Finance Chapter 18 NPV of Refunding Positive Then The Value The

Ch 18 Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

1. 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.

a.

True

b.

False

1

False

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2. 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.

a.

True

b.

False

True

1

False

financing

3. 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.

d

1

Difficulty: Moderate

Multiple Choice

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Going public

TYPE: Multiple Choice: Conceptual

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4. 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.

b

1

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5. 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.

a.

True

b.

False

False. Leaving money on the table occurs when a security issue is underpriced.

1

False

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IPOs

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False

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Listing

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Ch 18 Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

6. 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.

a.

True

b.

False

True

1

False

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7. 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

e

8. 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.

a.

True

b.

False

1

False

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1

False

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9. 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.

a.

True

b.

False

1

Difficulty: Easy

True / False

False

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Private placements

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10. 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.

d

1

Difficulty: Moderate

Multiple Choice

False

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11. 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.

c

Difficulty: Moderate

Multiple Choice

False

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Investment banking process

TYPE: Multiple Choice: Conceptual

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Private placements

TYPE: Multiple Choice: Conceptual

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Ch 18 Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

12. 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.”

a

1

Difficulty: Moderate

Multiple Choice

False

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United States – OH – Default City – TBA

Investment banking process

TYPE: Multiple Choice: Conceptual

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13. 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

c

14. 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.

a.

True

b.

False

1

False

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1

False

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15. 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.

a.

True

b.

False

True

1

False

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16. 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.

a.

True

b.

False

1

False

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17. 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.

a.

True

b.

False

True

1

Difficulty: Moderate

True / False

False

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Refunding and callable bonds

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18. 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

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Refunding decision

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Ch 18 Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

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.

b

1

Difficulty: Moderate

Multiple Choice

False

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United States – OH – Default City – TBA

Refunding decision

TYPE: Multiple Choice: Conceptual

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19. 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.

a

1

Difficulty: Moderate

Multiple Choice

False

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United States – OH – Default City – TBA

Refunding decision

TYPE: Multiple Choice: Conceptual

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

a

1

False

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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

a

1

False

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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%

d

1

False

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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%

c

1

False

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NorthWest Water (NWW)

Five years ago, NorthWest Water (NWW) issued $50,000,000 face value of 30-year bonds carrying a 14% (annual

payment) coupon. NWW is now considering refunding these bonds. It has been amortizing $3 million of flotation costs on

these bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest rate of

11.67% in today’s market. A call premium of 14% would be required to retire the old bonds, and flotation costs on the

new issue would amount to $3 million. NWW’s marginal tax rate is 40%. The new bonds would be issued when the old

bonds are called.

24. Refer to the data for NorthWest Water (NWW). 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

e

Amount:

Tax saving on unexpensed float cost

After tax cost of call premium:

1

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25. Refer to the data for NorthWest Water (NWW). 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

b

1

False

financing

False

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GCID-55dff5e86350-9ae8-0424-5970-64e2f85c

Ch 18 Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

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26. Refer to the data for NorthWest Water (NWW). 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

c

False

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27. Refer to the data for NorthWest Water (NWW). 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

d

1

False

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GCID-55dff5e86350-9ae8-0424-5970-64e2f85c