15: Chapter Investment Banking: Public and Private Placement
Chapter 15
Problems
1.
Dilution effect of stock issue (LO3) The Hamilton Corporation Company has
4 million shares of stock outstanding and will report earnings of $6,000,000 in the current
year. The company is considering the issuance of 1 million additional shares that will net
$30 per share to the corporation.
a. What is the immediate dilution potential for this new stock issue?
b. Assume the Hamilton Corporation can earn 10.5 percent on the proceeds of the stock
issue in time to include them in the current years results. Should the new issue be
undertaken based on earnings per share?
15-1. Solution:
15-1
Chapter 15: Investment Banking: Public and Private Placement
Hamilton Corporation
a. Earnings per share before stock issue
$6,000,000/4,000,000 = $1.50
Earnings per share after stock issue
$6,000,000/5,000,000 = $1.20
b. Net income = $6,000,000 + .105 (1,000,000 $30)
= $6,000,000 + .105 ($30,000,000)
= $6,000,000 + $3,150,000
= $9,150,000
15-1. (Continued)
Earnings per share after additional income
EPS = $9,150,000/$5,000,000
=
$1.83
Based on the current years results, the public offering should be
undertaken. E.P.S. goes from $1.50 to 1.83. Of course, other variables
may also be considered.
2.
Dilution effect of stock issue (LO3) In problem 1, if the one million additional shares can
only be issued at $23 per share and the company can earn 6.0 percent on the proceeds,
should the new issue be undertaken based on earnings per share?
15-2. Solution:
2
Chapter 15: Investment Banking: Public and Private Placement
Hamilton Corporation (Continued)
Net income = $6,000,000 + .06 ($23,000,000)
= $6,000,000 + $1,380,000 = $7,378,000
Earnings per share after additional income
EPS = $7,378,000/5,000,000 = $1.48
No, E.P.S. would decline by 2 cents from $1.50 to $1.48.
3.
Dilution effect of stock issue (LO3) American Health Systems currently has 6,000,000
shares of stock outstanding and will report earnings of $15 million in the current year. The
company is considering the issuance of 1,500,000 additional shares that will net $50 per
share to the corporation.
a. What is the immediate dilution potential for this new stock issue?
b. Assume that American Health Systems can earn 12 percent on the proceeds of the stock
issue in time to include them in the current years results. Should the new issue be
undertaken based on earnings per share?
15-3. Solution:
American Health Systems
a. Earnings per share before stock issue
$15,000,000/6,000,000 = $2.50
Earnings per share after stock issue
$15,000,000/7,500,000 = $2.00
15-3
Chapter 15: Investment Banking: Public and Private Placement
b. Net income = $15,000,000 + .12 (1,500,000 $50)
= $15,000,000 + .12 ($75,000,000)
= $15,000,000 + $9,000,000
= $24,000,000
Earnings per share after additional income
EPS = $24,000,000/7,500,000
= $3.20
Yes, the EPS of $3.20 is higher than $2.50.
4.
Dilution effect of stock issue (LO3) In problem 3, if the 1,500,000 additional shares can
be issued at $28 per share and the company can earn 10 percent on the proceeds, should the
new issue be undertaken based on earnings per share?
15-4. Solution:
American Health Systems (Continued)
Net income = $15,000,000 + .10 (1,500,000 $28)
= $15,000,000 + .10 ($42,000,000)
= $15,000,000 + $4,200,000
= $19,200,000
Earnings per share after additional income
EPS = $19,200,000/7,500,000
= $2.56
Yes, the EPS of $2.56 is higher than $2.50.
4
Chapter 15: Investment Banking: Public and Private Placement
5.
Dilution and pricing effect of stock issue (LO3) Jordan Broadcasting Company is going
public at $40 net per share to the company. There also are founding stockholders that are
selling part of their shares at the same price. Prior to the offering, the firm had $24 million
in earnings divided over eight million shares. The public offering will be for five million
shares; three million will be new corporate shares and two million will be shares currently
owned by the founding stockholders.
a. What is the immediate dilution based on the new corporate shares that are being
offered?
b. If the stock has a P/E of 23 immediately after the offering, what will the stock price be?
c. Should the founding stockholders be pleased with the $40 they received for their
shares?
15-5. Solution:
Jordan Broadcasting Company
a. Earnings per share before stock issue
$24,000,000 / 8,000,000 = $3.00
Earnings per share after stock issue
$24,000,000 / $11,000,000 = $2.18
Note only three million new corporate shares were issued.
The other two million belonged to founding stockholders and
do not increase the number of shares outstanding.
b. EPS
$ 2.18
P/E
23
Stock price $50.14
c. The founding stockholders will probably not be pleased.
They received a net price of $40 and the stock has a value of
$50.14 immediately after the offering. They may wish the
initial offering price had been higher.
15-5
Chapter 15: Investment Banking: Public and Private Placement
6.
Underwriting Spread (LO2) Solar Energy Corp. has $5 million in earnings with 2 million
shares outstanding. Investment brokers think the stock can justify a P/E ratio of 18. If the
underwriting spread is 5 percent, what should the price to the public be?
15-6. Solution:
Solar Energy Corp.
Earnings per share = $5 million / 2 million = $2.50
Stock price (prior to underwriting spread)
P/E x EPS = 18 x $2.50 = $45
Price to public (with 5% spread) $45 x 95% = $42.75
7.
Underwriting Spread (LO2) Tiger Golf Supplies has 15 million in earnings with 4 million
shares outstanding. Its investment banker thinks the stock should trade at a P/E ratio of 22.
If there is an underwriting spread of 2.8 percent, what should the price to the public be?
15-7. Solution:
Tiger Golf Supplies
Earnings per share = $15 million / 4 million = $3.75
Stock price (prior to underwriting spread)
P/E x EPS = 22 x $3.75 = $82.50
Price to public (with 2.8% spread) $82.50 x 97.2% = $80.19
6
Chapter 15: Investment Banking: Public and Private Placement
8.
Underwriting Spread (LO2) Assume Fisher Food Products is thinking about three
different size offerings for issuance of additional shares.
Size of Offer
Public Price
a. $1.6 million......
b. 6.0 million......
c. 25.0 million......
$40
40
40
Net to Corporation
$36.70
37.28
38.12
What is the percentage underwriting spread for each size offer? What principle does this
demonstrate?
15-8. Solution:
Fisher Food Products
a. Spread = $40 $36.70 = $3.30 (on $1.6 million)
% underwriting spread = $3.30 / $40 = 8.25%
b. Spread = $40 $37.28 = $2.72 (on $6 million)
% underwriting spread = $2.72 / $40 = 6.80%
c. Spread = $40 $38.02 = $1.88 (on $25 million)
% underwriting spread = $1.88 /$40 = 4.70%
The principle demonstrated is the larger the offer size, the
lower the percentage spread.
9.
Underwriting spread (LO2)Walton and Company is the managing investment banker for
a major new underwriting. The price of the stock to the investment banker is $18 per share.
Other syndicate members may buy the stock for $18.25. The price to the selected dealers
group is $18.80, with a price to brokers of $19.20. Finally, the price to the public is $19.50.
a. If Walton and Company sells its shares to the dealer group, what will the percentage
return be?
b. If Walton and Company performs the dealers function also and sells to brokers, what
will the percentage return be?
c. If Walton and Company fully integrates its operation and sells directly to the public,
what will its percentage return be?
15-9. Solution:
15-7
Chapter 15: Investment Banking: Public and Private Placement
8
Chapter 15: Investment Banking: Public and Private Placement
Walton and Company
a. $18.80
18.00
$ .80
$ .80
$18.00
b. $19.20
18.00
$ 1 .20
$ 1.20
18.00
c. $19.50
18.00
$ 1 .50
$ 1.50
18.00
10.
Selected dealer groups price
Managing investing bankers price
Differential
= 4.44% Return
Brokers price
Managing investing bankers price
Differential
= 6.67% Return
Public price
Managing investing bankers price
Differential
= 8.33% Return
Underwriting spread (LO2) The Wrigley Corporation needs to raise $30 million. The
investment banking firm of Tinkers, Evers, & Chance will handle the transaction.
a. If stock is utilized, 2,000,000 shares will be sold to the public at $15.70 per share.
The corporation will receive a net price of $15 per share. What is the percentage
underwriting spread per share?
b. If bonds are utilized, slightly over 30,000 bonds will be sold to the public at $1,001 per
bond. The corporation will receive a net price of $992 per bond. What is the percentage
of underwriting spread per bond? (Relate the dollar spread to the public price.)
c. Which alternative has the larger percentage of spread? Is this the normal relationship
between the two types of issues?
15-10. Solution:
15-9
Chapter 15: Investment Banking: Public and Private Placement
Wrigley Corporation
a. Spread = $15.70 $15.00 = $0.70
% underwriting spread = $.70$15.70 = 4.46%
b. Spread = $1,001 $992 = $9
% underwriting spread = $9/$1,001 = .899%
c. The stock alternative has the larger percentage spread. This is
normal because there is more uncertainty in the market
associated with a stock offering and investment bankers want
to be appropriately compensated.
11.
Secondary offering (LO2) Kevins Bacon Company Inc. has earnings of $6 million with
2,000,000 shares outstanding before a public distribution. Five hundred thousand shares
will be included in the sale, of which 300,000 are new corporate shares, and 200,000 are shares
currently owned by Ann Fry, the founder and CEO. The 200,000 shares that Ann is selling are
referred to as a secondary offering and all proceeds will go to her.
The net price from the offering will be $15.50 and the corporate proceeds are expected
to produce $1.5 million in corporate earnings.
a. What were the corporations earnings per share before the offering?
b. What are the corporations earnings per share expected to be after the offering?
15-11. Solution:
Kevins Bacon Company
a. Earnings per share before the stock issue
$6,000,000/$2,000,000 = $3.00
b. Earnings per share after the stock issue
Total Earnings
10
Chapter 15: Investment Banking: Public and Private Placement
Before offering
Incremental Earnings
Earnings after offering
$6,000,000
1,500,000
$7,500,000
Corporate shares outstanding
Before offering
2,000,000
Incremental Shares
300,000*
Shares after offering
2,300,000
* The 200,000 secondary shares are not included as new
corporate shares.
12.
Market Stabilization and risk (LO2) Becker Brothers is the managing underwriter for a
1-million-share issue by Jays Hamburger Heaven. Becker Brothers is handling 10
percent of the issue. Its price is $25 per share and the price to the public is $26.40.
Becker also provides the market stabilization function. During the issuance, the market
for the stock turned soft, and Becker is forced to repurchase 40,000 shares in the open
market at an average price of $25.75. They later sell the shares at an average value of $23.
Compute Becker Brothers overall gain or loss from managing the issue.
15-12. Solution:
Becker Brothers
Original Distribution
10% 1,000,000 =
100,000 shares for Becker
$
1.40 profit per share
$140,000 profit on original distribution
Market Stabilization
40,000
$ 2.75
shares for Becker
loss per share ($23.00 - $25.75)
15-11
Chapter 15: Investment Banking: Public and Private Placement
$110,000
loss on market stabilization
Gain on original distribution
Loss on market stabilization
Net gain
13.
$140,000
110,000
$ 30,000
Underwriting costs (LO2) Trump Card Co. will issue stock at a retail (public) price of
$30. The company will receive $27.60 per share.
a. What is the spread on the issue in percentage terms?
b. If the firm demands receiving a net price only $1.50 below the public price suggested in
part a, what will the spread be in percentage terms?
c. To hold the spread down to 3 percent based on the public price in part a, what net
amount should Trump Card Co. receive?
15-13. Solution:
Trump Card Company
a.
b.
c. Public Price
$30.00
3% Spread
.90
Net Amount Received $29.10
14.
Underwriting costs (LO2) Winston Sporting Goods is considering a public offering of
common stock. Its investment banker has informed the company that the retail price will be $18
per share for 600,000 shares. The company will receive $16.50 per share and will incur
$150,000 in registration, accounting, and printing fees.
a. What is the spread on this issue in percentage terms? What are the total expenses of the
issue as a percentage of total value (at retail)?
b. If the firm wanted to net $18 million from this issue, how many shares must be sold?
12
Chapter 15: Investment Banking: Public and Private Placement
15-14. Solution:
Winston Sporting Goods
a. $18 $16.50 = $1.50 spread $1.50/$18.00 = 8.33% spread
Total expenses = ($1.50 x 600,000 shares)
+ $150,000 (out-of-pocket)
= $900,000 + $150,000
= $1,050,000
Total value
= 600,000 shares $18 = $10,800,000
b. Amount needed
= $18,000,000
Total shares to be sold to net
$18,000,000
= ($18,000,000 + issue costs)/net price per share
= $18,150,000/$16.50 per share = 1,100,000 shares
15.
P/E ratio for new public issue (LO2) Rodgers Homebuilding is about to go public. The
investment banking firm of Leland Webber and Company is attempting to price the issue.
The home building industry generally trades at a 20 percent discount below the P/E ratio on
the Standard & Poors 500 Stock Index. Assume that index currently has a P/E ratio of 25.
Rodgers can be compared to the home building industry as follows:
Rodgers
Growth rate in earnings per share.........
Consistency of performance.................
Debt to total assets................................
Turnover of product..............................
Quality of management.........................
12 percent
Increased earnings
4 out of 5 years
55 percent
Slightly below
average
High
15-13
Homebuilding Industry
10 percent
Increased earnings
3 out of 5 years
40 percent
Average
Average
Chapter 15: Investment Banking: Public and Private Placement
Assume, in assessing the initial P/E ratio, the investment banker will first determine the
appropriate industry P/E based on the Standard & Poors 500 Index. Then point will be
added to the P/E ratio for each case in which Rodgers is superior to the industry norm, and
point will be deducted for an inferior comparison. On this basis, what should the initial
P/E be for Rodgers Homebuilding?
15-15. Solution:
Rodgers Homebuilding
80% of the Standard and Poors 500 Stock Index =
80% 25 = 20
Industry Comparisons
Growth rate in earnings per share-superior
Consistency of performance-superior
Debt to total assets-inferior
Turnover of product-inferior
Quality of management-superior
Quality of management-superior
+
+
+
+
Initial P/E ratio = 20 + = 20
16.
Dividend valuation model for new public issue (LO1) The investment banking firm of
Einstein & Co. will use a dividend valuation model to appraise the shares of the Modern
Physics Corporation. Dividends (D1) at the end of the current year will be $1.44. The
growth rate (g) is 8 percent and the discount rate (Ke) is 12 percent.
a. Using Formula 109 in Chapter 10, what should be the price of the stock to the public?
b. If there is a 6 percent total underwriting spread on the stock, how much will the issuing
corporation receive?
c. If the issuing corporation requires a net price of $34.50 (proceeds to the corporation)
and there is a 6 percent underwriting spread, what should be the price of the stock to the
public? (Round to two places to the right of the decimal point.)
15-16. Solution:
14
Chapter 15: Investment Banking: Public and Private Placement
Einstein & Co.
b. Public Price
Underwriting spread (6%)
Net price to the corporation
17.
$36.00
2.16
$33.84
Comparison of private and public debt offering (LO1) The Landers Corporation needs
to raise $1 million of debt on a 25-year issue. If it places the bonds privately, the interest
rate will be 11 percent. Thirty thousand dollars in out-of-pocket costs will be incurred. For
a public issue, the interest rate will be 10 percent, and the underwriting spread will be 4
percent. There will be $100,000 in out-of-pocket costs. Assume interest on the debt is paid
semiannually, and the debt will be outstanding for the full 25 year period, at which time it
will be repaid.
Which plan offers the higher net present value? For each plan, compare the net amount
of funds initially availableinflowto the present value of future payments of interest and
principal to determine net present value. Assume the stated discount rate is 12 percent
annually. Use 6 percent semiannually throughout the analysis. (Disregard taxes.)
15-17. Solution:
Landers Corporation
Private Placement
$1,000,000 debt
30,000 out-of-pocket costs
$ 970,000 net amount to Landers
15-15
Chapter 15: Investment Banking: Public and Private Placement
Present value of future interest payments
interest payments (semiannually) = 11%/2 = 5.5%
interest payments = 5.5% $1,000,000 = $55,000
PVA = A PVIFA (n 50, = i = 6%)
PVA = $55,000 15.762 (Appendix D)
PVA = $866,910
Present value of lump-sum payment at maturity
PV = FV PVIF (n = 50, i = 6%)
PV = $1,000,000 .054 (Appendix B)
PV = $54,000
15-17. (Continued)
Total present value of interest and maturity payments
The net present value equals the net amount to Landers minus the
present value of future payments.
Public Issue
16
Chapter 15: Investment Banking: Public and Private Placement
Present value of future interest payments
interest payments (semiannually) = 10%/2 = 5%
interest payments = 5% $1,000,000 = $50,000
PVA = A PVIFA (n = 50, i = 6%)
PVA = $50,000 15.762 (Appendix D)
PVA = $788,100
Present value of lump-sum payment at maturity
PV = FV PVIF (n = 50, i = 6%)
15-17. (Continued)
PV = $1,000,000 .054 (Appendix B)
PV = $54,000
Total present value of interest and maturity payments
Net present value equals the net amount to Landers minus the
present value of future payments.
15-17
Chapter 15: Investment Banking: Public and Private Placement
The private placement has the higher net present value ($49,090
vs. $17,900)
18.
Features associated with a stock distribution (LO3) Midland Corporation has a net
income of $15 million and 6 million shares outstanding. Its common stock is currently
selling for $40 per share. Midland plans to sell common stock to set up a major new
production facility with a net cost of $21,660,000. The production facility will not produce
a profit for one year, and then it is expected to earn a 15 percent return on the investment.
Stanley Morgan and Co., an investment banking firm, plans to sell the issue to the public
for $38 per share with a spread of 5 percent.
a. How many shares of stock must be sold to net $21,660,000? (Note: No out-of-pocket
costs must be considered in this problem.)
b. Why is the investment banker selling the stock at less than its current market price?
c. What are the earnings per share (EPS) and the price-earnings ratio before the issue
(based on a stock price of $40)? What will be the price per share immediately after the
sale of stock if the P/E stays constant?
d. Compute the EPS and the price (P/E stays constant) after the new production facility
begins to produce a profit.
e. Are the shareholders better off because of the sale of stock and the resultant
investment? What other financing strategy could the company have tried to increase
earnings per share?
15-18. Solution:
Midland Corporation
a. $21,660,000 net amount to be raised.
Determine net price to the corporation
18
Chapter 15: Investment Banking: Public and Private Placement
Determine number of shares to be sold
15-18. (Continued)
b. The new shares will increase the total number of shares
outstanding and dilute EPS. This dilution effect may reduce
the stock price in the market temporarily until income from
the new assets becomes included in the price the market is
willing to pay for the stock. By selling at below market
value, the investment banker is attempting to attract
investors into this temporarily dilutive situation. The
investment banking firm is also reducing its own
underwriting risk by pricing the issue at the lower value.
c. EPS
P/E ratio
EPS after offering
Price
d. Net income
=
=
=
=
$15,000,000/6,000,000 =
Price/EPS = $40/$2.50 =
$15,000,000/6,600,000 =
P/E EPS = 16 $2.27 =
$2.50
16x
$2.27
$36.32
= $15,000,000 + 15% ($21,660,000)
= $15,000,000 + $3,249,000
= $18,249,000
EPS after contribution = $18,249,000/6,600,000 =$2.77
Price
= P/E EPS = 16 $2.77
=
$44.32
15-19
Chapter 15: Investment Banking: Public and Private Placement
e. In the long run, it appears that the company is better off
because of the additional investment. Earnings per share are
$.27 higher and the stock price also increased. If the firm had
used debt financing or a combination of debt and stock, they
would have increased earnings per share even more, but
would have created additional financial obligations in the
process.
19.
Dilution and rates of return (LO3) The Presley Corporation is about to go public. It
currently has aftertax earnings of $7,500,000 and 2,500,000 shares are owned by the
present stockholders (the Presley family). The new public issue will represent 600,000 new
shares. The new shares will be priced to the public at $20 per share, with a 5 percent spread
on the offering price. There will also be $200,000 in out-of-pocket costs to the corporation.
a.
b.
c.
d.
Compute the net proceeds to the Presley Corporation.
Compute the earnings per share immediately before the stock issue.
Compute the earnings per share immediately after the stock issue.
Determine what rate of return must be earned on the net proceeds to the corporation so
there will not be a dilution in earnings per share during the year of going public.
e. Determine what rate of return must be earned on the proceeds to the corporation so
there will be a 5 percent increase in earnings per share during the year of going public.
15-19. Solution:
Presley Corporation
a. $20 price 95% = $19 net price
$19
600,000
$11,400,000
200,000
$11,200,000
b.
20
net price
new shares
proceeds before out-of-pocket costs
out-of-pocket costs
net proceeds
Chapter 15: Investment Banking: Public and Private Placement
c.
15-19. (Continued)
d. There are now 3,100,000 shares outstanding. To maintain
earnings of $3 per share, total earnings must be $9,300,000
($3 x 3,100,000 shares). This would imply an increase in
earnings of $1,800,000 ($9,300,000 $7,500,000).
16.07% must be earned on the net proceeds to produce EPS
of $3.00.
e. $3.00 (1.05) = $3.15 (5% increase in EPS)
Total earnings = $3.15 3,100,000 shares =
$9,765,000
incremental earnings = $9,765,000 $7,500,000=
$2,265,000
20.22% would have to be earned to produce EPS of $3.15
and the 5% growth in EPS.
15-21
Chapter 15: Investment Banking: Public and Private Placement
20.
Dilution and rates of return (LO3) Tyson Iron Works is about to go public. It currently
has aftertax earnings of $4,500,000 and 3,000,000 shares are owned by the present
stockholders. The new public issue will represent 400,000 new shares. The new shares will
be priced to the public at $15 per share with a 4 percent spread on the offering price. There
will also be $160,000 in out-of-pocket costs to the corporation
a.
b.
c.
d.
Compute the net proceeds to Tyson Iron Works.
Compute the earnings per share immediately before the stock issue.
Compute the earnings per share immediately after the stock issue.
Determine what rate of return must be earned on the net proceeds to the corporation so
there will not be a dilution in earnings per share during the year of going public.
e. Determine what rate of return must be earned on the proceeds to the corporation so
there will be a 10 percent increase in earnings per share during the year of going public.
15-20. Solution:
Tyson Iron Works
a.
$15 96% = $14.40 net price
$14.40
400,000
$5,760,000
160,000
$5,600,000
22
net price
new shares
proceeds before out-of-pocket costs
out-of-pocket costs
net proceeds
Chapter 15: Investment Banking: Public and Private Placement
15-20. (Continued)
d. There are now 3,400,000 shares outstanding. To maintain
earnings per share of $1.50, total earnings must be
$5,100,000 ($1.50 3,400,000 shares). This would imply an
increase in earnings of $600,000 ($5100,000 $4,500,000)
10.71% must be earned on the net proceeds to produce EPS
of $1.50.
e. $1.50 (1.10)
= $1.65 (10% increase in EPS)
total earnings
= $1.65 3,400,000 = $5,610,000
incremental earnings = $5,610,000 - 4,500,000 = $1,110,000
19.82% would have to be earned to produce EPS of $1.65.
21.
Aftermarket for new public issue (LO4) I. B. Michaels has a chance to participate in a
new public offering by Hi-Tech Micro Computers. His broker informs him that demand for
the 500,000 shares to be issued is very strong. His brokers firm is assigned 15,000 shares
in the distribution and will allow Michaels, a relatively good customer, 1.5 percent of its
15,000 share allocation.
The initial offering price is $30 per share. There is a strong aftermarket, and
the stock goes to $33 one week after issue. The first full month after issue,
Mr. Michaels is pleased to observe his shares are selling for $34.75. He is content to place
his shares in a lockbox and eventually use their anticipated increased value to help send his
son to college many years in the future. However, one year after the distribution, he looks
up the shares in The Wall Street Journal and finds they are trading at $28.75.
a. Compute the total dollar profit or loss on Mr. Michaelss shares one week, one month,
and one year after the purchase. In each case compute the profit or loss against the
initial purchase price.
15-23
Chapter 15: Investment Banking: Public and Private Placement
b. Also compute this percentage gain or loss from the initial $30 price and compare this to
the results that might be expected in an investment of this nature based on prior
research. Assume the overall stock market was basically unchanged during the period
of observation.
c. Why might a new public issue be expected to have a strong aftermarket?
15-21. Solution:
I. B. Michaels
a. Mr. Michael's purchase = 1.5% 15,000 shares = 225 shares
Dollar profit or loss
1 week
225 shares ($33 $30) = $ 675.00 profit
1 month 225 shares ($34.75 $30) = $1,068.75 profit
1 year
225 shares ($28.75 $30)
= $ 281.25
loss
b. Percentage profit or loss
1 week
$3.00/$30
1 month $4.75/$30
1 year $1.25/$30
= +10.00%
= +15.83%
= 4.17%
15-21. (Continued)
The results are in line with prior research. The stock went up
one week and one month after issue, but actually provided a
negative return for one year after issue. This is consistent
with the research of Reilly (footnote 1 in this chapter), which
showed excess returns of 10.9 percent, 11.6 percent and 3.0
percent over comparable periods of study. Actually, the stock
was a bit stronger than that indicated by the Reilly research
for one month after issue.
24
Chapter 15: Investment Banking: Public and Private Placement
c. A new public issue may be expected to have a strong aftermarket because investment bankers often underprice the
issue to insure the success of the distribution.
22.
Leveraged buyout (LO5) The management of Mitchell Labs decided to go private in 2002
by buying in all 3 million of its outstanding shares at $19.50 per share. By 2006,
management had restructured the company by selling off the petroleum research division
for $13 million, the fiber technology division for $9.5 million, and the synthetic products
division for $21 million. Because these divisions had been only marginally profitable,
Mitchell Labs is a stronger company after the restructuring. Mitchell is now able to
concentrate exclusively on contract research and will generate earnings per share of $1.25
this year. Investment bankers have contacted the firm and indicated that if it reentered the
public market, the 3 million shares it purchased to go private could now be reissued to the
public at a P/E ratio of 16 times earnings per share.
a. What was the initial total cost to Mitchell Labs to go private?
b. What is the total value to the company from (1) the proceeds of the divisions that were
sold, as well as (2) the current value of the 3 million shares (based on current earnings
and an anticipated P/E of 16)?
c. What is the percentage return to the management of Mitchell Labs from the
restructuring? Use answers from parts a and b to determine this value.
15-22. Solution:
Mitchell Labs
a. 3 million shares $19.50 = $58.5 million (cost to go
private)
b. Proceeds from sale of the divisions
Petroleum research division
Fiber Technology division
Synthetic products division
$13.0
9.5
21.0
$43.5
Current value of the 3 million shares
15-25
million
million
million
million
Chapter 15: Investment Banking: Public and Private Placement
3 million shares (P/E EPS)
3 million (16 $1.25)
3 million $20
$60.0
Total value to the company
$103.5
million
million
15-22. (Continued)
c.
Total value to the company
Cost to go private
Profit from restructuring
$103.5
58.5
$ 45.0
million
million
million
COMPREHENSIVE PROBLEM
Bailey Corporation (impact of new public offering) (LO4) The Bailey Corporation, a
manufacturer of medical supplies and equipment, is planning to sell its shares to the general
public for the first time. The firms investment banker, Robert Merrill and Company, is working
with Bailey Corporation in determining a number of items. Information on the Bailey
Corporation follows:
BAILEY CORPORATION
Income Statement
For the Year 201X
Sales (all on credit)...........................................
Cost of goods sold.............................................
Gross profit.......................................................
Selling and administrative expenses.................
Operating profit.................................................
Interest expense.................................................
Net income before taxes....................................
Taxes.................................................................
Net income........................................................
26
$42,680,000
32,240,000
10,440,000
4,558,000
5,882,000
600,000
5,282,000
2,120,000
$ 3,162,000
Chapter 15: Investment Banking: Public and Private Placement
CP 15-1. (Continued)
BAILEY CORPORATION
Balance Sheet
As of December 31, 201X
Assets
Current assets
Cash..............................................................
Marketable securities...................................
Accounts receivable.....................................
Inventory......................................................
Total current assets.....................................
Net plant and equipment...................................
Total assets........................................................
Liabilities and Stockholders Equity
Current liabilities:
Accounts payable.........................................
Notes payable...............................................
Total current liabilities.............................
Long-term liabilities..........................................
Total liabilities..................................................
Stockholders equity:
Common stock (1,800,000 shares at $1 par).
Capital in excess of par.................................
Retained earnings..........................................
Total stockholders equity...........................
Total liabilities and stockholders equity..........
$
250,000
130,000
6,000,000
8,300,000
$14,680,000
13,970,000
$28,650,000
$ 3,800,000
3,550,000
7,350,000
5,620,000
$12,970,000
$ 1,800,000
6,300,000
7,580,000
15,680,000
$28,650,000
a. Assume that 800,000 new corporate shares will be issued to the general public. What
will earnings per share be immediately after the public offering? (Round to two places
to the right of the decimal point.) Based on the price-earnings ratio of 12 what will the
initial price of the stock be? Use earnings per share after the distribution in the
calculation.
b. Assuming an underwriting spread of 5 percent and out-of-pocket costs of $300,000,
what will net proceeds to the corporation be?
c. What return must the corporation earn on the net proceeds to equal the earnings per
share before the offering? How does this compare with current return on the total assets
on the balance sheet?
15-27
Chapter 15: Investment Banking: Public and Private Placement
d. Now assume that, of the initial 800,000-share distribution, 400,000 belong to current
stockholders and 400,000 are new shares, and the latter will be added to the 1,800,000
shares currently outstanding. What will earnings per share be immediately after the
public offering? What will the initial market price of the stock be? Assume a priceearnings ratio of 12 and use earnings per share after the distribution in the calculation.
e. Assuming an underwriting spread of 5 percent and out-of-pocket costs of $300,000,
what will net proceeds to the corporation be?
f. What return must the corporation now earn on the net proceeds to equal earnings per
share before the offering? How does this compare with current return on the total assets
on the balance sheet?
CP 15-1. Solution:
New Public Offering
Bailey Corporation
28
Chapter 15: Investment Banking: Public and Private Placement
In order to earn $1.76 after the offering, the return on
$10,826,400 must produce new earnings equal to X.
CP 15-1. (Continued)
The firm must earn 13.06% on net proceeds to equal earnings
per share before the offering.
This is greater than current return on assets of 11.04%.
15-29
Chapter 15: Investment Banking: Public and Private Placement
CP 15-1. (Continued)
Initial market price = P/E EPS
12 $1.44 = $17.28
e.
400,000 $17.28 = $6,912,000
345,600
300,000
$6,266,400
gross proceeds
5% spread
out-of-pocket costs
net proceeds
f.
$3,162,000 + X = $1.76 (2,200,000)
X = $3,872,000 $3,162,000
X = $710,000
proof:
30
Chapter 15: Investment Banking: Public and Private Placement
CP 15-1. (Continued)
thus:
This is greater than the current return on assets of 11.04%.
15-31