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
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:
PV of net benefits $9,109,413
Answers and Solutions: 18 – 14
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:
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
Answers and Solutions: 18 – 15
SOLUTION TO SPREADSHEET PROBLEM
18-8 The detailed solution for the spreadsheet problem, Solution for Ch18 P06 Build a
Answers and Solutions: 18 – 16
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 – 17
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
Mini Case: 18 – 18
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.
• The firm will have to disclose operating data to the public. Many small firms do
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 a
f. What criteria are important in choosing an investment banker?
Answer: (1) reputation and experience in the industry. (2) existing mix of institutional and retail
Mini Case: 18 – 19
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 the
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 – 20
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 cities,
and make three to five presentations in each city. Management can’t say anything that
Mini Case: 18 – 21
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
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
The parent usually retains a controlling interest.
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. Companies
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 – 22
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
Mini Case: 18 – 23
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
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
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.
Mini Case: 18 – 24