Title: Sizing Up Tesla’s $10 Billion Debt Stack Link: https://www.wsj.com/articl
ID: 2616632 • Letter: T
Question
Title: Sizing Up Tesla’s $10 Billion Debt Stack
Link: https://www.wsj.com/articles/sizing-up-teslas-10-billion-debt-stack-1529240400?mod=hp_lista_pos2
Summary: Tesla has accumulated over $11 billion dollars in debt, while profits are still elusive. From 2013 to present day, Tesla’s debt has increased sixfold; this is largely attributed to manufacturing problems and the rollout of the Model 3 car. Currently, about $3.5 billion of their total debt is in the form of convertible bonds. Recently, CEO Elon Musk has projected the company to create a positive cash flow by the end of the year. Cash flows will improve after about 9% of Tesla’s workforce will be let go.
Questions:
1) What is a convertible bond? How do these bonds contribute to a company’s overall debt?
2) Suppose Tesla’s stock is trading at $358. Suppose the initial conversion rate is 3.0534 shares of Common Stock per $1,000 principal amount of bonds. Would it make sense to convert a Tesla bond today that has a $1000 par level, 5.3% coupon rate, yield to maturity of 7.5%, current value of $92, and will mature on August 15, 2025? Explain.
3) If the majority of Tesla bondholders decided to convert their bonds, what impact would this have on Tesla’s cash flow? Is this a positive or negative event?
Explanation / Answer
1) Convertible bonds are type of bond that comes with a unique feature of convertibility, using which these bonds can be converted to a predefined number of common stocks of the issuing entity at certain times usually predefined. Due to this specific additional feature, these bonds are relatively cheaper way of financing when compared with plain vanilla bonds.
When a convertible bond is issued, issuing company treats it like a plain vanilla bond increasing its debt portion for the amount equal to present value of all future payments which include periodic coupon payments and principal. In case, face value of the bonds differs from the present value calculated, the difference is recorded as “Share Premium” or “Share Discounts”. So, issuing convertible bonds increases the debt for the amount equal to present value of cash flows.
b) In order to determine, if it is advisable to convert bonds today, we need to first compute the present value of all cash-flows of bond. If the present value is higher than the price of 3.0534 shares, it is wise to convert the bonds else not.
PV of all cash-flows:
Formula for PV of periodic cash flows = C*{[1-(1+i)-n]/i}
Formula for PV of single cash flow = CF / (1+i)n
Periodic Coupon Payments (C) = $1,000 x 5.3% = $53
Number of Coupon Payments (n) = 7 (2025 – 2018)
Face Value = $1,000
Discount Rate (i) = 7.5% (YTM)
PV of coupon payments = $53*{[1-(1+0.075)-7]/0.075} = $280.72
PV of face value = $1,000 / (1+0.075)7 = $602.76
Net Present Value = $280.72 + $602.76 = $883.48
Amount to be received, if converted today = $358 x 3.0534 = $1,093.12
Since the value to be received, if converted today is greater than the present value of all cash-flows, it is wise to convert the bonds into stocks today.
c) For each bond converted into equity, the obligation arising out of coupon payment reduces, which is a positive event in relation to cash positions as it will decrease cash-outflow. So, Tesla will have higher cash flows having a positive impact.
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