Finance Chapter 11 A government sells all or part of its ownership

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11. A firm’s stock price goes down when it announces a seasoned equity offering. The market

knows that the company knows more about the firm than average investors do, and will only

12. Companies—and their shareholders—found that restricting share sales to existing shareholders

severely restricted the potential market for new share sales. By voluntarily allowing public

13. An accredited investor is one who meets certain income and wealth requirements. Accredited

14. Private placements are less costly in terms of time and money than registering with the SEC.

Issuers do not have to reveal confidential information. Since fewer investors are involved,

15. Less IPO money is raised in non-U.S. countries, and international IPOs are generally smaller

than U.S.company IPOs. Like U.S. IPOs, non-U.S. issues often face significant first day un-

derpricing, sometimes even larger than U.S. IPO underpricing. U.S. and international IPO

16. American Depositary Receipts are dollar-denominated claims issued by U.S. banks that repre-

sent ownership of shares in a foreign company’s stock held on deposit by the U.S. bank in the

17. In a share issue privatization, a government sells all or part of its ownership in a state-owned

enterprise to private investors via a public share offering. These have done a great deal to de-

velop many national stock markets. SIPs tend to be very large and often dramatically increase

Chapter 11 Raising Long-Term Financing 311

Solutions to Self-Test Problems

ST11-1. Last year, Guaraldi Instruments Inc. conducted an IPO, issuing 2 million common shares

with a par value of $0.25 to investors at a price of $15 per share. During its first year of

operation, Guaraldi earned net income of $0.07 per share and paid a dividend of $0.005

per share. At the end of the year, the company’s stock was selling for $20 per share.

Construct the equity account for Guaraldi at the end of its first year in business, and cal-

culate the firm’s market capitalization.

A: Immediately after the IPO, during which Guaraldi Instruments sold 2 million shares with

ST11-2. The Bloomington Company needs to raise $20 million of new equity capital. Its common

stock is currently selling for $42 per share. The investment bankers require an underwrit-

ing spread of 7% of the offering price, and the company’s legal, accounting, and printing

expenses associated with the seasoned offering are estimated to be $450,000. How many

new shares must the company sell to net $20 million?

A: The Bloomington Company needs to raise $20,000,000 + $450,000 = $20,450,000

Answers to End-of-Chapter Questions

Q11-1. How should a corporation estimate the amount of financing that must be raised externally

during a given year? Once that amount is known, what other decision must be made?

A11-1. The amount of financing a company needs depends on the capital budgeting projects that it

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financed with debt, hybrid securities or equity? If internally financed, how much of the

company’s net income should be retained and how much paid out as dividends?

Q11-2. What is the dominant source of capital funding in the United States? Given this result and

A11-2. The dominant source of funding is internal financing. However, the amounts of internal

Q11-3. Define the term financial intermediary. What role do financial intermediaries play

in U.S. corporate finance? How does this compare to the role of non-U.S. financial

intermediaries?

A11-3. A financial intermediary is an institution, such as a bank, that raises capital by issuing lia-

bilities against itself, or a commercial bank or other entity that lends to corporations.

Q11-4. Discuss the U.S. banking system regulations that have had a major impact on the develop-

ment of the U.S. financial system. In what ways has the U.S. system been affected (posi-

tively and negatively) by these regulations?

A11-4. U.S. laws have discouraged the growth of large intermediaries, especially commercial

banks by imposing geographical restrictions. The McFadden Act of 1927 prohibited inter-

Q11-5. What are the general trends regarding public security issuance by U.S. corporations? Spe-

cifically, which security type is most often sold to the public? What is the split between

initial and seasoned equity offerings?

A11-5. U.S. corporate issues account for a large proportion of total global securities issued.

Companies issue far more debt than equity. Straight (nonconvertible) debt typically ac-

Q11-6. Distinguish between a Eurobond, a foreign bond, and a Yankee bond. Which of these

three represents the greatest volume of security issuance?

Chapter 11 Raising Long-Term Financing 313

A11-6. A Eurobond is a single currency bond sold in several foreign countries simultaneously and

Q11-7. What do you think are the most important costs and benefits of becoming a publicly trad-

ed firm? What questions would you ask before advising whether or not an entrepreneur’s

firm should go public?

A11-7. The benefits of going public include: raising new capital for the company, providing pub-

licly traded stocks that can be used in acquiring other companies, having listed stock that

can be used to compensate and retain key employees and providing personal wealth and

Q11-8. If you were an investment banker, how would you determine the offering price of an IPO?

A11-8. An investment banker determines the initial offer price through discounted cash flow

analysis – looking at revenue, cost and investment projections for the company, then de-

Q11-9. Are the significantly positive short-run and significantly negative long-run returns earned

by IPO shareholders compatible with market efficiency? If not, why not?

A11-9. At first glance, high positive short-term returns on IPOs and negative risk-adjusted long-

term returns seem inconsistent with market efficiency. In an efficient market, no investor

should be able to follow an investment strategy that yields excess risk-adjusted profits.

With regard to IPO returns, two strategies may at first glance appear to violate market ef-

ficiency. First, suppose an investor purchased IPO shares at the offer price each time a

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Q11-10. List and briefly describe the key services investment banks provide to firms before, dur-

ing, and after a securities offering.

A11-10. In preparing for an equity offering, an IB will file necessary documents with regulators,

starting with the registration statement. The bankers must value the IPO shares, typically

using discounted cash flow models and market comparables. The firm and its bankers go

Q11-11.Explain why the underwriting spread on IPOs averages about 7% of the offering price

whereas the spread on a seasoned offering of common stock averages less than 5%?

A11-11. IPOs are riskier than SEOs, and investment bankers require higher compensation for tak-

Q11-12.Discuss the various issues that must be considered in selecting an investment banker for an

IPO. Which type of placement is usually preferred by the issuing firm?

A11-12. A firm can choose a negotiated offer, in which the issuing firm negotiates the terms of the

offer directly with an investment bank. In a competitive bid offer, the firm announces the

terms of its intended equity sale, and investment banks bid for the business. Most equity

sales are negotiated, rather than competitive bids. A negotiated bid may be advantageous

Q11-13. In terms of IPO investing, what does it mean to flip a stock? According to the empirical

results regarding short- and long-term returns following equity offerings, is flipping a

wise investment strategy?

Chapter 11 Raising Long-Term Financing 315

A11-13. Flipping a stock means buying shares at the IPO price and almost immediately selling

the shares to realize high first-day returns. This is a wise investment practice – first

Q11-14. What materials are presented in an IPO prospectus? In general, what result is documented

regarding sales of shares by insiders and venture capitalists?

A11-14. The prospectus provides the following information:

• number of shares offered

• details of the underwriting agreement

• description of the company and its products

Q11-15. What are American Depositary Receipts (ADRs), and why have they proven so popular

with U.S. investors?

A11-15. American Depositary Receipts are dollar denominated claims issued by U.S. banks which

represent ownership of shares in a foreign company’s stock held on deposit by the U.S.

Q11-16. How do you explain the highly politicized nature of share issue privatization (SIP) pric-

ing and share allocation policies? Are governments maximizing offering proceeds, or are

they pursuing primarily political and economic objectives?

A11-16. The higher the growth rate of cash flows, the higher the terminal value of the project. A project

where cash flows level off in time will have a much smaller terminal value.

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Answers to End-of-Chapter Problems

Investment Banking and the Public Sale of Securities

P11-1. West Coast Manufacturing Company (WCMC) is executing an initial public offering with the

following characteristics. The company will sell 10 million shares at an offer price of $25 per

share, the underwriter will charge a 7% underwriting fee, and the shares are expected to sell for $32

per share by the end of the first day’s trading. Assuming this IPO is executed as expected, answer

the following:

a. Calculate the initial return earned by investors who are allocated shares in the IPO.

b. How much will WCMC receive from this offering?

c. What is the total cost (underwriting fee and underpricing) of this issue to WCMC?

A11-1. a. Investors who can buy at the $25 offer price will have realized a 28% gain in one day as

the price rises to $32.

P11-2. Suppose you purchase shares of Engel, Inc. (EI), which recently executed an IPO at the

A11-2. The EI investment grew from $32 to $35 in one year, equivalent to a 9.375% return.

In the same period, the stock market returned 11%. You would have made a higher return

by investing in the broad market rather than buying shares in the IPO.

P11-3. Norman Internet Service Company (NISC) is interested in selling common stock to raise

capital for capacity expansion. The firm has consulted First Tulsa Company, a large un-

derwriting firm, which believes that the stock can be sold for $50 per share. The underwrit-

er’s investigation found that its administrative costs will be 2.5% of the sale price and its

selling costs will be 2.0% of the sale price. If the underwriter requires a profit equal to 1%

of the sale price, how much spread (in dollars) is necessary to cover the underwriter’s costs

and profit?

P11-4. The Mitchell Company needs to raise $50 million of new equity capital. Its common stock

is currently selling for $50 per share. The investment bankers require an underwriting

spread of 3% of the offering price. The company’s legal, accounting, and printing expens-

es, associated with the secondary offering, are estimated to be $750,000. How many new

shares must the company sell to net $50 million?

Chapter 11 Raising Long-Term Financing 317

P11-5. LaJolla Securities Inc. specializes in the underwriting of small companies. The terms of a

recent offering were as follows:

Number of shares 2 million

Offering price $25 per share

Net proceeds $45 million

LaJolla Securities’ expenses associated with the offering were $500,000. Determine LaJol-

la Securities’ profit on the offering if the secondary market price of the shares immediately

after the offering began were as follows:

a. $23 per share

b. $25 per share

c. $28 per share

The U.S. Market for Initial Public Offerings (IPOs)

P11-6 Find an Internet site that provides data on recent IPOs, and pick 4 companies that conduct-

ed an IPO in recent weeks. Write down the ticker symbols and offer prices for the firms

you select; then go to Yahoo! and download daily price quotes since the IPO date. For each

firm, calculate the following:

a. The percentage return measured from the offer price to the closing price

b. The percentage return measured from the opening price to the closing price

P11-7. Four companies conducted IPOs last month: Hot.Com, Biotech Pipe Dreams Corp., Sleepy

Tyme Inc., and Bricks N Mortar International. All four companies went public at an offer

price of $10 per share. The first-day performance of each stock (measured as the percent-

age difference between the IPO offer price and the first-day closing price) was as follows:

Company First-Day Return

Hot.Com 45%

Biotech Pipe Dreams 30%

Sleepy Tyme 5%

Bricks N Mortar 0%

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a. If you submitted a bid through your broker for 100 shares of each company, if your

orders were filled completely, and if you cashed out of each deal after one day, what

was your average return on these investments?

b. Next, suppose your orders were not all filled completely because of excess demand for

hot IPOs. Specifically, after ordering 100 shares of each company, you were able to

buy only 10 shares of Hot.Com, 20 shares of Biotech Pipe Dreams, 50 shares of Sleepy

Tyme, and 100 shares of Bricks N Mortar. Recalculate your average return, taking into

account that your orders were only partially filled.

A11-7. a. Because you purchased equal dollar amounts of each company, the weight attached to

Seasoned Equity Offerings in the United States

P11-8. GSM Corporation sold 20 million shares of common stock in a seasoned offering. The

market price of the company’s shares immediately before the offering was $14.75. The

shares were offered to the public at $14.50, and the underwriting spread was 4%. The

company’s expenses associated with the offering were $7.5 million. How much new cash

did the company receive?

A11-8. The shares are sold to the public at $14.50, but with an underwriting spread of 4%, the

P11-9. After a banner year of rising profits and positive stock returns, the managers of Raptor

Pharmaceuticals Corporation (RPC) decided to launch a seasoned equity offering to raise

new equity capital. RPC currently has 10 million shares outstanding, and yesterday’s clos-

ing market price was $75.00 per RPC share. The company plans to sell 1 million newly

issued shares in its seasoned offering. The investment banking firm Robbum and Blindum

(R&B) has agreed to underwrite the new stock issue for a 2.5% discount from the offering

price, which RPC and R&B have agreed should be $0.75 per share lower than RPC’s clos-

ing price the day before the offering is sold.

a. What is likely to happen to RPC’s stock price when the plan for this seasoned offering

is publicly announced?

b. Assume that RPC’s stock price closes at $72.75 per share the day before the seasoned

offering is launched. What net proceeds will RPC receive from this offering?

c. Calculate the return earned by RPC’s existing stockholders on their shares from the

time preceding the announcement of the seasoned offering through the time it was ac-

tually sold for $72.75 per share.

d. Calculate the total cost of the seasoned equity offering to RPC’s existing stockholders

as a percentage of the offering proceeds.

Chapter 11 Raising Long-Term Financing 319

A11-9. a. Seasoned equity issue announcements usually cause the stock price to fall by about 3

percent, so RPC’s announcement of its planned offering would cause the stock price

to fall from $75.00/share to $72.75/share ($75  0.97).

THOMSON ONE Business School Edition: For instructions on using Thomson ONE for P11-

10, refer to the instructions provided with the Thomson ONE problems at the end of Chap-

ters 1–6.

Answer to MiniCase

Raising Long-Term Financing

Since graduation from college, you have worked at Precision Manufacturing, Incorporated, as a

financial analyst. You have recently been promoted to the position of senior financial manager,

with responsibilities that include capital budgeting decisions and the raising of long-term financing.

Therefore, you decide to investigate the various alternatives for raising funds. You understand that

your goal is to ascertain that the marginal benefits received from undertaking long-term projects

should be greater than the marginal costs of raising the long-term funds needed to finance those

projects. With this goal in mind, you decide to answer the following questions.

Assignment

1. What should managers consider when making the decision whether to finance internally or ex-

ternally?

2. What services does an investment banker offer to corporations that choose to raise funds in the

capital market?

3. What legal rules govern the issue of securities to the public in the United States?

4. What are the benefits to the corporation of going public?

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5. What are the drawbacks to the corporation of going public?

6. What returns can investors in the common stock expect on the first day of trading if they com-

mit to purchase shares through the IPO issue? What factors may affect the relative amount of

these first-day returns?

7. Describe the following offers: (a) seasoned equity offer; (b) rights offer, and (c) private place-

ment. In what circumstances would a company use each of these offerings to raise funds?

8. Discuss the differences between international public offerings and domestic (U.S.) public of-

ferings.

Answers

1. The decision of whether to finance internally or externally is based upon the amount of work-

ing capital available, the desire to increase or decrease these working capital stocks over time,

2. Investment bankers provide services before, during, and after corporate security offerings. Be-

fore the offering the investment bank will assist the firm in filing the necessary documents with

regulators, starting with the registration statement. The investment bank must also begin to es-

3. The pertinent legal rules governing security issuance are found at both the state and federal

level. State regulations are typically enforced by a state official or commissioner. The perti-

nent state laws are somewhat uniform across states and are referred to a Blue Sky Laws. Fed-

4. The benefits to a corporation of going public include; (a) obtaining new capital for the compa-

ny, (b) having publicly traded stock for use in acquisitions, (c) having listed stock that can be

Chapter 11 Raising Long-Term Financing 321

5. The drawbacks to a corporation of going public include; (a) the financial costs related with un-

6. In the United States, the share price in the typical IPO closes roughly 15 percent above the of-

fer price on the first day of trading. This is referred to as IPO underpricing. In the United

7. Seasoned equity offerings (SEOs) are subsequent offers of common stock after the firm has

gone public through the IPO. SEOs are relatively rare due to transactions costs and because the

8. The international market for equity offerings can be broken down into two parts: (a) each na-

tion’s market for domestic stock offerings, and (b) the international market for equity offerings.

For domestic stock offerings in markets outside the United States, the total number of IPOs

usually exceeds the number in American by a wide margin each year. However, since these in-