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Chapter 15: Investment Banking: Public and Private Placement
Chapter 15
Investment Banking: Public and Private Placement
Discussion Questions
15-1.
In what way is an investment banker a risk taker?
The investment banker is a risk taker (underwriter) in that the investment banking
house agrees to buy the securities from the corporation and resell them to other
security dealers and the public at an agreed upon price. If they can’t sell the
securities at the initial offering price, they suffer a loss.
15-2.
What is the purpose of market stabilization activities during the distribution
process?
Market stabilization activities are managed in an attempt to insure that the market
price will not fall below a desired level during the distribution process. Syndicate
members committed to purchasing the stock at a given price could be in trouble if
there is a rapid decline in the price of the stock.
15-3.
Discuss how an underwriting syndicate decreases risk for each underwriter and at
the same time facilitates the distribution process.
By forming a syndicate of many underwriters rather than just one, the overall risk
is diffused and the capabilities for widespread distribution are enhanced.
A syndicate may comprise as few as two or as many as 50 investment banking
houses.
15-4.
Discuss the reason for the differences between underwriting spreads for stocks
and bonds.
Common stocks often carry a larger underwriting spread than bonds because the
market reaction to stocks is more uncertain.
Chapter 15: Investment Banking: Public and Private Placement
15-2
15-5.
What is shelf registration? How does it differ from the traditional requirements
for security offerings?
Shelf registration permits large companies to file one comprehensive registration
statement (under SEC Rule 415). This statement outlines the firm's plans for
future long-term financing. Then, when market conditions appear to be
appropriate, the firm can issue the securities without further SEC approval. Shelf
registration is different from the traditional requirement that security issuers file
a detailed registration statement for SEC review and approval each and every
time they plan a sale.
15-6.
Discuss the benefits accruing to a company that is traded in the public securities
markets.
The benefits of having a publicly traded security are:
a. Greater ability to raise capital.
b. Additional prestige and visibility that can be helpful in bank negotiations,
executive recruitment, and the marketing of products.
c. Increased liquidity for existing stockholders.
d. Ease in estate planning for existing stockholders.
e. An increased capability to engage in the merger and acquisition process.
15-7.
What are the disadvantages to being public?
The disadvantage of being public are:
a. All information must be made available to the public through SEC and state
filings. This can be very expensive for a small company.
b. The president must be a public relations representative to the investment
community.
c. Tremendous pressure is put on the firm for short-term performance.
d. Large downside movement in the stock can take place in a bear market.
e. The initial cost of going public can be very expensive for a small firm.
f. There are high reporting compliance costs.
15-8.
If a company were looking for capital by way of a private placement, where
would it look for funds?
Funds for private placement can be found through insurance companies, pension
funds, mutual funds, and wealthy individuals.
Chapter 15: Investment Banking: Public and Private Placement
15-9.
How does a leveraged buyout work? What does the debt structure of the firm
normally look like after a leveraged buyout? What might be done to reduce the
debt?
The use of a leveraged buy-out implies that either management or some other
investor group borrows the needed cash to repurchase all the shares of the
company. After the repurchase, the company exits with a lot of debt and heavy
interest expense. To reduce the debt load, assets may be sold off to generate
cash. Also, returns from asset sales may be redeployed into higher return areas.
15-10.
How might a leveraged buyout eventually lead to high returns for companies?
Companies may restructure their companies and once again take them public at a
large profit.
15-11.
What is privatization?
In the international markets, investment bankers sell companies to the public that
were previously owned by the government. Since the new owners are the private
sector rather than the public sector, the process of distributing the shares to the
private sector is called privatization.
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 year’s results. Should the new issue be
undertaken based on earnings per share?
15-1. Solution:
Chapter 15: Investment Banking: Public and Private Placement
15-4
Hamilton Corporation
a. Earnings per share before stock issue
Earnings per share after stock issue
dilution $1.50
1.20
$ .30 per share
b. Net income = $6,000,000 + .105 (1,000,000 $30)
15-1. (Continued)
Earnings per share after additional income
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:
Chapter 15: Investment Banking: Public and Private Placement
Hamilton Corporation (Continued)
Earnings per share after additional income
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 year’s 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
Earnings per share after stock issue
dilution $2.50
2.00
$ .50 per share
Chapter 15: Investment Banking: Public and Private Placement
15-6
b. Net income = $15,000,000 + .12 (1,500,000 $50)
Earnings per share after additional income
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)
Earnings per share after additional income
Chapter 15: Investment Banking: Public and Private Placement
15-7
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
Earnings per share after stock issue
b. EPS $ 2.18
c. The founding stockholders will probably not be pleased.
Chapter 15: Investment Banking: Public and Private Placement
15-8
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.
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)
Chapter 15: Investment Banking: Public and Private Placement
15-9
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 Net to Corporation
a. $1.6 million ..... $40 $36.70
b. 6.0 million ..... 40 37.28
c. 25.0 million ..... 40 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%
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 dealer’s 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:
Chapter 15: Investment Banking: Public and Private Placement
15-10
Walton and Company
a. $18.80 Selected dealer group’s price
18.00 Managing investing banker’s price
$ .80 Differential
b. $19.20 Broker’s price
18.00 Managing investing banker’s price
c. $19.50 Public price
10. 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:
