Finance Chapter 10 Most Importantly Management Understands The Business And These Expenditures Not Disrupt The

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CHAPTER 10

THE PRACTICE OF FUNDAMENTAL INVESTING

Answers to Questions

1. Explanations and theories for underpricing include:

1. It is a way to compensate institutional investors for providing pricing information.

2. To the extent that the investor trusts the banker to systematically underprice the

security based on the best available information, the investor will provide an accurate

2. During the early trading in the secondary market, the SEC allows the investment bank to

help stabilize the price. The investment bank stabilizes the price by purchasing shares in

3. In a dirty auction, the issuing company could agree to sell the shares at a price below the

clearing price. For example, even if $14 is the price at which 10 million shares could be

4. If an analyst is seen as influential within an industry, it is easier for the investment

5. Management should repurchase shares when they are trading below intrinsic value and

pay a dividend when the shares are trading above intrinsic value. When the stock is

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or in part.

different from increases that occur because companies have increased revenue or cut

expenses.

6. Four important dates surrounding a dividend are as follows:

1. The declaration date: the date that a dividend is announced by the board of directors.

7. To a large extent, investors don’t worry about capital expenditures in the same way that

they worry when companies do acquisitions. The reason for this is that companies are not

8. Poison pills were very unpopular with institutional investors because it’s hard to

determine whether a poison pill is shareholder-friendly and whether management acted in

9. Many investors disagree about whether top managers are overpaid and whether

compensation is related to performance.

Arguments to say that CEOs are overpaid include:

2. Management has most of their wealth in this one company, so they may take too little

Arguments to say that CEOs compensation is fair include:

1. It provides strong incentives to create shareholder value (and address the three issues

10. Student Exercise.

CHAPTER 10

Answers to Problems

1.

1 (a). Market Cap = 20 million shares x $19 = $380 million

2. Pre-cost equity value = market cap at end of first day = $380 million

3 (a). 15 percent overallotment of 20 million shares = 3 million shares

3 (b). If the stock price immediately drops to $11.50 in the secondary market, the underwriter

will not exercise its option. There is no reason for the underwriter to pay $14.88 for

4. In a traditional auction, all the winning bidders receive the auction clearing price of $19.

The investors who bid $20 pay only $19 and all their orders would be filled (2.5 million

5. In a dirty auction, the issuing company could agree to sell the shares at a price below the

clearing price at $17. There are bids for 18.5 million shares at $17 or higher. Because

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or in part.

The investors who bid $19 pay $17 and 3.78 4million shares would be filled (7 x

10/18.5).

The investors who bid $18 pay $17 and 2.162 million shares would be filled (4 x

10/18.5).

The investors who bid $18 pay $17 and 2.703 million shares would be filled (5 x

10/18.5).

6. a. The declaration date is May 18.

7.

7 (a). If the company uses $300,000,000 to repurchase $35 shares, it will repurchase 8,571,429

shares.

7(b). PE multiple was 10, so EPS was (100,000,000 x $35)/10 = $3.50 per share or

7( c). If the company pays a $300 million cash dividend the value of the company should drop

7( d). Using a PE multiple of 10 earnings before the dividend are 35/10 = $3.50 per share

8.

8 (a). If the company uses $300,000,000 to repurchase $35 shares, it will repurchase 8,571,429

shares.

7(b). PE multiple was 10, so EPS was (100,000,000 x $35)/10 = $3.50 per share or

$350,000,000 in earnings.

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8 (c). If the company pays a $300 million cash dividend the value of the company should drop

8 (d). Using a PE multiple of 10 earnings before the dividend are 35/10 = $3.50 per share

The PE multiple after the dividend is $32/$3.50 = 9.14

9. If the shares are sold for $20 per share, the issuing firm will receive:

10. 15 percent overallotment of 25 million shares = 3.75 million shares

$16.74. In doing this, the underwriter makes $18 – $16.74 = $3.26 per share profit on 3.75

The underwriter would have purchased 3.75 million shares from the issuing company at

11. Student Exercise.