Question 1

In the second quarter of 2013, Tesla Motors, Inc. (symbol: TSLA) raised $1 billion in funds by issuing common stock (about 3.4 million shares) and senior convertible bonds. Of this $1 billion, $600M came from the convertible bond issuance. The prospectus supplement that contains details about the convertible bond issuance can be found using the following link from the SEC website (focus on the section below the red-texted Tesla logo and above the table of contents):

http://1.usa.gov/11DpDL0

1. a) Explain the primary reason why Tesla raised this cash.
2. b) The prospectus supplement states that conversion is only allowed under certain circumstances. In your own words, summarize these circumstances and why you think these rules are in place.
3. c) Explain why a company like Tesla would be interested in issuing convertible bonds as opposed to straight bonds.
4. d) Each convertible note is priced at $1,000, has a face value of $1,000 and a 5-year maturity, and pays a coupon of 0.75 percent every half-year. Assume that if Tesla were to issue straight debt, it would have an expected return of 4 percent per year (2 percent per half-year). What is the value of the option to convert for each convertible bond?
5. e) Suppose that it is December 1, 2015 and you own one Tesla convertible bond. You are considering two choices: convert the bond now or never convert the bond and receive the interest and principal payments until maturity. Assume that there are no rules in place that prevent you from converting the bond. The Tesla closing stock price on December 1, 2015 can be found online. Explain why you would or would not convert the bond. Keep in mind that you need to recalculate the value of the straight bond since there are now only five more coupons (plus the face value at maturity).

Question 2

The manager of a young firm releases an optimistic forecast about the growth of the firm. The manager decides to raise $100M by issuing 80K convertible bonds at a price of $1,250 per bond. Each bond has a face value of $1,000, a coupon rate of 6 percent, an expected return of 8 percent, and a 5-year maturity. Straight debt issued by the firm typically has an 8 percent expected return. The bonds can be exchanged for 50 shares only when there is one day left until maturity. Currently, there are 10M shares outstanding priced at $20 per share. There is no other debt outstanding.

1. a) What are the conversion price and conversion premium on the convertible bonds today?
2. b) What is the value of the bond?s conversion option today?

c) Assume that five years minus one day has passed. What is the minimum value of the firm that will induce the bondholders to convert the bonds into stock?

1. d) Draw the payoff diagram for the convertible bondholders as a function of the firm value. Specify the slopes of the lines that you draw.
2. e) Draw the payoff diagram for the original shareholders as a function of firm value. Specify the slopes of the lines that you draw.
3. f) Suppose that the manager actually lied to investors about the growth forecast and knows that the value of the firm will never be high enough for the convertible bonds to go ?in-the-money.? What is the APV of the convertible bond issuance at t=0, given that the manager has this private information?

Finance 320 Problem Set 6 Due: Nov. 23, 2016 Question 1 In the second quarter of 2013, Tesla Motors, Inc. (symbol: TSLA) raised $1 billion in funds by issuing common stock (about 3.4 million shares) and senior convertible bonds. Of this $1 billion, $600M came from the convertible bond issuance. The prospectus supplement that contains details about the convertible bond issuance can be found using the following link from the SEC website (focus on the section below the red-texted Tesla logo and above the table of contents): http://1.usa.gov/11DpDL0 a) Explain the primary reason why Tesla raised this cash. b) The prospectus supplement states that conversion is only allowed under certain circumstances. In your own words, summarize these circumstances and why you think these rules are in place. c) Explain why a company like Tesla would be interested in issuing convertible bonds as opposed to straight bonds. d) Each convertible note is priced at $1,000, has a face value of $1,000 and a 5-year maturity, and pays a coupon of 0.75 percent every half-year. Assume that if Tesla were to issue straight debt, it would have an expected return of 4 percent per year (2 percent per half-year). What is the value of the option to convert for each convertible bond? e) Suppose that it is December 1, 2015 and you own one Tesla convertible bond. You are considering two choices: convert the bond now or never convert the bond and receive the interest and principal payments until maturity. Assume that there are no rules in place that prevent you from converting the bond. The Tesla closing stock price on December 1, 2015 can be found online. Explain why you would or would not convert the bond. Keep in mind that you need to recalculate the value of the straight bond since there are now only five more coupons (plus the face value at maturity). Question 2 The manager of a young firm releases an optimistic forecast about the growth of the firm. The manager decides to raise $100M by issuing 80K convertible bonds at a price of $1,250 per bond. Each bond has a face value of $1,000, a coupon rate of 6 percent, an expected return of 8 percent, and a 5-year maturity. Straight debt issued by the firm typically has an 8 percent expected return. The bonds can be exchanged for 50 shares only when there is one day left until maturity. Currently, there are 10M shares outstanding priced at $20 per share. There is no other debt outstanding. a) What are the conversion price and conversion premium on the convertible bonds today? b) What is the value of the bond's conversion option today? c) Assume that five years minus one day has passed. What is the minimum value of the firm that will induce the bondholders to convert the bonds into stock? d) Draw the payoff diagram for the convertible bondholders as a function of the firm value. Specify the slopes of the lines that you draw. e) Draw the payoff diagram for the original shareholders as a function of firm value. Specify the slopes of the lines that you draw. f) Suppose that the manager actually lied to investors about the growth forecast and knows that the value of the firm will never be high enough for the convertible bonds to go \"in-the-money.\" What is the APV of the convertible bond issuance at t=0, given that the manager has this private information? Question 3 Waysafe Inc. consists of two grocery stores. The first store is fairly valued at $60M and the second store, valued at $50M, could be torn down and then the land could be sold for $75M. Waysafe is unwilling to tear down this store and sell the land, however, because the store has been with the business since the beginning. The firm is all-equity and has 1M shares outstanding priced at $110.00 per share. Your business, Blair Capital, is interested in purchasing half of the equity of Waysafe so you can tear down the second store and sells its valuable real estate. Your firm is a publicly traded company that has 4M shares outstanding at a price of $125 per share. a) You announce your intention to purchase this firm using cash. Shareholders are aware of the value you will add to the firm by tearing down the second store and thus will revise the price at which they are willing to sell their shares upward upon hearing the announcement. What is the NPV of your investment? b) You quietly purchase 5 percent of this firm at the current market price using cash and you then announce your intention to purchase the remaining 45 percent of the firm. What is the NPV of this investment? c) You announce your intention to purchase 50 percent of this firm by issuing shares of your own firm and paying with those shares. Shareholders will revise the price of their shares upward upon hearing your announcement. What percentage of your firm do you have to sell to obtain 50 percent of Waysafe? Question 4 When a firm has cash flow problems, there are potential negative feedback effects. For example, the firm may need to cut capital expenditures and research and development activities that are necessary to remain competitive in its industry. Your firm, Goldmine Incorporated, is considering the purchase of a technology firm called Techworks. The reason that your firm is considering this purchase is that when Goldmine has a bad year, Techworks tends to have a good year. Thus, Goldmine will not have cash flow problems in its bad years because Techworks would produce high cash flows in those years. Specifically, one of three states can occur every year (in perpetuity). Here are the cash flows produced by each firm within each state: Probability Goldmine Cash Flow Techworks Cash Flow State A 25% $40M $75M State B 50% $120M $60M State C 25% $200M $45M In addition, assume that the Goldmine cash flow in State A will be $30M lower because of the negative feedback effects resulting from the cash flow problems. If Goldmine purchases Techworks, then Goldmine will not incur this $30M cost in State A. Assume that the annual expected return on Goldmine assets is 8 percent and the expected return on Techworks assets is 10 percent. Both firms are all-equity and will operate in perpetuity. Each firm has 20M shares outstanding. a) First assume that no merger announcement has been made yet. What is the price per share of each firm? Goldmine announces that it will purchase all of the shares in Techworks and pay a premium of 20 percent on the Techworks share price that you calculated in part (a). This will be a stock-for-stock merger. That is, Goldmine will issue shares in its own firm and exchange them for shares in Techworks (the exchange will be based on the value of Goldcorp shares from (a) relative to the value of Techworks shares with the 20 percent premium). b) What percentage of Goldcorp will have to be sold in order to acquire all of the shares in Techworks? c) What is the value of the combined firm? d) Is the merger a good idea? For this, you will have to compare the value created from the merger to its cost. e) What is the share price of Goldcorp after it purchases Techworks? Compare this to the price per share calculated for Goldcorp in part (a)