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
c. A venture capitalist is the manager of a venture capital fund. The fund raises most of
its capital from institutional investors and invests in start-up companies in exchange
for equity. The venture capitalist gets a seat on the companies’ boards of directors.
Answers and Solutions: 18 – 2
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
SEC, along with other government agencies and self-regulation, helps ensure stable
markets, sound brokerage firms, and the absence of stock manipulation. Registration
of securities is required of companies by the SEC before the securities can be offered
e. A prospectus summarizes information about a new security issue and the issuing
company. A fired herring,” or preliminary prospectus, may be distributed to potential
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.
Answers and Solutions: 18 – 3
capital required by the project, while the rest of the project’s capital is supplied by
lenders and lessors. The most important aspect of project financing is that the lenders
and 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. Securitization
is the process whereby financial instruments that were previously thinly traded are
18-2 No. The role of the investment banker is more important if the stock demand curve has a
steep slope and the negative signaling effect is substantial. Under such conditions, the
investment banker will have a harder time holding up the stock price.
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.
b. The increasing institutionalization of the fibuy side” of the stock and bond markets
should increase a firm’s ability to attract capital and should reduce flotation costs.
Answers and Solutions: 18 – 4
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.
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.
Net profit = $15,000,000 – $14,000,000 – $300,000 = $700,000.
18-2 Net proceeds per share = $22(1 – 0.05) = $20.90.
Number of shares to be sold = ($20,000,000 + $150,000)/$20.90 = 964,115 shares.
18-3 POffer = VPre-issue/(F nNew + nExisting) = $800,000/( 0(nNew) + 40,000) = $20.
NNew = Investment/Price = $200,000/$20 = 10,000.
18-4 a.
Answers and Solutions: 18 – 6
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
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
Answers and Solutions: 18 – 7
b.
Abercrombe
Gunter
B&C
D/A
30.43%
20.00%
18.18%
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,
or book value per share or FCF per share) by the corresponding ratio (also called a
fimultiple”) for each of the two comparison companies:
18-5 POffer = VPre-issue/(F nNew + nExisting) = $60/( (0.07)(1) + 4) = $14.742 ≈ $14.74
Amount raised = POffer(1-F)(nNew) = $14.74(1 – 0.07)(1) = $13.708 million.
Market/Book
P/FCF
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
hence $2,400,000/25 = $96,000 are being expensed each year, or $48,000 each 6
months. Since the bonds were issued 5 years ago, (5/25)($2,400,000) = $480,000 of
d. The net after-tax cash outlay is $3,472,000, as shown below:
Old issue call premium $2,640,000
New issue flotation cost 1,600,000
Tax savings on old issue flotation costs (768,000)
Net cash outlay $3,472,000
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.
g. The net amortization tax effects are ─$3,200 per year for 20 years, while the net
interest savings are $360,000 per year for 20 years. Thus, the net semiannual cash
flow is $356,800, as shown below.
Semiannual Flotation Cost Tax Effects:
The cash flows are based on contractual obligations, and hence have about the
same amount of risk as the firm’s debt. Further, the cash flows are already net of
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
h. The bond refunding would require a $3,472,000 net cash outlay, but it would produce
$9,109,413 in net savings on a present value basis. Thus, the NPV of refunding is
$5,637,413:
Answers and Solutions: 18 – 11
18-7 a. Investment outlay required to refund the issue (all figures after-tax):
Call premium on old issue: $5,400,000
New flotation cost: 5,000,000
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:
Annual interest on old bond: $5,400,000
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
Answers and Solutions: 18 – 12
SOLUTION TO SPREADSHEET PROBLEM
18-8 The detailed solution for the spreadsheet problem, Solution for Ch18 P06 Build a
Model.xls, is available on the textbook’s Web site.
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
Commission. Some of the responsibilities of the SEC include: regulation of all
Mini Case: 18 – 14
b. How are start-up firms usually financed?
Answer: The first financing comes from the founders. The first external financing comes from
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
d. Why would a company consider going public? What are some advantages and
disadvantages?
Answer: A firm is said to be figoing public” when it sells stock to the public for the first time.
A company’s first stock offering to the public is called an fiinitial public offering
(IPO).” Thus, Randy’s will go public if it goes through with its planned IPO. There
are several advantages and disadvantages to going public:
Advantages to going public:
• Going public will allow the family members to diversify their assets and reduce
the riskiness of their personal portfolios.
Mini Case: 18 – 15
Disadvantages to going public:
• The firm will have to file financial reports with the SEC and perhaps with state
officials. There is a cost involved in preparing these reports.
e. What are the steps of an initial public offering?
Answer: Select an investment banker, file the S-1 registration document with the SEC, choose
f. What criteria are important in choosing an investment banker?
Answer: (1) reputation and experience in the industry. (2) existing mix of institutional and
Mini Case: 18 – 16
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
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
i. The estimated pre-IPO value of equity in the company is about 63 million and
there are 4 million shares of existing shares of stock held by family members.
The investment bank will charge a 7% spread, which is the difference between
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?
Mini Case: 18 – 17
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:
j. What is a roadshow? What is bookbuilding?
Answer: The senior management team, the investment banker, and the lawyer make
presentations to potential institutional investors. They usually visit ten to twenty
Mini Case: 18 – 18
k. Describe the typical first-day returns of an IPO and the long-term returns to
IPO investors.
Answer: First-day returns average 14.1%, with many stocks having much higher returns. The
investment banker has an incentive to set a low price, both to make its brokerage
l. What are the direct and indirect costs of an IPO?
Answer: The underwriter usually charges a 7% fee, based on the offer price. In addition, there
m. What are equity carve-outs?
Answer: Equity carve-outs are a special type of IPO in which a public company creates a new
n. Describe some ways other than an IPO that companies use to raise funds from
the capital markets.
Answer: In seasoned equity offers, publicly traded companies issue additional stock.
o. What are some other investment banking activities? How did these increase
investment banks’ risk?
Answer: The repeal of Glass-Stegall in 1999 blurred lines between traditional investment
banks and other financial institutions.
Mini Case: 18 – 19
p. What is meant by going private? What are some advantages and disadvantages?
Answer: Going private is the reverse of going public. Typically, the managers of a firm team
up with a small group of outside investors, who furnish most of the equity capital, and
purchase all of the publicly held shares of the company. The new equity holders
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).”
Mini Case: 18 – 20
q. How do companies manage the maturity structure of their debt?
Answer: In discussing this question, we emphasize that, if markets are truly efficient and
conditions are stable, the type of debt instrument will be immaterial, as the cost of
each will be commensurate with its risk. However, if markets are not totally efficient
r. Under what conditions would a firm exercise a bond’s call provision?
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
s. Explain how firms manage the risk structure of their debt with project
financing.
Answer: 1. Project financings are arrangements used to finance mainly large capital projects
such as energy explorations, oil tankers, refineries, utility power plants, and so on.