Chapter 15 - How Corporations Issue Securities

Chapter 15 - How Corporations Issue Securities

CHAPTER 15

How Corporations Issue Securities

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 price at which the underwriter buys the

security from the company and resells it to investors

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 overpai and adjusts his or her price down correspondingly.

c. True

Est. Time: 01 – 05

6. a. Net proceeds of public issue = face value ($10,000,000) minus underwriting expense ($10,000,000 x .015) minus other expenses ($80,000) = 10,000,000 − 150,000 − 80,000 = $9,770,00

Net proceeds of private placement = face value ($10,000,000) minus issuing expenses ($30,000) = $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 extra interest on private placement =

i.e., extra cost of higher interest on private placement more than outweighs saving in issue costs ($200,000). (We ignore taxes.)

c.  Private placement debt can be custom tailored and the terms more easily renegotiated.

Est. Time: 06 – 10

7. a. Number of new shares = 100,000 existing shares / 2 = 50,000.

b. Amount of new investment = number of new shares x price per share = 50,000 x $10= $500,000.

c. Total value of company after issue = existing value of company (100,000 shares x $40/share = $400,000) + amount of new investment ($500,000) = $4,500,000.

d. Total number of shares after issue = existing shares + new shares = 100,000 + 50,000= 150,000.

e. Stock price after issue = total value of company after issue / total number of shares after issue, $4,500,000/150,000 = $30.

f. The opportunity to buy one share is worth the difference between the stock price after issue and the price of one of the new shares: $30 − $10 = $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.

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:

Note that new shareholders gain: 20 ´ $4.17 = $83.

Old shareholders lose: 100 ´ $0.83 = $83.

b.  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:

The new share price is $9.17. If a shareholder sells his right, he receives $0.83 cash and the value of each share declines by: $10$9.17=$0.83.

The shareholder’s total wealth is unaffected.

Est. Time: 06 – 10

14. a. The total amount of new money raised equals the number of new shares x the new share price: 10,000,000 existing shares/4 = 2,500,000 new shares listed.

2,500,000 new shares listed x €5 = €12.5 million.

b. €0.20.

c. €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: 10 million ´ €5 = €50 million.

Est. Time: 11 – 15

15. €12,500,000/€4 = 3,125,000 shares.

10,000,000/3,125,000 = 3.20 rights per share.

€0.48

€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 an 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) = €23.18 (difference due to rounding).

Est. Time: 06 – 10

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

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 = €0.4762 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 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. 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 31%; this seems higher than the average underpricing of IPOs.

d. Underwriting Cost: $5.04 million

Administrative Cost (as listed in in footnote 1): $0.82 million

Underpricing: 900,000 shares x $25 per share: $22.5 million

TOTAL $28.36 million

Est. Time: 06 – 10

18. Some possible reasons for cost differences:

a.  Large issues have lower proportionate costs.

b.  Debt issues have lower costs than equity issues.

c.  Initial public offerings involve more risk for underwriters than issues of seasoned stock. Underwriters demand higher spreads in compensation.

Est. Time: 11 – 15

19. 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.

b.  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.

c.  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

20. 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

21. 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 + (0.08 ´ $80,000)/0.10 = −$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 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

One can show that, if the proceeds of the stock issue are invested at 10%, then share price remains unchanged.

Est. Time: 11 – 15

15-1

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