Tesla needs to raise 1 billion to develop a new car. The firm has three options....

Tesla needs to raise 1 billion to develop a new car. The firm has three options. It can use a one-year debt. Tesla believes 10% would be a fair rate given the investment risk, however, investors love Tesla’s CEO Elon Musk so much, Tesla only needs to pay 5% interest rate for its Debt. Tesla can also issue equity, which is overpriced by 100%. Last, Tesla can use its own cash reserve to fund the investment.

a. What is the cost to Tesla’s shareholders if Tesla uses its cash to fund the investment?

b. What is the cost to Tesla’s shareholders if Tesla issues debt to fund the investment?

c. What is the cost to Tesla’s shareholders if Tesla issues equity to fund the investment?

d. Should Tesla choose cash, debt, or equity? Just answer which one.

Expert Solution

SOLUTION:-

a)

If Tesla chooses to use cash for expansion then the cost to shareholders would be the amount of dividend that they could have received had it not been used in business.
However, primary purpose of earning is reinvestment and dividend. So, that would be the cost.

b)

If Tesla chooses debt as a medium of expansion then cost to company would be the interest amount they need to pay on the loan taken.
So 5% of 1 billion will be the interest cost.
Though this cost is tax Deductible, interest amount next of tax will be the cost to shareholders.
This is the amount that they could have earned through medium of dividend or increase in EPS (earning per share).

c)

If Tesla chooses equity method of expansion, then the shares which are currently overpriced by 100% would fall.
Since, new share would be issued, the flow of equity shares in market would increase which would lead to fall in pricing of Tesla.
Which means overpricing will fall.
This would be the cost to the Shareholders.

All the three methods of expansion can be used. However, I would prefer cash mode since the company had extra cash which would be given to shareholders as dividend. This can be avoided and next year, dividend can be paid. Next method, I would choose would be debt because cost of debt is less than cist of equity. Simply because equity shareholders bear more risk.

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jeff jeffy answered 2 years ago

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