Quiz 1. Equity Accounts. The authorized share capital of the Alfred Cake Company is 100,000
shares. The equity is currently shown in the companyÔÇ™s books as follows:
Common stock ($1.00 par value) $ 60,000
Additional paid-in capital 10,000
Retained earnings 30,000
Common equity 100,000
Treasury stock (2,000 shares) 5,000
Net common equity 95,000
a. How many shares are issued?
b. How many are outstanding?
c. How many more shares can be issued without the approval of shareholders?
An Overview of Corporate Financing 513
2. Equity Accounts.
a. Look back at problem 1. Suppose that the company issues 10,000 shares at $5 a share.
Which of the above figures would change?
b. What would happen to the companyÔÇ™s books if instead it bought back 1,000 shares at $5
3. Financing Terms. Fill in the blanks by choosing the appropriate term from the following
list: lease, funded, floating-rate, eurobond, convertible, subordinated, call, sinking fund,
prime rate, private placement, public issue, senior, unfunded, eurodollar rate, warrant,
debentures, term loan.
a. Debt maturing in more than 1 year is often called _________ debt.
b. An issue of bonds that is sold simultaneously in several countries is traditionally called
c. If a lender ranks behind the firmÔÇ™s general creditors in the event of default, the loan is
said to be _________.
d. In many cases a firm is obliged to make regular contributions to a(n) _________, which
is then used to repurchase bonds.
e. Most bonds give the firm the right to repurchase or _________ the bonds at specified
f. The benchmark interest rate that banks charge to their customers with good to excellent
credit is generally termed the _________.
g. The interest rate on bank loans is often tied to short-term interest rates. These loans are
usually called _________ loans.
h. Where there is a(n) _________, securities are sold directly to a small group of institu-
tional investors. These securities cannot be resold to individual investors. In the case of
a(n) _________, debt can be freely bought and sold by individual investors.
i. A long-term rental agreement is called a(n) _________.
j. A(n) _________ bond can be exchanged for shares of the issuing corporation.
k. A(n) _________ gives its owner the right to buy shares in the issuing company at a pre-
4. Financing Trends. True or false? Explain.
a. In several recent years, nonfinancial corporations in the United States have repurchased
more stock than they have issued.
b. A corporation pays tax on only 30 percent of the common or preferred dividends it re-
ceives from other corporations.
c. Because of the tax advantage, a large fraction of preferred shares is held by corporations.
5. Preferred Stock. In what ways is preferred stock like long-term debt? In what ways is it like
6. Voting for Directors. If there are 10 directors to be elected and a shareholder owns 90
Practice shares, indicate the maximum number of votes that he or she can cast for a favorite candi-
Problems date under
a. majority voting
b. cumulative voting
514 SECTION FIVE
7. Voting for Directors. The shareholders of the Pickwick Paper Company need to elect five
directors. There are 400,000 shares outstanding. How many shares do you need to own to
ensure that you can elect at least one director if the company has
a. majority voting
b. cumulative voting
Hint: How many votes in total will be cast? How many votes are required to ensure that at
least one-fifth of votes are cast for your choice?
8. Equity Accounts. Look back at Table 5.8.
a. Suppose that Heinz issues 10 million shares at $55 a share. Rework Table 5.8 to show the
companyÔÇ™s equity after the issue.
b. Suppose that Heinz subsequently repurchased 500,000 shares at $60 a share. Rework part
(a) to show the effect of the further change.
9. Equity Accounts. Common Products has just made its first issue of stock. It raised $2 mil-
lion by selling 200,000 shares of stock to the public. These are the only shares outstanding.
The par value of each share was $1.50. Fill in the following table:
Common shares (par value) ________
Additional paid-in capital ________
Retained earnings ________
Net common equity $2,500,000
10. Protective Covenants. Why might a bond agreement limit the amount of assets that the firm
11. Bond Yields. Other things equal, will the following provisions increase or decrease the yield
to maturity at which a firm can issue a bond?
a. A call provision
b. A restriction on further borrowing
c. A provision of specific collateral for the bond
d. An option to convert the bonds into shares
12. Income Bonds. Income bonds are unusual. Interest payments on such bonds may be skipped
or deferred if the firmÔÇ™s income is insufficient to make the payment. In what way are these
bonds like preferred stock? Why might a firm choose to issue an income bond instead of
13. Preferred Stock. Preferred stock of financially strong firms sometimes sells at lower yields
than the bonds of those firms. For weaker firms, the preferred stock has a higher yield. What
might explain this pattern?
1 Par value of common shares must be $1 ├— 100,000 shares = $100,000. Additional paid-in
capital is ($15 ÔÇ“ $1) ├— 100,000 = $1,400,000. Since book value is $4,500,000, retained
Self-Test earnings must be $3,000,000. Therefore, the accounts look like this:
Questions Common shares ($1.00 par value per share) 100,000
Additional paid-in capital 1,400,000
Retained earnings 3,000,000
Net common equity $4,500,000
An Overview of Corporate Financing 515
2 Book value is $10 million. At a discount rate of 10 percent, the market value of the firm
ought to be $2 million ├— 20-year annuity factor at 10% = $17 million, which exceeds book
value. At a discount rate of 20 percent, market value falls to $9.7 million, which is below
3 The corporationÔÇ™s after-tax yield on the bonds is 10% ÔÇ“ (.35 ├— 10%) = 6.5%. The after-tax
yield on the preferred is 8% ÔÇ“ [.35 ├— (.30 ├— 8%)] = 7.16%. The preferred stock provides the
higher after-tax rate despite its lower before-tax rate. For the individual, the tax rate on both
the preferred and the bond is equal to 35 percent, so the investment with the higher before-
tax rate also provides the higher after-tax rate.
4 Because the coupon on floating-rate debt adjusts periodically to current market conditions,
the bondholder is less vulnerable to changes in market yields. The coupon rate paid by the
bond is not locked in for as long a period of time. Therefore, prices of floaters should be
less sensitive to changes in market interest rates.
5 The callable bond will sell at a lower price. Investors will not pay as much for the callable
bond since they know that the firm may call it away from them if interest rates fall. Thus
they know that their capital gains potential is limited, which makes the bond less valuable.
If both bonds are to sell at par value, the callable bond must pay a higher coupon rate as
compensation to the investor for the firmÔÇ™s right to call the bond.
6 The extra debt makes it more likely that the firm will not be able to make good on its prom-
ised payments to its creditors. If the new debt is not junior to the already-issued debt, then
the original bondholders suffer a loss when their bonds become more susceptible to default
risk. A protective covenant limiting the amount of new debt that the firm can issue would
have prevented this problem. Investors, having witnessed the problems of the RJR bond-
holders, generally demanded the covenant on future debt issues.
7 Capital markets provide liquidity for investors. Because individual stockholders can always
lay their hands on cash by selling shares, they are prepared to invest in companies that re-
tain earnings rather than pay them out as dividends. Well-functioning capital markets allow
the firm to serve all its stockholders simply by maximizing value. Capital markets also pro-
vide managers with information. Without this information, it would be very difficult to de-
termine opportunity costs of capital or to assess financial performance.
The Initial Public Offering
Arranging a Public Issue
Who Are the Underwriters?
General Cash Offers by Public Companies
General Cash Offers and Shelf Registration
Costs of the General Cash Offer
Market Reaction to Stock Issues
The Private Placement
Appendix: Hotch PotÔÇ™s New Issue Prospectus
Planet Hollywood shares are offered to investors.
IPOs often provide stellar first-day returns, but their long-term performance tends to be weak.
Reuters/Ethan Miller/Archive Photos
ill Gates and Paul Allen founded Microsoft in 1975, when both
B were around 20 years old. Eleven years later Microsoft shares were sold
to the public for $21 a share and immediately zoomed to $35. The largest
shareholder was Bill Gates, whose shares in Microsoft then were worth
In 1976 two college dropouts, Steve Jobs and Steve Wozniak, sold their most valu-
able possessions, a van and a couple of calculators, and used the cash to start manufac-
turing computers in a garage. In 1980, when Apple Computer went public, the shares
were offered to investors at $22 and jumped to $36. At that point, the shares owned by
the companyÔÇ™s two founders were worth $414 million.
In 1994 Marc Andreesen, a 24-year-old from the University of Illinois, joined with
an investor, James Clark, to found Netscape Communications. Just over a year later
Netscape stock was offered to the public at $28 a share and immediately leapt to $71.
At this price James ClarkÔÇ™s shares were worth $566 million, while Marc AndreesenÔÇ™s
shares were worth $245 million.
Such stories illustrate that the most important asset of a new firm may be a good
idea. But that is not all you need. To take an idea from the drawing board to a prototype
and through to large-scale production requires ever greater amounts of capital.
To get a new company off the ground, entrepreneurs may rely on their own savings
and personal bank loans. But this is unlikely to be sufficient to build a successful en-
terprise. Venture capital firms specialize in providing new equity capital to help firms
over the awkward adolescent period before they are large enough to ÔÇťgo public.ÔÇŁ In the
first part of this material we will explain how venture capital firms do this.
If the firm continues to be successful, there is likely to come a time when it needs to
tap a wider source of capital. At this point it will make its first public issue of common
stock. This is known as an initial public offering, or IPO. In the second section of the
material we will describe what is involved in an IPO.
A companyÔÇ™s initial public offering is seldom its last. Earlier we saw that internally
generated cash is not usually sufficient to satisfy the firmÔÇ™s needs. Established compa-
nies make up the deficit by issuing more equity or debt. The remainder of this material
looks at this process.
After studying this material you should be able to
Understand how venture capital firms design successful deals.
Understand how firms make initial public offerings and the costs of such offerings.
Know what is involved when established firms make a general cash offer or a pri-
vate placement of securities.
Explain the role of the underwriter in an issue of securities.
How Corporations Issue Securities 519
You have taken a big step. With a couple of friends, you have formed a corporation to
open a number of fast-food outlets, offering innovative combinations of national dishes
such as sushi with sauerkraut, curry Bolognese, and chow mein with Yorkshire pudding.
Breaking into the fast-food business costs money, but, after pooling your savings and
borrowing to the hilt from the bank, you have raised $100,000 and purchased 1 million
shares in the new company. At this zero-stage investment, your companyÔÇ™s assets are
$100,000 plus the idea for your new product.
That $100,000 is enough to get the business off the ground, but if the idea takes off,
you will need more capital to pay for new restaurants. You therefore decide to look for
an investor who is prepared to back an untried company in return for part of the prof-
its. Equity capital in young businesses is known as venture capital and it is provided
by specialist venture capital firms, wealthy individuals, and investment institutions such
Money invested to finance a
as pension funds.
Most entrepreneurs are able to spin a plausible yarn about their company. But it is as
hard to convince a venture capitalist to invest in your business as it is to get a first novel
published. Your first step is to prepare a business plan. This describes your product, the
potential market, the production method, and the resourcesÔÇ”time, money, employees,
plant, and equipmentÔÇ”needed for success. It helps if you can point to the fact that you
are prepared to put your money where your mouth is. By staking all your savings in the
company, you signal your faith in the business.
The venture capital company knows that the success of a new business depends on
the effort its managers put in. Therefore, it will try to structure any deal so that you have
a strong incentive to work hard. For example, if you agree to accept a modest salary
(and look forward instead to increasing the value of your investment in the companyÔÇ™s
stock), the venture capital company knows you will be committed to working hard.
However, if you insist on a watertight employment contract and a fat salary, you wonÔÇ™t
find it easy to raise venture capital.
You are unlikely to persuade a venture capitalist to give you as much money as you
need all at once. Rather, the firm will probably give you enough to reach the next major
checkpoint. Suppose you can convince the venture capital company to buy 1 million
new shares for $.50 each. This will give it one-half ownership of the firm: it owns 1 mil-
lion shares and you and your friends also own 1 million shares. Because the venture