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CHAPTER 20
ISSUING SECURITIES TO THE PUBLIC
Answers to Concepts Review and Critical Thinking Questions
1. A company’s internally generated cash flow provides a source of equity financing. For a profitable
company, outside equity may never be needed. Debt issues are larger because large companies have
2. From the previous question, economies of scale are part of the answer. Beyond this, debt issues are
easier and less risky to sell from an investment bank’s perspective. The two main reasons are that
4. Yields on comparable bonds can usually be readily observed, so pricing a bond issue accurately is
7. It’s an important factor. Only 9.68 million of the shares were underpriced. The other 30 million were,
8. The evidence suggests that a non-underwritten rights offering might be substantially cheaper than a
9. He could have done worse since his access to the oversubscribed and, presumably, underpriced
10. a. The price will probably go up because IPOs are generally underpriced. This is especially true
b. It is probably safe to assume that they are having trouble moving the issue, and it is likely that
11. Competitive offer and negotiated offer are two methods to select investment bankers for
underwriting. Under competitive offers, the issuing firm can award its securities to the underwriter
12. There are two possible reasons for stock price drops on the announcement of a new equity issue: 1)
Management may attempt to issue new shares of stock when the stock is overvalued, that is, the
intrinsic value is lower than the market price. The price drop is the result of the downward
13. If the interest of management is to increase the wealth of the current shareholders, a rights offering
may be preferable because issuing costs as a percentage of capital raised are lower for rights
14. Reasons for shelf registration include: 1) Flexibility in raising money only when necessary without
15. Basic empirical regularities in IPOs include: 1) Underpricing of the offer price, 2) Best-efforts
offerings are generally used for small IPOs and firm-commitment offerings are generally used for
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.
Basic
1. a. The new market value will be the current shares outstanding times the stock price plus the
rights offered times the rights price, so:
b. The number of rights associated with the old shares is the number of shares outstanding divided
by the rights offered, so:
c. The new price of the stock will be the new market value of the company divided by the total
number of shares outstanding after the rights offer, which will be:
d. The value of a right is the difference between the current price and the ex-rights price, so:
e. A rights offering usually costs less; it protects the proportionate interests of existing share-
2. a. The maximum subscription price is the current stock price, or $28. The minimum price is
b. The number of new shares will be the amount raised divided by the subscription price, so:
c. A shareholder can buy 2.79 rights-on shares for:
The investor will then have:
The ex-rights price per share is:
So, the value of a right is:
d. Before the offer, a shareholder will own shares at the current market price, or:
After the rights offer, the share price will fall, but the shareholder will also hold the rights, so:
3. Using the equation we derived in Problem 2, part c to calculate the price of the stock ex-rights, we
can find the number of shares a shareholder will have ex-rights, which is:
The number of new shares is the amount raised divided by the per-share subscription price, so:
And the number of old shares is the number of new shares times the number of shares ex-rights, so:
4. If you receive 1,000 shares of each, the profit is:
Since you will only receive one-half of the shares of the oversubscribed issue, your profit will be:
This is an example of the winner’s curse.
5. Using X to stand for the required sale proceeds, the equation to calculate the total sale proceeds,
including flotation costs, is:
So the number of shares offered is the total amount raised divided by the offer price, which is:
6. This is basically the same as the previous problem, except we need to include the $1,900,000 of
expenses in the amount the company needs to raise, so:
7. We need to calculate the net amount raised and the costs associated with the offer. The net amount
raised is the number of shares offered times the price received by the company, minus the costs
associated with the offer, so:
The company received $222,325,000 from the stock offering. Now we can calculate the direct costs.
Part of the direct costs are given in the problem, but the company also had to pay the underwriters.
We are given part of the indirect costs in the problem. Another indirect cost is the immediate price
appreciation. The total indirect costs were:
The flotation costs as a percentage of the amount raised are the total cost divided by the amount
raised, so:
8. The number of rights needed per new share is:
Number of rights needed = 145,000 old shares / 30,000 new shares = 4.83 rights per new share
Using PRO as the rights-on price, and PS as the subscription price, we can express the price per share
of the stock ex-rights as:
PX = [NPRO + PS] / (N + 1)
9. In general, the new price per share after the offering will be:
P =
Current market value + Proceeds from offer
Old shares + New shares
The current market value of the company is the number of shares outstanding times the share price,
or:
If the new shares are issued at $40, the share price after the issue will be:
P =
$2,000,000 + 9,000($40)
50,000 + 9,000
P = $40.00
If the new shares are issued at $20, the share price after the issue will be:
P =
$2,000,000 + 9,000($20)
50,000 + 9,000
P = $36.95
If the new shares are issued at $10, the share price after the issue will be:
P =
$2,000,000 + 9,000($10)
50,000 + 9,000
P = $35.42
Intermediate
10. a. The number of shares outstanding after the stock offer will be the current shares outstanding,
plus the amount raised divided by the current stock price, assuming the stock price doesn’t
change. So:
Number of shares after offering = 6,800,0000 + $30,000,000 / $65
Number of shares after offering = 7,261,538
Since the par value per share is $1, the old book value of the shares is the current number of
shares outstanding. From the previous solution, we can see the company will sell 461,538
shares, and these will have a book value of $65 per share. The sum of these two values will give
The current EPS for the company is:
And the current PE is:
If the net income increases by $675,000, the new EPS will be:
EPS1 = NI1 / shares1
Assuming the PE remains constant, the new share price will be:
The current market-to-book ratio is:
Using the new share price and book value per share, the new market-to-book ratio will be:
Accounting dilution has occurred because new shares were issued when the market-to-book
ratio was less than one; market value dilution has occurred because the firm financed a negative
b. For the price to remain unchanged when the PE ratio is constant, EPS must remain constant.
The new net income must be the new number of shares outstanding times the current EPS,
which gives:
