Chapter 15 - How Corporations Issue Securities

CHAPTER 15

How Corporations Issue Securities

The values shown in the solutions may be rounded for display purposes. However, the answers were derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1.a.Further sale of an already publicly traded stock

b.U.S. bond issue by foreign corporation

c.Bond issue by industrial company

d.Bond issue by large industrial company

Est. Time: 01 – 05

2.a.B; best efforts occur when the underwriter promises “only to try” and sell

the issue.

b.A; bookbuilding is the effort of the underwriter to determine interest in the sale.

c.D; a shelf registration sets up later sales, or tranches, under the same registration document.

d.C; Rule 144A sales are not registered.

Est. Time: 01 – 05

3.a.Financing of start-up companies

b.Underwriters gather nonbinding indications of demand for a new issue.

c.The difference between the offer price and the price paid to the issuer

d.Description of a security offering filed with the SEC

e.Winning bidders for a new issue tend to overpay.

Est. Time: 01 – 05

4.a.A large issue

b.A bond issue

c.Subsequent issue of stock

d.A small private placement of bonds

Est. Time: 01 – 05

5.a.False. First stage financing is normally provided by family funds and bank

loans. Second, stage financing is sometimes provided by angel investors or venture capital firms, but venture capital firms rarely provide funding for all development expenses up front. Rather, they provide funding on a stage-by-stage basis. Very few companies will continue on to the phase of issuing an IPO to raise funds.

b.False. Underpricing can happen for various reasons. First, it is very

difficult to judge how much investors will be willing to pay for a stock. Second, some investment bankers say that underpricing raises the price when it is subsequently traded on the market, thereby making it easier for the firm to raise further capital. Third, is the concept of the winner’s curse—the knowledge on the part of the highest bidder that he or she may have overpaid and adjusts his or her price down correspondingly.

c. True

Est. Time: 01 – 05

6.a.Net proceeds of public issue = [$10,000,000 × (1 – .015)]– 80,000

Net proceeds of public issue = $9,770,000

Net proceeds of private placement = $10,000,000 – 30,000

Net proceeds of private placement = $9,970,000

b.To answer this question, we must now take into account the differing

interest rates. To do this, calculate the PV of the extra interest on the private placement:

PV =C × ((1 / r) – {1 / [r(1 + r)t]})

PV = ((.09 – .085) × $10,000,000) × ((1 / .085) – {1 / [.085(1 + .085)10]})

PV = $328,067

The extra cost of the higher interest on the private placement more than outweighs the savings of $200,000 in issue costs, ignoring taxes.

Private placement debt can be customtailored and the terms more easily renegotiated than public debt.

Est. Time: 06 – 10

7.a.Number of new shares = existing shares / number of new shares per

existing share

Number of new shares = 100,000 / 2

Number of new shares = 50,000

b.New investment = number of new shares ×offer price per share

New investment = 50,000 × $10

New investment = $500,000

c.After-issue company value = existing value + new investment

After-issue company value = (100,000 × $40) + $500,000)

After-issue company value = $4,500,000

d.After-issue number of shares = existing shares + new shares

After-issue number of shares = 100,000 + 50,000

After-issue number of shares = 150,000

e.After-issue stock price = after-issue company value / after-issue number of

After-issue stock price = $4,500,000/150,000

After-issue stock price = $30

This answer can also be computed as follows:

After-issue stock price = [(number of shares required to obtain one right ×

stock price) + offer price per one new share] /

after-issue number of shares

After-issue stock price = [(2 × $40) + $10] / 3

After-issue stock price = $30

f.Opportunity value = $30 −10

Opportunity value = $20

Est. Time: 06 – 10

8.a.Zero-stage financing represents the savings and personal loans the company’s principals raise to start a firm. First-stage and second-stage financing comes from funds provided by others (often venture capitalists) to supplement the founders’ investment.

b.Carried interest is the name for the investment profits paid to a private equity or venture capitalist partnership.

c.A rights issue is a sale of additional securities to existing investors; it can be contrasted with an at-large issuance (which is made to all interested investors).

d.A road show is a presentation about the firm given to potential investors in order to gauge their reactions to a stock issue and to estimate the demand for the new shares.

e.A best efforts offer is an underwriter’s promise to sell as much as possible of a security issue.

f.A qualified institutional buyer is a large financial institution which, under SEC Rule 144A, is allowed to trade unregistered securities with other qualified institutional buyers.

g.Blue-sky laws are state laws governing the sale of securities within the state.

h.A greenshoe option in an underwriting agreement gives the underwriter the option to increase the number of shares the underwriter buys from the issuing company.

Est. Time: 06 – 10

9.a.Management’s willingness to invest in Marvin’s equity was a credible signal because the management team stood to lose everything if the new venture failed, and thus they signaled their seriousness. By accepting only part of the venture capital that would be needed, management was increasing its own risk and reducing that of First Meriam. This decision would be costly and foolish if Marvin’s management team lacked confidence that the project would get past the first stage.

b.Marvin’s management agreed not to accept lavish salaries. The cost of management perks comes out of the shareholders’ pockets. In Marvin’s case, the managers are the shareholders.

Est. Time: 01 – 05

10.If he is bidding on underpriced stocks, he will receive only a portion of the shares he applies for. If he bids on undersubscribed stocks, he will receive his full allotment of shares, which no one else is willing to buy. Hence, on average, the stocks may be underpriced but once the weighting of all stocks is considered, it may not be profitable. This is known as the winner’s curse.

Est. Time: 01 – 05

11.There are several possible reasons why the issue costs for debt are lower than those of equity, among them:

The cost of complying with government regulations may be lower for debt.
The risk of the security is less for debt and hence the price is less volatile. This decreases the probability that the issue will be mispriced and therefore decreases the underwriter’s risk.

Est. Time: 01 – 05

12.a.Inelastic demand implies that a large price reduction is needed in order to sell additional shares. This would be the case only if investors believe that a stock has no close substitutes (i.e., they value the stock for its unique properties).

b.Price pressure may be inconsistent with market efficiency. It implies that the stock price falls when new stock is issued and subsequently recovers.

c.If a company’s stock is undervalued, managers will be reluctant to sell new stock, even if it means forgoing a good investment opportunity. The converse is true if the stock is overvalued. Investors know this and, therefore, mark down the price when companies issue stock. (Of course, managers of a company with undervalued stock become even more reluctant to issue stock because their actions can be misinterpreted.)

If (b) is the reason for the price fall, there should be a subsequent price recovery. If (a) is the reason, we would not expect a price recovery, but the fall should be greater for large issues. If (c) is the reason, the price fall will depend only on issue size (assuming the information is correlated with issue size).

Est. Time: 06 – 10

13.a.Example: Before issue, there are 100 shares outstanding at $10 per share. The company sells 20 shares for cash at $5 per share. Company value increases by: (20x$5) = $100. Thus, after issue, each share is worth:

[(100 × $10) + $100] / (100 + 20) = $9.17

New shareholders gain = 20  $4.17 = $83

Old shareholders loss = 100  $.83 = $83

Example: Before issue, there are 100 shares outstanding at $10 per share. The company makes a rights issue of 20 shares at $5 per share. Each right is worth:

Value of one right = (rights on price – issue price) / (N + 1)

Value of one right = ($10 – 5) / (5 + 1)

Value of one right = $.83

Shareholder value = stock value + right value

Shareholder value = $9.17 + .83

Shareholder value = $10

The shareholder’s total wealth is unaffected as the right can be sold for $.83, in which case the shareholder will own a stock worth $9.17 and have $.83 in cash. Thus, the shareholder will still have a value of $10.

Est. Time: 06 – 10

14.a.Number of new shares = existing shares / number of new shares per

existing share

Number of new shares = 10,000,000 / 4

Number of new shares =2,500,000

New investment = number of new shares × offer price per share

New investment = 2,500,000 × €5

New investment = €12,500,000

b.Opportunity value = (rights on price – issue price) / (N + 1)

Opportunity value = €6 – 5) / (4 + 1)

Opportunity value = €.20

c.After-issue stock price = after- issue company value / after-issue shares

After-issue stock price = [(10,000,000 × €6) + €12,500,000] / (10,000,000

+ 2,500,000)

After-issue stock price = €5.80

A stockholder who previously owned four shares had stocks with a value of: (4 €6) = €24. This stockholder has now paid €5 for a fifth share so that the total value is: (€24 + €5) = €29. This stockholder now owns five shares with a value of: (5 €5.80) = €29, so that she is no better or worse off than she was before.

d.The share price would have to fall to the issue price per share, or €5 per share. Firm value would then be:

Firm value = 10 million€5

Firm value = €50.00 million

Est. Time: 11 – 15

15.See problem 14 for the €5 issue price calculations.

At the €4 issue price, the number of shares needed to raise the same amount of funds is:

a.Number of shares needed = amount needed / issue price

Number of new shares = €12,500,000 / €4

Number of new shares =3,125,000

b.Shares per right = 10,000,000 / 3,125,000

Shares per right = 3.2

Opportunity value = (rights on price – issue price) / (N + 1)

Opportunity value = €6 – 4) / (3.2 + 1)

Opportunity value = €.48

c.After-issue stock price = after- issue company value / after-issue shares

= [(10,000,000 × €6) + €12,500,000] / (10,000,000

+ 3,125,000)

After-issue stock price = €5.52

A stockholder who previously owned 3.2 shares had stocks with a value of: (3.2€6) = €19.20. This stockholder has now paid €4 for one additional share so that the total value is: (€19.20 + €4) = €23.20. This stockholder now owns 4.2 shares with a value of: (4.2€5.52) = €23.20, so that she is no better or worse off than she was before. Thus, the shareholder is the same position regardless of the issue price.

d.The share price would have to fall to the issue price per share, or €4 per share. Firm value would then be:

Firm value = 10 million€4

Firm value = €40 million

Est. Time: 06 – 10

16.Before the general cash offer, the value of the firm’s equity is:

Pre-offer equity = 10,000,000 ×€6 = €60,000,000

New financing raised (from Problem 15) is€12,500,000

Total equity after general cash offer = €60,000,000 + 12,500,000 = €72,500,000

Total new shares = €12,500,000/€4 = 3,125,000

Total shares after general cash offer = 10,000,000 + 3,125,000 = 13,125,000

Price per share after general cash offer = €72,500,000/13,125,000 = €5.5238

Existing shareholders have lost = €6.00 – 5.5238 = €.4762 per share

Total loss for existing shareholders = €0.4762 × 10,000,000 = €4,762,000

New shareholders have gained = €5.5238 – 4.00 = €1.5238 per share

Total gain for new shareholders = €1.5238 × 3,125,000 = €4,761,875

Except for the rounding error, we see that the gain for the new shareholders comes at the expense of the existing shareholders.

Est. Time: 11 – 15

17.a-1. Issue proceeds to company = number of shares × net price

Issue proceeds to company = (100 × .50) × $50 × (1 – .07)

Issue proceeds to company = $2,325

a-2.Issue proceeds to shareholders = number of shares ×net price

Issue proceeds to shareholders = (100 × .50) × $50 × (1 – .07)

Issue proceeds to shareholders = $2,325

b.Commission = number of shares × offer price × commission rate

Commission = 100 × $50 × .07

Commission = $350

c.Money left on table = number of shares × (end of day price – offer price)

Money left on table = 100 × ($160 – 50)

Money left on table = $11,000

d.Selling shareholders’ cost = number of shares × (end of day price – net

price)

Selling shareholders’ cost = (100 × .50) × {$160 – [$50 × (1– .07)]}

Selling shareholders’ cost = $5,675

This can also be computed as:

Selling shareholders’ cost = Percent of shares sold × (commission +

money left on table)

Selling shareholders’ cost = .50 × ($350 + 11,000)

Selling shareholders’ cost = $5,675

Est. Time: 11 – 15

18.a.135,000 shares (as explained in footnote 2)

b.500,000 shares in the primary offering; 400,000 shares in the secondary offering

c.The price to the public was $80 per share, so if one day later they sold at $105 per share, the degree of underpricing was $25 or 24% [= 1 – ($80 / $105)]; this seems higher than the average underpricing of IPOs.

d.Underwriting expense$ 5.04 million

Administrative cost (as listed in in footnote 1) .82 million

Underpricing (900,000 shares × $25 per share) 22.50 million

TOTAL$28.36 million

Est. Time: 06 – 10

19.Answers will vary. Some possible reasons for cost differences:

Large issues have lower proportionate costs.
Debt issues have lower costs than equity issues.
Initial public offerings involve more risk for underwriters than issues of seasoned stock. Underwriters demand higher spreads in compensation.

Est. Time: 11 – 15

20.a.Venture capital companies prefer to advance money in stages because this approach provides an incentive for management to reach the next stage, and it allows First Meriam to check at each stage whether the project continues to have a positive NPV. Marvin is happy because it signals their confidence. With hindsight, First Meriam loses because it has to pay more for the shares at each stage.

The problem with this arrangement would be that, while Marvin would have an incentive to ensure that the option was exercised, it would not have the incentive to maximize the price at which it sells the new shares.

The right of first refusal could make sense if First Meriam was making a large up-front investment that it needed to be able to recapture in its subsequent investments. In practice, Marvin is likely to get the best deal from First Meriam.

Est. Time: 11 – 15

21.In a uniform-price auction, all successful bidders pay the same price. In a discriminatory auction, each successful bidder pays a price equal to his own bid. A uniform-price auction provides for the pooling of information from bidders and reduces the winner’s curse.

Est. Time: 06 – 10

22.Pisa Construction’s return on investment is 8%, whereas investors require a 10% rate of return. Pisa proposes a scenario in which 2,000 shares of common stock are issued at $40 per share, and the proceeds ($80,000) are then invested at 8%. Assuming that the 8% return is received in the form of a perpetuity, then the NPV for this scenario is computed as follows:

−$80,000 + (.08  $80,000)/.10 = −$16,000

Share price would decline as a result of this project, not because the company sells shares for less than book value, but rather due to the fact that the NPV is negative.

Note that, if investors know the price will decline as a consequence of Pisa’s undertaking a negative NPV investment, Pisa will not be able to sell shares at $40 per share. Rather, after the announcement of the project, the share price will decline to:

($400,000 −16,000)/10,000 = $38.40

Therefore, Pisa will have to issue: $80,000/$38.40 = 2,083 new shares

If the proceeds of the stock issue could be invested at 10%, then the share price would remain unchanged.

Est. Time: 11 – 15