to Solutions Chapter 14 How Corporations Issue Securities
1.
a.
A rights issue can be used for subsequent issues of stock. A rights issue requires that there are already existing shareholders. Seasoned offerings are security issues by firms that are already publicly traded. Publicly traded firms usually find it advantageous to sell new shares in a public offering because the public offering is less costly than a private placement. In contrast, even publicly traded firms may find it advantageous to use a private placement of bonds. Such bonds can be issued with unusual terms and can allow the firm to negotiate directly with the bondholders should the firm later wish to make changes in the terms of the debt. Therefore, it is more likely that the private placement is used for the bond issue. Shelf registration is more likely to be used for bonds issued by a large industrial company.
b.
c.
2.
a. b. c.
C A B A large issue (economies of scale). See Figure 14-1. A bond issue is less expensive. Private placements are less expensive for small amounts.
3.
a. b. c.
4.
Issue costs for debt are less than for equity for several reasons. Underwriting spreads are lower because there is less risk to the underwriters concerning the price at which the debt can be placed. Debt is more standard than equity, so it can be evaluated by, and marketed to, the public more easily. Underpricing is much less of a concern because debt issues are far less likely to signal management assessments of the value of the firm relative to the market price.
5.
Issuing in stages rather than fully funding a project all at once serves at least two goals. First, it keeps the entrepreneur on a `short leash.' There will not be any excess funds available to squander on luxuries. Moreover, the firm will have to show good evidence of progress and likely success in order to proceed successfully to the next stage of financing. Second, staged financing limits the amount of money initially put at risk by the venture capitalist. New money will not be committed until evidence of the likely success of the firm is forthcoming. 14-1
6.
You should be suspicious. If the issue were underpriced, preferred customers would be likely to snap up the offering. If the underwriters have to aggressively market the issue to the general public, it could be a sign that more knowledgeable investors are staying away because they view the issue as overpriced. a. Average underpricing can be estimated as the average initial return on the sample of IPOs: (7% + 12% 2% + 23%)/4 = 10% b. The average initial return, weighted by the amount invested in each issue, is calculated as follows: Investment (Shares price) $5,000 4,000 8,000 0 $17,000 Initial Return 7% 12% 2% 23% Profit (% return investment) $350 480 160 0 $670
7.
A B C D Total
Average return = $670/$17,000 = 0.0394 = 3.94% Alternatively, you can calculate average return as:
5,000 7% 17,000
c.
4,000 12% 17,000
8,000 ( 2%) 17,000
3.94%
The average return is far below the average initial return for the sample of IPOs. This is because I have received smaller allocations of the best performing IPOs and larger allocations of the poorly performing IPOs. I have suffered the winner's curse: On average, I have been awarded larger allocations of the IPOs that other players in the market knew to stay away from, and my average performance has suffered as a result.
8.
Underwriting costs for Moonscape: Underwriting spread: $0.50 3 million = $1.5 million Underpricing: $4.00 3 million = $12.0 million Other direct costs = $0.1 million Total = $13.6 million Funds raised = $8 3 million = $24 million
Flotation costs Funds raised
13.6 24
0.567 56.7%
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From Figure 14-1, average direct costs for IPOs in the range of $20 to $40 million have been only 10%. Moonscape's direct costs are:
1.5 1.0 24
0.0667 6.67%
Direct costs are below average, but the underpricing is very large, as indicated by the first-day return: $4/$8 = 50%
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9.
a.
The offering is both a primary and a secondary offering. The firm is selling 500,000 shares (primary) and the existing shareholders are selling 300,000 shares (secondary). Direct costs are as follows: Underwriting spread: $1.30 800,000 = $1.04 million Other direct costs = $0.40 million Total = $1.44 million Funds raised = $12 800,000 = $9.6 million
b.
Direct costs Funds raised
1.44 9.60
0.15 15.0%
From Figure 14-1, direct costs for IPOs in the range of $2 to $10 million have been approximately 17%. Direct costs for IPOs in the range of $10 to $20 million have been approximately 12%. The direct costs of this $9.6 million IPO, at 15%, seem about in line with the size of the issue. c. If the stock price increases from $12 to $15 per share, we infer underpricing of $3 per share. Direct costs per share are: $1.44 million/800,000 = $1.80 Therefore, total costs are: $3.00 + $1.80 = $4.80 per share This is equal to: $4.80/$15 = 0.32 = 32% of the market price Emma Lucullus will sell 25,000 shares and retain 375,000 shares. She will receive $12 for each of her shares, less $1.80 per share direct costs: ($12 $1.80) 25,000 = $255,000 Her remaining shares, selling at $15 each, will be worth: $15 375,000 = $5,625,000
d.
10.
Unlike interest payments, which are made annually, the issue cost is a one-time cost. Rather than adjust the cost of capital, the issue costs should be deducted from the project's NPV. Remember that the cost of capital is the required rate of return to investors in a project with a given level of risk. While flotation costs reduce the NPV of a project because an extra cash outflow is required, flotation costs do not affect the rate of return commensurate with the project's risk.
11.
a.
The price of each share, net of the underwriting spread, was: $21 $1.31 = $19.69 Therefore, by selling new stock in the primary issue, the company received: 2 million $19.69 = $39.38 million The existing shareholders sold their 800,000 shares to the underwriters for total proceeds of: 800,000 $19.69 = $15.752 million If the underwriters had paid $30 per share, the number of new shares the company would have needed to sell is: $39.38 million/$30 = 1.313 million
b.
c.
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e.
If the existing shareholders had sold their 800,000 shares to the underwriters for $30 per share, rather than $19.69, the increase in their proceeds would have been: 800,000 ($30.00 $19.69) = $8.248 million $600 million = $12 million
12.
The lost value to the original shareholders is: 0.02 This is 12 percent of the value of the funds raised.
13.
a.
The firm will receive only: $30 (1 0.06) = $28.20 per share The firm will need to issue: $3,000,000/$28.20 = 106,383 shares The gross proceeds from the issue will be: 106,383 $30 = $3,191,490 The firm will be left with $3,000,000 (which it uses in part to pay the other direct costs of the issue). The underwriting spread costs the firm $191,490. Therefore, total direct costs are: $191,490 + $60,000 = $251,490 The total market value of the stock is $30 million. If the share price falls by 3% on the announcement of the offering, the existing shareholders suffer a loss in value of: 0.03 $30 million = $0.9 million = $900,000 This loss is more than three times the direct costs of the offering. Net proceeds of public issue = $10,000,000 $150,000 $80,000 = $9,770,000 proceeds Net of private placement = $9,970,000
b.
c.
14.
a.
b.
The extra interest paid on the private placement is: 0.005 $10 million = $50,000 per year The present value is: $50,000 annuity factor(8.5%,10 years) = $328,067 This exceeds the savings in direct issue costs ($200,000) so the public issue appears to be the better deal. (Note that we use a discount rate of 8.5%, rather than 9%, because 8.5% is the yield to maturity at which public investors are willing to invest in the bond when the company pays the cost of the issue directly to the underwriters. In the private placement, part of the 9% coupon rate should be considered compensation for issuance costs that are not charged for explicitly.)
c.
The private placement is more expensive, but it has the advantages that the terms of the debt can be custom-tailored and the terms can be more easily renegotiated.
15.
a.
The number of new shares is: $10 million/$4 = 2.5 million Each share is sold for $5, so new money raised is $12.5 million. After the issue, there are 12.5 million shares. The total value of the firm is: 14-5
b.
$60 million (the original value of the firm) plus $12.5 million. The new share price is: $72.5 million/12.5 million shares = $5.80 per share
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16. If the new stock were issued at $4 a share, the company would have needed to issue: $12.5 million/$4 per share = 3.125 million shares The stock would then sell for: $72.5/13.125 = $5.5238 per share (The firm will need to issue 3.125 million rights, meaning that one new share can be purchased for every 3.2 shares currently held.) Despite the lower stock price, the shareholders are just as well off. In the original plan, an investor who owns 1,000 shares would have the right to buy 250 additional shares for $5 per share. The total value of the position would be: (1,000 $5.80) + [250 ($5.80 $5.00)] = $6,000
In the modified plan the investor will be able to buy: 1,000/3.2 = 312.5 shares for $4 each Total value is the same: (1,000 $5.5238) + [312.5 ($5.5238 $4.00)] = $6,000
17.
a. b.
$2 million/200,000 = $10 per share The total value of the firm currently is $20 million, and there are 1 million shares outstanding. When the rights are exercised, the firm will raise $2 million, and total value will increase to $22 million. Shares outstanding will increase to 1.2 million. Price per share will be: $22 million/1.2 million = $18.3333 The value of each right is the difference between the value of each share after exercise ($18.3333) and the $10 subscription price (the price the right holder pays for each share). Therefore, each right is worth: $8.3333 An investor who holds 1,000 shares would receive 200 rights. (The firm distributes 200,000 rights among its 1 million shares, or 1 right per 5 shares.) Before the announcement of the rights offering, the 1,000 shares were worth $20,000. After the announcement, the stock price falls and the shares fall in value to $18,333. However, the rights are worth: 200 $8.3333 = $1,667 The value of the rights plus the value of the shares is $20,000. Wealth is unchanged.
c.
d.
e.
18.
a. b. c.
Number of new shares = 50,000 since one new share will be issued for every two of the outstanding 100,000 shares. New investment = 50,000 shares $10 per share = $500,000
Value of company = $4,000,000 original value + 500,000 new investment $4,500,000 total value of company after issue
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d.
Total number of shares = 100,000 original shares + 50,000 new shares 150,000 total shares
19.
e. Share price after issue = $4.5 million/150,000 = $30 The payoffs in year 5 to George Pickwick and First Cookham Venture Partners (FC) are as follows: a. FC buys 2 million shares at $1 This gives FC two-thirds of Pickwick Electronics. Thus the possible payoffs at the end of five years are determined by splitting up the company value in proportions of 1/3 and 2/3: Company value in 5 years after stage-2 financing $ 2 million $12 million Payoff to: G. Pickwick (1 million shares) $0.67 million $ 4 million FC (2 million shares) $1.33 million $ 8 million b. FC buys 1 million shares now and invests an additional $1 million in shares in year 5 Company value in 5 years after stage-2 financing $ 2 million $12 million Company value in 5 years before issue of $1 million in stage-2 financing Price per share (Price = value/2 million shares) No. of new shares issued to FC Total shares outstanding Total shares owned by FC % of shares owned by Pickwick % of all shares owned by FC Payoff* to: G. Pickwick (1 million shares) FC
$1 million $0.50 $1m/$0.50 = 2 million 4 million 3 million 25% 75% $0.5 million $1.5 million
$11 million $5.50 $1m/$5.50 = 0.182 million 2.182 million 1.182 million 45.83% 54.17% $5.5 million $6.5 million
*Payoff equals percentage ownership times total value of firm after issue of stage 2 financing. Note that, by putting up only part of the money now, FC takes on less risk. If the company does not do well (future value = $2 million), then FC can buy a large number of shares for the $1 million of stage-2 financing. If the firm does well, FC receives fewer shares. Staged financing gives George Pickwick more risk and makes it more important for him to make a success of stage 1.
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Solution to Minicase for Chapter 14 Underwriting costs for Pet.com (including costs to the existing shareholders) are: Underwriting spread: $1.25 1.25 million shares = $ 1.56 million Other direct expenses: = $ 1.30 million Underpricing*: $6 1.25 million shares = $ 7.50 million TOTAL $10.36 million * Underpricing based on the assumption that the shares could be sold for $24 rather than $18. Funds raised = $18 1.25 million shares = $22.5 million 1.25 million shares = $30 million
Value of shares issued = $24
Direct costs Funds raised
2.86 22.5
0.127 12.7% 7.5 22.5 0.333 33.3% 0.345 34.5%
Underpricing costs Funds raised
Total flotation costs Value of shares issued
10.36 30
Notice that we follow convention by reporting the direct costs as a percentage of the issue price ($18), but total costs as a percentage of the market value of the shares ($24). Figure 14-1 shows that the average direct costs for IPOs in the range of $40 to $60 million have been about 10%, less than the direct costs for Pet.com. Moreover, Pet.com's underpricing is higher than the average 19% underpricing for IPOs reported in the text. The underwriter's comments miss the point. Of course managers and shareholders prefer a high price to a low price. For any given price at which the shares are issued, they still prefer the stock price to rise. However, a very high initial-day return (i.e., evidence of considerable underpricing) indicates that the shares could have been issued at a higher price - in other words, that the company "left some money on the table." To the extent that the shares are issued at a lower-than-necessary price, the firm gives up some value to the new shareholders. This is correctly considered a cost of the issue. Moreover, this is a cost to existing shareholders whether or not they plan to sell their shares. Underpricing means the firm must sell more new shares to raise the same amount of cash. Consequently, the existing shareholders end up owning a smaller fraction of the firm than they would if the shares were issued at a higher price. Their wealth is lower.
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