CHAPTER 18—PUBLIC AND PRIVATE FINANCING: INITIAL OFFERINGS,
SEASONED OFFERINGS, AND INVESTMENT BANKS
TRUE/FALSE
1. If its managers make a tender offer and buy all shares that were not held by the management team, this
is called a private placement.
2. Going public establishes a market value for the firm’s stock, and it also ensures that a liquid market
will continue to exist for the firm’s shares. This is especially true for small firms that are not widely
followed by security analysts.
3. The cost of meeting SEC and possibly additional state reporting requirements regarding disclosure of
financial information, the danger of losing control, and the possibility of an inactive market and an
attendant low stock price are potential disadvantages of going public.
4. The term “leaving money on the table” refers to the situation where an investment banking house
makes a very low bid for the right to underwrite a firm’s new stock offering. The banker is, in effect,
“buying the job” with the low bid and thus not getting all the money his firm would normally earn on
the job.
5. Whereas commercial banks take deposits from some customers and make loans to other customers, the
principal activities of investment banks are (1) to help firms issue new stock and bonds and (2) to give
firms advice with regard to mergers and other financial matters. However, financial corporations often
own and operate subsidiaries that operate as commercial banks and others that are investment banks.
This was not true some years ago, when the two types of banks were required by law to be completely
independent of one another.
6. The term “equity carve-out” refers to the situation where a firm’s managers give themselves the right to
purchase new stock at a price far below the going market price. Since this dilutes the value of the
public stockholders, it “carves out” some of their value.
7. Suppose a company issued 30-year bonds 4 years ago, when the yield curve was inverted. Since then
long-term rates (10 years or longer) have remained constant, but the yield curve has resumed its
normal upward slope. Under such conditions, a bond refunding would almost certainly be profitable.
8. The appropriate discount rate to use when analyzing a refunding decision is the after-tax cost of new
debt, in part because there is relatively little risk of not realizing the interest savings.
9. If the firm uses the after-tax cost of new debt as the discount rate when analyzing a refunding decision,
and if the NPV of refunding is positive, then the value of the firm will be maximized if it immediately
calls the outstanding debt and replaces it with an issue that has a lower coupon rate.
10. When a firm refunds a debt issue, the firm’s stockholders gain and its bondholders lose. This points out
the risk of a call provision to bondholders and explains why a non-callable bond will typically
command a higher price than an otherwise similar callable bond.
MULTIPLE CHOICE
11. Which of the following is generally NOT true and an advantage of going public?
a.
Increases the liquidity of the firm’s stock.
b.
Makes it easier to obtain new equity capital.
c.
Establishes a market value for the firm.
d.
Makes it easier for owner-managers to engage in profitable self-dealings.
e.
Facilitates stockholder diversification.
12. Which of the following statements about listing on a stock exchange is most CORRECT?
a.
Any firm can be listed on the NYSE as long as it pays the listing fee.
b.
Listing provides a company with some “free” advertising, and it may enhance the firm’s
prestige and help it do more business.
c.
Listing reduces the reporting requirements for firms, because listed firms file reports with
the exchange rather than with the SEC.
d.
The OTC is the second largest market for listed stock, and it is exceeded only by the
NYSE.
e.
Listing is a decision of more significance to a firm than going public.
13. Which of the following statements is most CORRECT?
a.
Private placements occur most frequently with stocks, but bonds can also be sold in a
private placement.
b.
Private placements are convenient for issuers, but the convenience is offset by higher
flotation costs.
c.
The SEC requires that all private placements be handled by a registered investment
banker.
d.
Private placements can generally bring in funds faster than is the case with public
offerings.
e.
In a private placement, securities are sold to private (individual) investors rather than to
institutions.
14. Which of the following statements is most CORRECT?
a.
The key benefits associated with refunding debt are the reduction in the firm’s debt ratio
and the creation of more reserve borrowing capacity.
b.
The mechanics of finding the NPV of a refunding decision are fairly straightforward.
However, the decision of when to refund is not always clear because it requires a forecast
of future interest rates.
c.
If a firm with a positive NPV refunding project delays refunding and interest rates rise, the
firm can still obtain the entire NPV by locking in a low coupon rate when the rates are
low, even though it actually refunds the debt after rates have risen.
d.
Suppose a firm is considering refunding and interest rates rise during time when the
analysis is being done. The rise in rates would tend to lower the expected price of the new
bonds, which would make them cheaper to the firm and thus increase the expected interest
savings.
e.
If new debt is used to refund old debt, the correct discount rate to use in the refunding
analysis is the before-tax cost of new debt.
15. Which of the following factors would increase the likelihood that a company would call its outstanding
bonds at this time?
a.
A provision in the bond indenture lowers the call price on specific dates, and yesterday
was one of those dates.
b.
The flotation costs associated with issuing new bonds rise.
c.
The firm’s CFO believes that interest rates are likely to decline in the future.
d.
The firm’s CFO believes that corporate tax rates are likely to be increased in the future.
e.
The yield to maturity on the company’s outstanding bonds increases due to a weakening of
the firm’s financial situation.
16. Which of the following statements concerning common stock and the investment banking process is
NOT CORRECT?
a.
If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primary
market.
b.
Listing a large firm’s stock is often considered to be beneficial to stockholders because the
increases in liquidity and reputation probably outweigh the additional costs to the firm.
c.
Stockholders have the right to elect the firm’s directors, who in turn select the officers who
manage the business. If stockholders are dissatisfied with management’s performance, an
outside group may ask the stockholders to vote for it in an effort to take control of the
business. This action is called a tender offer.
d.
The announcement of a large issue of new stock could cause the stock price to fall. This
loss is called “market pressure,” and it is treated as a flotation cost because it is a cost to
stockholders that is associated with the new issue.
e.
The preemptive right gives each existing common stockholder the right to purchase his or
her proportionate share of a new stock issue.
17. Which of the following statements is NOT CORRECT?
a.
“Going public” establishes a firm’s true intrinsic value and ensures that a liquid market
will always exist for the firm’s shares.
b.
Publicly owned companies have sold shares to investors who are not associated with
management, and they must register with and report to a regulatory agency such as the
SEC.
c.
When stock in a closely held corporation is offered to the public for the first time, the
transaction is called “going public,” and the market for such stock is called the new issue
market.
d.
It is possible for a firm to go public and yet not raise any additional new capital.
e.
When a corporation’s shares are owned by a few individuals who own most of the stock or
are part of the firm’s management, we say that the firm is “closely, or privately, held.”
18. In its negotiations with its investment bankers, Patton Electronics has reached an agreement whereby
the investment bankers receive a smaller fee now (6% of gross proceeds versus their normal 10%) but
also receive a 1-year option to purchase an additional 200,000 shares at $5.00 per share. Patton will go
public by selling $5,000,000 of new common stock. The investment bankers expect to exercise the
option and purchase the 200,000 shares in exactly one year, when the stock price is forecasted to be
$6.50 per share. However, there is a chance that the stock price will actually be $12.00 per share one
year from now. If the $12 price occurs, what would the present value of the entire underwriting
compensation be? Assume that the investment banker’s required return on such arrangements is 15%,
and ignore taxes.
a.
$1,235,925
b.
$1,300,973
c.
$1,369,446
d.
$1,441,522
e.
$1,517,391
19. To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,000 of new capital
during each of the next 3 years. The firm has a choice of issuing new debt or equity each year as the
funds are needed, or issue only debt now and equity later. Its target capital structure is 40% debt and
60% equity, and it wants to be at that structure in 3 years, when the project has been completed. Debt
flotation costs for a single debt issue would be 1.6% of the gross debt proceeds. Yearly flotation costs
for 3 separate issues of debt would be 3.0% of the gross amount. Ignoring time value effects, how
much would the firm save by raising all of the debt now, in a single issue, rather than in 3 separate
issues?
a.
$79,425
b.
$83,606
c.
$88,006
d.
$92,406
e.
$97,027
20. 10 years ago, the City of Melrose issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-
exempt muni bonds. The bonds had 10 years of call protection, but now the bonds can be called if the
city chooses to do so. The call premium would be 6% of the face amount. New 20-year, 6%,
semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2% of the
amount of bonds sold. What is the net present value of the refunding? Note that cities pay no income
taxes, hence taxes are not relevant.
a.
$453,443
b.
$476,115
c.
$499,921
d.
$524,917
e.
$551,163
21. Five years ago, the State of Oklahoma issued $2,000,000 of 7% coupon, 20-year semiannual payment,
tax-exempt bonds. The bonds had 5 years of call protection, but now the state can call the bonds if it
chooses to do so. The call premium would be 5% of the face amount. Today 15-year, 5%, semiannual
payment bonds can be sold at par, but flotation costs on this issue would be 2%. What is the net
present value of the refunding? Because these are tax-exempt bonds, taxes are not relevant.
a.
$278,606
b.
$292,536
c.
$307,163
d.
$322,521
e.
$338,647
22. Palmer Company has $5,000,000 of 15-year maturity bonds outstanding. Each bond has a maturity
value of $1,000, an annual coupon of 12.0%. The bonds can be called at any time with a premium of
$50 per bond. If the bonds are called, the company must pay flotation costs of $10 per new refunding
bond. Ignore tax considerations⎯assume that the firm’s tax rate is zero.
The company’s decision of whether to call the bonds depends critically on the current interest rate on
newly issued bonds. What is the breakeven interest rate, the rate below which it would be profitable to
call in the bonds?
a.
9.57%
b.
10.07%
c.
10.60%
d.
11.16%
e.
11.72%
23. Stanovich Enterprises has 10-year, 12.0% semiannual coupon bonds outstanding. Each bond is now
eligible to be called at a call price of $1,060. If the bonds are called, the company must replace them
with new 10-year bonds. The flotation cost of issuing new bonds is estimated to be $45 per bond. How
low would the yield to maturity on the new bonds have to be in order for it to be profitable to call the
bonds today, i.e., what is the nominal annual “breakeven rate”?
a.
9.29%
b.
9.78%
c.
10.29%
d.
10.81%
e.
11.35%
24. Refer to Exhibit 18.1. What is the required after-tax refunding investment outlay, i.e., the cash outlay
at the time of the refunding?
a.
$5,049,939
b.
$5,315,725
c.
$5,595,500
d.
$5,890,000
e.
$6,200,000
25. Refer to Exhibit 18.1. What will the after-tax annual interest savings for NWW be if the refunding
takes place?
a.
$664,050
b.
$699,000
c.
$768,900
d.
$845,790
e.
$930,369
26. Refer to Exhibit 18.1. The amortization of flotation costs reduces taxes and thus provides an annual
cash flow. What will the net increase or decrease in the annual flotation cost tax savings be if
refunding takes place?
a.
$6,480
b.
$7,200
c.
$8,000
d.
$8,800
e.
$9,680
27. Refer to Exhibit 18.1. What is the NPV if NWW refunds its bonds today?
a.
$1,746,987
b.
$1,838,933
c.
$1,935,719
d.
$2,037,599
e.
$2,241,359