Answers and Solutions: 18 – 11
18-7 a. Investment outlay required to refund the issue (all figures after-tax):
Annual Flotation Cost Tax Effects:
Annual tax savings on new flotation: $ 80,000
Tax benefits lost on old flotation: (66,667)
Amortization tax effects $ 13,333
Annual Interest Savings Due to Refunding:
NPV = ? NPV = $2,717,128.
b. The company should consider what interest rates might be next year. If there is a
high probability that rates will drop below the current rate, it may be more
advantageous to refund later versus now. If there is a high probability that rates will
increase, the firm should act now to refund the old issue. Also, the company should
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SOLUTION TO SPREADSHEET PROBLEM
Mini Case: 18 – 13
MINI CASE
Randy’s, a family-owned restaurant chain operating in Alabama, has grown to the point
that expansion throughout the entire Southeast is feasible. The proposed expansion would
require the firm to raise about $18.3 million in new capital. Because Randy’s currently has
a debt ratio of 50% and because family members already have all their personal wealth
invested in the company, the family would like to sell common stock to the public to raise
the $18.3 million. However, the family wants to retain voting control. You have been asked
to brief family members on the issues involved by answering the following questions.
a. What agencies regulate securities markets?
Answer: The main agency that regulates the securities market is the Securities And Exchange
The Federal Reserve Board controls flow of credit into security transactions
through margin requirements. States also have some control over the issuance of new
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b. How are start-up firms usually financed?
c. Differentiate between a private placement and a public offering.
Answer: In a private placement stock is sold directly to one or a small group of investors rather
than being distributed to the public at large. A private placement has the advantage of
listed above would not be obtained. For these reasons, a public placement makes
more sense in Randy’s situation.
d. Why would a company consider going public? What are some advantages and
disadvantages?
Going public will allow the family members to diversify their assets and reduce
the riskiness of their personal portfolios.
It will increase the liquidity of the firm’s stock, allowing the family stockholders
It will make it easier for the firm to raise funds. The firm would have a difficult
time trying to sell stock privately to an investor who was not a family member.
Outside investors would be more willing to purchase the stock of a publicly held
corporation which must file financial reports with the sec.
The firm will have to disclose operating data to the public. Many small firms do
not like having to do this, because such information is available to competitors.
Also, some of the firm’s officers, directors, and major stockholders will have to
disclose their stock holdings, making it easy for others to estimate their net worth.
If the company is very small, its stock may not be traded actively and the market
price may not reflect the stock’s true value.
The advantages of public ownership would be recognized by key employees, who
would most likely be granted stock options, which would certainly be more valuable
if the stock were publicly traded.
f. What criteria are important in choosing an investment banker?
g. Would companies going public use a negotiated deal or a competitive bid?
Answer: The firm would almost certainly use a negotiated deal. The competitive bid process
for setting investment bankers’ fees is feasible only for large, well-established firms
h. Would the sale be on an underwritten or best efforts basis?
Answer: Most stock offerings are done on an underwritten basis, but the price is not set until
the investment banker has checked investors for interest in the stock, and has received
oral assurances of commitments at a price that will virtually guarantee the success of
the price the new investor pays and the proceeds to the company. To net $18.3
million, what is the value of stock that must be sold? What is the total post-IPO
value of equity? What percentage of this equity will the new investors require?
How many shares will the new investors require? What is the estimated offer
price per share?
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Answer: To net $18.6 million, the company must issue $18.6/(1 – 0.07) = $20.
The value of equity after the IPO is equal to the value before plus the net proceeds:
Post-IPO equity = $63 + $20(1 – 0.07) = $81.6 million.
The new owners are investing $20 million, so they require a share of the equity that is
= [0.2451)(4)] / (1 – 0.2451)
= 1.30 million.
The estimated offer price is the total amount purchased by the new investors divided
by the number of new shares:
cities, and make three to five presentations in each city. Management can’t say
anything that is not in the registration statement, because the SEC imposes a fiquiet
period” from the time it makes the registration effective until 25 days after the stock
begins trading. The purpose is to prevent select investors from getting information
that is not available to other investors.
Mini Case: 18 – 18
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k. Describe the typical first-day returns of an IPO and the long-term returns to
are generally lower than for comparable firms, indicating that the offering price is too
low, but that the first-day run-up is too high.
l. What are the direct and indirect costs of an IPO?
m. What are equity carve-outs?
Answer: Equity carve-outs are a special type of IPO in which a public company creates a new
public company from one of its subsidiaries by issuing public stock in the subsidiary.
Companies can issue securities using shelf registration (SEC rule 451) in which
securities are registered but not all of the issue is sold at once. Instead, the company
sells a percentage of the issue each time it needs to raise capital. Companies can use
private placements. Some companies raise capital by securitizing their assets, such as
credit card receivables.
banks and other financial institutions.
Mini Case: 18 – 19
website, in whole or in part.
Modern investment banking companies engage in underwriting debt and equity
offerings (the same as traditional investment banks),mergers and acquisitions, finding
potential acquisition targets, advising M&A clients, securitization, asset management
for clients and on their own behalf, trading operations.
Traditional investment banks were primarily fee-generating organizations, but
investment banks in 2007 were highly levered, often with ST borrowings (such as
commercial paper). They also had large positions in risky assets, including mortgage–
backed securities and credit default swaps. As a consequence, many from 2007
fifailed” and were sold (Bear Stearns; Merrill Lynch), liquidated (Lehman Brothers),
or converted into bank to get TARP (Goldman Sachs).
usually use a large amount of debt financing, up to 90 percent, to complete the
purchase. Such a transaction is called a fileveraged buyout (LBO).”
Going private gives the managers greater incentives and more flexibility in
running the company. It also removes the burden of sec filings, stockholder relations,
annual reports, analyst meetings, and so on. The major disadvantage of going private
After several years of operating the business as a private firm, the owners
typically go public again. At this time, the firm is presumably operating at its peak,
and it will command top dollar compared to when it went private. In this way, the
equity investors of the private firm are able to recover their investment and,
hopefully, make a tidy profit. So far LBOs have, on average, been extremely
q. Under what conditions would a firm exercise a bond’s call provision?
Mini Case: 18 – 20
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website, in whole or in part.
Answer: Refunding decisions involve two separate questions: (1) is it profitable to call an
outstanding issue in the current period and replace it with a new issue; and (2) if
refunding is currently profitable, would the value of the firm be increased even more
if the refunding were postponed to a later date? If these two conditions are true, a
company would exercise their bond’s call provision.
r. Explain how firms manage the risk structure of their debt with project
financing.
lessors do not have recourse against the sponsors; they must be repaid from the
project’s cash flows and the equity cushion provided by the sponsors.