Officer (CEO), Proterra.
From: Finance Director, Proterra.
Subject: Sub-Peer Comparison Note
Dear Sir,
I am writing this memo with reference to the discussion on determining which company in the automotive industry Proterra can compare itself with in order to evaluate Proterra’s likely cost of capital. At the moment, Proterra has two known peers in the market –Tesla, Inc., and New Flyer Industries, Inc. Both of these companies have different product profiles. Tesla Motor Vehicles designs, develops, manufactures, and sells electric vehicles (Tesla, 2011). The company also sells stationery energy units, which are similar to some products manufactured by Proterra. On the other hand, New Flyer Industries, Inc. is a maker of heavy-duty transit buses (NFI Group Inc., N.d). The company also offers a mixture of fuel sources, which include clean diesel, natural gas, diesel-electric hybrid, electric trolley, and battery-electric (NFI Group Inc., N.d). Both Tesla and New Flyer are not directly related to Proterra’s business.
Tesla’s stationary energy units are the only products that are similar to some of Proterra’s products. The company does not manufacture electric buses. Tesla’s core business is to manufacture and sell electric vehicles and cars. New Flyer does not manufacture electric buses. Its core business is to produce a mix of diesel, natural gas, and hybrid-electric powered trucks. Therefore, these two companies businesses are not closely related to that of Proterra. Therefore, it is relatively inapplicable to use these firms as peers to evaluate Proterra’s likely cost of capital. In addition, we do not know the level of leverage of both these firm to estimate the WACC of Proterra.
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However, Proterra can use the securities market line (SML) to calculate its cost of equity in the calculation of the cost of capital. In this case, the Capital Asset Pricing Model (CAPM) equation can be used;
(Hill, 2010)
Where;
If the T-bill rate is 2.85% and assuming the risk measure (beta) is 1.28, and the market return is 12%, the cost of equity can be calculated as follows;
However, there are many problems of using an SML approach in determining the cost of capital of Proterra. The problems of using an SML approach are as follows;
Have to estimate the expected market risk premium, which does vary over time. In reality, the expected market risk premium changes on a daily basis, which makes the cost of capital to change on a daily basis,
The beta measures only the risk associated with the stock; additional unsystematic risks are not considered.
The market return on average, is taken as the historical return, but this, just like expected market risk premium, changes on a daily basis. Sometimes the market return on average can be negative.
The SML model assumes that a company or organisation can borrow at the risk-free rate. However, this not the case in reality as the company may be borrowing at a rate that is higher than the risk-free rate.
The problems stated above are the ones that are associated with using the SML approach in determining Proterra’s cost of capital.
Thanks and Regards,
Finance Manager,
Proterra.
References
Hill, A. (2010). The capital asset pricing model. Robert Alan Hill & Ventus Publishing ApS.
Levy, H. (2012). The capital asset pricing model in the 21 st Century: Analytical, empirical, and behavioural perspectives. New York: USA, Cambridge University Press.
Tesla Motors. (2011). The promise of electric vehicles. [Online]. Retrieved from: https://www.tesla.com/blog/promise-electric-vehicles . Accessed 21 st August 2019.
NFI Group Inc. (N.d). Company: NFI Group. [Online]. Retrieved from: https://www.nfigroup.com/company/nfi-group/ . Accessed 21 st August 2019.
