Answers and Solutions: 18 – 1
Chapter 18
Public and Private Financing: Initial Offerings, Seasoned
Offerings, and Investment Banks
ANSWERS TO END-OF-CHAPTER QUESTIONS
18-1 a. A closely held corporation goes public when it sells stock to the general public.
Going public increases the liquidity of the stock, establishes a market value,
facilitates raising new equity, and allows the original owners to diversify. However,
going public increases business costs, requires disclosure of operating data, and
reduces the control of the original owners. The new issue market is the market for
stock of companies that go public, and the issue is called an initial public offering
(IPO).
b. A public offering is an offer of new common stock to the general public; in other
words, an offer in which the existing shareholders are not given any preemptive right
to purchase the new shares. A private placement is the sale of stock to only one or a
few investors, usually institutional investors. The advantages of private placements
are lower flotation costs and greater speed, since the shares issued are not subject to
SEC registration.
c. A venture capitalist is the manager of a venture capital fund. The fund raises most of
website, in whole or in part.
d. The Securities and Exchange Commission (SEC) is a government agency which
regulates the sales of new securities and the operations of securities exchanges. The
offering. This procedure is termed shelf registration because companies put new
securities fion the shelf” and then later sell them when the market is right. Blue sky
laws are laws that prevent the sale of securities that have little or no asset backing.
The margin is the percentage of a stock’s price that an investor has borrowed in order
buyers prior to approval of the registration statement by the SEC. After the
registration has become effective, the securities, accompanied by the prospectus, may
be offered for sale.
f. The National Association of Securities Dealers (NASD) is an industry group
price, and then resells the stock at the offering price. Thus, the risk of selling the
issue rests with the investment banker.
website, in whole or in part.
h. Refunding occurs when a company issues debt at current low rates and uses the
are callable issues, which means the company can purchase the debt at a lower-than-
market price. Project financings are arrangements used to finance mainly large
capital projects such as energy explorations, oil tankers, refineries, utility power
plants, and so on. Usually, one or more firms (sponsors) will provide the equity
situation where specific assets are pledged as collateral for securities, and hence
asset-backed securities are created. One example of the former is junk bonds; an
example of the latter is mortgage-backed securities.
18-2 An IPO Increases liquidity and allows founders to harvest their wealth, permits founders
18-3 No. The real value of a security is determined by the equilibrium forces of an efficient
18-4 a. Going public would tend to make attracting capital easier and to decrease flotation
costs.
flotation costs would decrease.
Answers and Solutions: 18 – 4
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website, in whole or in part.
f. The introduction of shelf registration tended to speed up SEC review time and lower
the costs of floating each new issue. Thus, the company’s ability to attract new
capital was increased.
18-5 Investment bankers must investigate the firms whose securities they sell, simply because,
Answers and Solutions: 18 – 5
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
18-1 a. $5 per share
Gross proceeds = (3,000,000)($5) = $15,000,000.
c. $4 per share
Gross proceeds = (3,000,000)($4) = $12,000,000.
18-2 Net proceeds per share = $22(1 – 0.05) = $20.90.
18-3 POffer = VPre-issue/(F nNew + nExisting) = $800,000/( 0(nNew) + 40,000) = $20.
NNew = Investment/Price = $200,000/$20 = 10,000.
Therefore, the angel must receive 10,000 new shares to have a 20% stake: 10,000/(10,000
+ 40,000) = 20%. If the angel pays a total of $200,000 for 10,000 shares, the shares must
Answers and Solutions: 18 – 6
18-4 a.
Year 1 2 3 4 5
FCF $1,000,000 $1,050,000 $1,208,000 $1,329,000 $1,462,000
Growth rate at horizon = 7%, WACC = 12%
)07.1(000,462,1
The present value of the horizon value (at Year 5) and the free cash flows in Years 1
through 5 is $22,545,783 and this is the value of operations for the company.
Value of operations $22,016,893
+ Non operating assets 0
– Debt 2,000,000
Value of equity $20,016,893
Company Data
Abercrombe
Gunter
B&C
Shares outstanding
5 million
10 million
500,000
Price per share
$35.00
$47.00
NA
Earnings per share
$2.20
$3.13
$2.60
Free cash flow per share
$1.63
$2.54
$2.00
Book value per share
$16.00
$20.00
$18.00
Total assets
$115 million
$250 million
$11 million
Total debt
$35 million
$50 million
$2 million
b.
Abercrombe
Gunter
B&C
30.43%
20.00%
18.18%
15.91
15.02
15.40
2.19
2.35
2.22
13.8%
15.7%
14.4%
21.47
18.50
20.02
Notes:
Market/Book = market price per share divided by book value of equity per share.
ROE can be calculated from per-share information as earnings per share divided by
book value per share.
c. The implied prices are obtained by multiplying B&C’s measure (earnings per share,
Answers and Solutions: 18 – 8
18-6 a. Since the call premium is 11 percent, the total premium is 0.11($40,000,000) =
$4,400,000. However, this is a tax deductible expense, so the relevant after-tax cost
is $4,400,000(1 – T) = $4,400,000(0.60) = $2,640,000.
c. The flotation costs on the old issue were 0.06($40,000,000) = $2,400,000. These
costs were deferred and are being amortized over the 25-year life of the issue, and
d. The net after-tax cash outlay is $3,472,000, as shown below:
Old issue call premium $2,640,000
e. The new issue flotation costs of $1,600,000 would be amortized over the 20-year life
$48,000 semiannually. The value of each $48,000 deduction forgone is
0.40($48,000) = $19,200.
Answers and Solutions: 18 – 9
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website, in whole or in part.
f. The interest on the old issue is 0.11($40,000,000) = $4,400,000 annually, or
$2,200,000 semiannually. Since interest payments are tax deductible, the after-tax
semiannual amount is 0.6($2,200,000) = $1,320,000.
The new issue carries an 8 percent coupon rate. Therefore, the annual interest
would be 0.08($40,000,000) = $3,200,000, or $1,600,000 semiannually. The
after-tax cost is thus 0.6($1,600,000) = $960,000. Thus, the after-tax net interest
savings if refunding takes place would be $1,320,000 ─ $960,000 = $360,000
Tax benefits lost on old flotation: (19,200)
Net amortization tax effects ($ 3,200)
Semiannual Interest Savings Due To Refunding:
taxes. Thus, the appropriate interest rate is GST’s after-tax cost of debt. (The source
of the cash to fund the net investment outlay also influences the discount rate, but
most firms use debt to finance this outlay, and, in this case, the discount rate should
be the after-tax cost of debt.) Finally, since we are valuing future flows, the
Answers and Solutions: 18 – 10
Refunding NPV $5,637,413
The decision to refund now rather than wait till later is much more difficult than
finding the NPV of refunding now. If interest rates were expected to fall, and hence
not have been high enough to worry about.