Question 1

In the second quarter of 2013, Tesla Motors, Inc. (symbol: TSLA) raised $1 billion in funds by issuingcommon stock (about 3.4 million shares) and senior convertible bonds. Of this $1 billion, $600M camefrom the convertible bond issuance. The prospectussupplement that contains details about theconvertible bond issuance can be found using the following link from the SEC website (focus on thesection 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.Explain 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 opposedtostraight bonds.

d)Each convertible note is priced at $1,000, has a face value of $1,000 anda 5-year maturity, andpays 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 5 percent per year (2.5percent per half-year). What is thevalue of the option to convert for each convertible bond?

e)Suppose that itisDecember 1, 2015and you own one Tesla convertible bond. You areconsidering two choices: convert the bond now or never convert the bond and receive theinterest and principal payments until maturity. Assume that there are norules in place thatprevent you from converting the bond and thatthe current stock price of Tesla(which can befound online)equal the price on December 1, 2015. Explain why you would or would not convert the bond.

Question 2 In this question, assume you are a CFO that is considering the issuance of a convertible bond and wants to determine the fairprice atwhich this bond should sell.Specifically, you are considering theissuance of a convertible bond with a face value of $100M, a maturity of 10years, and an annual coupon rate of 6percent. The conversion option is European and can only be exercised on the day before maturity. The conversion ratio is 2M shares.Based on your firms credit rating and regular bondsthat have been issued by your firm in the past, you determine the expected return on straight debt to be 5 percent. Given that the convertible bond is issued, assume that the stock price can take on only one of three values on the day beforematurity: $30(State B), $60(State M), or $90(State G). The respective risk-neutral probabilities are 40 percent, 40percent, and 20 percent. Because we are given risk-neutral probabilities, the proper discount rate for the expected payoff from the conversion option is the risk-free rate, which we will assume is 4 percent.

aWhat is the value of the straight bond component of the convertible bond? b)What is the payoff of the conversion option in each of the three states of the world on the day before maturity? The option payoff is given by max{ St*2M-FINAL BOND PAYMENT, 0). c)What is the value of the conversion option today? This is calculated as the present value of the expected payoff from the conversion option.)

d)Based on your numbers in (a) and (c), what is the value of the convertible bond?

Question 3 Your firm wants to issue more equity but finds it costly to do so because of investment banking fees and the adverse selectionproblemassociated with equity issuances. Given this, you decideto issue convertible bonds because you believe that the stock price will significantly appreciatein the future, implying a high likelihoodof conversion. That is, you plan to issue equityindirectly by raising money via the convertible bond market.Specifically, you raise $10M by selling convertible bonds at$1,250 per bond. Each bond hasa face value of $1,000, a coupon rate of 4 percent, and a 5 year maturity. The bonds can be exchanged at any time for 50 shares. The expected return on straight debt issued in the past by your firm is 5 percent. Your firm currently has1.2M shares outstanding priced at $25per share. There is currently no other debt outstanding. a)What is the value of eachbonds conversion option? (Hint: first find the value of the straight bond component of the convertible bond.) b)What is the minimum value of the firm that will induce the bondholders to convert the bonds into stockon the day beforematurity? c)Draw the payoff diagram for the convertible bondholders as a function of the firm value. Specify the slopes of the lines that you draw. d)Draw the payoff diagram for the current shareholders as a function of firm value. Specify the slopes of the lines that you draw.

Question 4 When a firm has cash flow problems, there are potential negative feedback effects. For example, the firm may need to cutcapital 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 isconsidering 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, oneof three states can occur every year. Here are the cash flows produced by each firm within each state: State A State B State C Probability 30% 40% 30%

Goldmine Cash Flow 20M 60M 100M

Techworks Cash Flow 50M 40M 30M

In addition, assume that the Goldminecash flow in State A will be $15M lower because of the negative feedback effects resulting from the cash flow problems. If Goldmine purchases Techworks, thenGoldmine will not incur this $15M cost in State A.Assume that the annual expected return on Goldmine assets is 10percent and the expected return on Techworks assets is 12.5percent. Both firms are all-equity and will operate in perpetuity. Each firm has 10M shares outstanding. a)First assume that no merger announcement has been madeyet. 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 Techworksshare price that you calculated in part (a). This will be a stock-for-stock merger. That is, Goldmine will issue shares inits own firmand 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).