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an implicit seal of approval to the offering. Because the underwriters will not want to
squander their reputation by misrepresenting facts to the public, the implied endorsement
may be quite important to a firm coming to the market for the first time.



www.FreeEDGAR.com/default.htm Information on registration of new securities offerings
Related Web http://cbs.marketwatch.com/news/current/ipo_rep.htx?source=htx/http2_mw List of new
Links IPOs
www.cob.ohio-state.edu/˜fin/resources_education/credit.htm The changing mix of corporate
financing
www.investorama.com/features/proxystatements.html The role of the proxy statement in in-
vestor relations
www.vnpartners.com/primer.htm Venture capital as a source of project financing

venture capital prospectus rights issue
Key Terms initial public offering (IPO) underpricing general cash offer
underwriter flotation costs shelf registration
spread seasoned offering private placement
534 SECTION FIVE


1. Underwriting.
Quiz
a. Is a rights issue more likely to be used for an initial public offering or for subsequent is-
sues of stock?
b. Is a private placement more likely to be used for issues of seasoned stock or seasoned
bonds by an industrial company?
c. Is shelf registration more likely to be used for issues of unseasoned stocks or bonds by a
large industrial company?

2. Underwriting. Each of the following terms is associated with one of the events beneath.
Can you match them up?

a. Shelf registration
b. Firm commitment
c. Rights issue

A. The underwriter agrees to buy the issue from the company at a fixed price.
B. The company offers to sell stock to existing stockholders.
C. Several issues of the same security may be sold under the same registration.

3. Underwriting Costs. State for each of the following pairs of issues which you would expect
to involve the lower proportionate underwriting and administrative costs, other things equal:
a. A large issue/a small issue
b. A bond issue/a common stock issue
c. A small private placement of bonds/a small general cash offer of bonds

4. IPO Costs. Why are the issue costs for debt issues generally less than those for equity is-
sues?
5. Venture Capital. Why do venture capital companies prefer to advance money in stages?
6. IPOs. Your broker calls and says that you can get 500 shares of an imminent IPO at the of-
fering price. Should you buy? Are you worried about the fact that your broker called you?




7. IPO Underpricing. Having heard about IPO underpricing, I put in an order to my broker
Practice for 1,000 shares of every IPO he can get for me. After 3 months, my investment record is as
Problems follows:

Shares Allocated Price per Initial
IPO to Me Share Return
A 500 $10 7%
B 200 20 12
C 1,000 8 “2
D 0 12 23

a. What is the average underpricing of this sample of IPOs?
b. What is the average initial return on my “portfolio” of shares purchased from the four
IPOs I bid on? Calculate the average initial return, weighting by the amount of money in-
vested in each issue.
c. Why have I performed so poorly relative to the average initial return on the full sample
of IPOs? What lessons do you draw from my experience?

8. IPO Costs. Moonscape has just completed an initial public offering. The firm sold 3 mil-
lion shares at an offer price of $8 per share. The underwriting spread was $.50 a share. The
How Corporations Issue Securities 535


price of the stock closed at $11 per share at the end of the first day of trading. The firm in-
curred $100,000 in legal, administrative, and other costs. What were flotation costs as a frac-
tion of funds raised? Were flotation costs for Moonscape higher or lower than is typical for
IPOs of this size (see Table 5.10)?
9. IPO Costs. Look at the illustrative new issue prospectus in the appendix.
a. Is this issue a primary offering, a secondary offering, or both?
b. What are the direct costs of the issue as a percentage of the total proceeds? Are these
more than the average for an issue of this size?
c. Suppose that on the first day of trading the price of Hotch Pot stock is $15 a share. What
are the total costs of the issue as a percentage of the market price?
d. After paying her share of the expenses, how much will the firm™s president, Emma Lu-
cullus, receive from the sale? What will be the value of the shares that she retains in the
company?
10. Flotation Costs. “For small issues of common stock, the costs of flotation amount to about
15 percent of the proceeds. This means that the opportunity cost of external equity capital is
about 15 percentage points higher than that of retained earnings.” Does this follow?
11. Flotation Costs. When Microsoft went public, the company sold 2 million new shares (the
primary issue). In addition, existing shareholders sold .8 million shares (the secondary issue)
and kept 21.1 million shares. The new shares were offered to the public at $21 and the un-
derwriters received a spread of $1.31 a share. At the end of the first day™s trading the mar-
ket price was $35 a share.

a. How much money did the company receive before paying its portion of the direct costs?
b. How much did the existing shareholders receive from the sale before paying their portion
of the direct costs?
c. If the issue had been sold to the underwriters for $30 a share, how many shares would the
company have needed to sell to raise the same amount of cash?
d. How much better off would the existing shareholders have been?

12. Flotation Costs. The market value of the marketing research firm Fax Facts is $600 million.
The firm issues an additional $100 million of stock, but as a result the stock price falls by 2
percent. What is the cost of the price drop to existing shareholders as a fraction of the funds
raised?
13. Flotation Costs. Young Corporation stock currently sells for $30 per share. There are 1 mil-
lion shares currently outstanding. The company announces plans to raise $3 million by of-
fering shares to the public at a price of $30 per share.

a. If the underwriting spread is 8 percent, how many shares will the company need to issue
in order to be left with net proceeds of $3 million?
b. If other administrative costs are $60,000 what is the dollar value of the total direct costs
of the issue?
c. If the share price falls by 3 percent at the announcement of the plans to proceed with a
seasoned offering, what is the dollar cost of the announcement effect?

14. Private Placements. You need to choose between the following types of issues:
A public issue of $10 million face value of 10-year debt. The interest rate on the debt would
be 8.5 percent and the debt would be issued at face value. The underwriting spread would
be 1.5 percent and other expenses would be $80,000.
A private placement of $10 million face value of 10-year debt. The interest rate on the
private placement would be 9 percent but the total issuing expenses would be only
$30,000.
536 SECTION FIVE


a. What is the difference in the proceeds to the company net of expenses?
b. Other things equal, which is the better deal?
c. What other factors beyond the interest rate and issue costs would you wish to consider
before deciding between the two offers?

15. Rights. In 2001 Pandora, Inc., makes a rights issue at a subscription price of $5 a share. One
new share can be purchased for every four shares held. Before the issue there were 10 mil-
lion shares outstanding and the share price was $6.

a. What is the total amount of new money raised?
b. What is the expected stock price after the rights are issued?

16. Rights. Problem 15 contains details of a rights offering by Pandora. Suppose that the com-
pany had decided to issue the new stock at $4 instead of $5 a share. How many new shares
would it have needed to raise the same sum of money? Recalculate the answers to problem
15. Show that Pandora™s shareholders are just as well off if it issues the shares at $4 a share
rather than the $5 assumed in problem 15.
17. Rights. Consolidated Jewels needs to raise $2 million to pay for its Diamonds in the Rough
campaign. It will raise the funds by offering 200,000 rights, each of which entitles the owner to
buy one new share. The company currently has outstanding 1 million shares priced at $20 each.

a. What must be the subscription price on the rights the company plans to offer?
b. What will be the share price after the rights issue?
c. What is the value of a right to buy one share?
d. How many rights would be issued to an investor who currently owns 1,000 shares?
e. Show that the investor who currently holds 1,000 shares is unaffected by the rights issue.
Specifically, show that the value of the rights plus the value of the 1,000 shares after the
rights issue equals the value of the 1,000 shares before the rights issue.

18. Rights. Associated Breweries is planning to market unleaded beer. To finance the venture it
proposes to make a rights issue with a subscription price of $10. One new share can be pur-
chased for each two shares held. The company currently has outstanding 100,000 shares
priced at $40 a share. Assuming that the new money is invested to earn a fair return, give
values for the

a. number of new shares
b. amount of new investment
c. total value of company after issue
d. total number of shares after issue
e. share price after the issue



19. Venture Capital. Here is a difficult question. Pickwick Electronics is a new high-tech com-
Challenge pany financed entirely by 1 million ordinary shares, all of which are owned by George Pick-
wick. The firm needs to raise $1 million now for stage 1 and, assuming all goes well, a fur-
Problem
ther $1 million at the end of 5 years for stage 2.

First Cookham Venture Partners is considering two possible financing schemes:
Buying 2 million shares now at their current valuation of $1.
Buying 1 million shares at the current valuation and investing a further $1 million at
the end of 5 years at whatever the shares are worth.

The outlook for Pickwick is uncertain, but as long as the company can secure the additional
finance for stage 2, it will be worth either $2 million or $12 million after completing stage
How Corporations Issue Securities 537


2. (The company will be valueless if it cannot raise the funds for stage 2.) Show the possi-
ble payoffs for Mr. Pickwick and First Cookham and explain why one scheme might be pre-
ferred. Assume an interest rate of zero.



1 Unless the firm can secure second-stage financing, it is unlikely to succeed. If the entre-
Solutions to preneur is going to reap any reward on his own investment, he needs to put in enough ef-
Self-Test fort to get further financing. By accepting only part of the necessary venture capital, man-
agement increases its own risk and reduces that of the venture capitalist. This decision
Questions would be costly and foolish if management lacked confidence that the project would be
successful enough to get past the first stage. A credible signal by management is one that
only managers who are truly confident can afford to provide. However, words are cheap and
there is little to be lost by saying that you are confident (although if you are proved wrong,
you may find it difficult to raise money a second time).
2 If an investor can distinguish between overpriced and underpriced issues, she will bid only
on the underpriced ones. In this case she will purchase only issues that provide a 10 percent
gain. However, the ability to distinguish these issues requires considerable insight and re-
search. The return to the informed IPO participant may be viewed as a return on the re-
sources expended to become informed.
3 Direct expenses:

Underwriting spread = 69 million — $4 $ 276.0 million
Other expenses 9.2
Total direct expenses $ 285.2 million
Underpricing = 69 million — ($70 “ $64) $ 414.0 million
Total expenses $ 699.2 million
Market value of issue = 69 million — $70 $4,830.0 million

Expenses as proportion of market value = 699.2/4,830 = .145 = 14.5%.
4 Ten issues of $15 million each will cost about 9 percent of proceeds, or .09 — $150 million
= $13.5 million. One issue of $150 million will cost only 4 percent of $150 million, or $6
million.




MINICASE The company estimated that the issue would involve legal
Pet.Com was founded in 1997 by two graduates of the University
fees, auditing, printing, and other expenses of $1.3 million, which
of Wisconsin with help from Georgina Sloberg, who had built up
would be shared proportionately between the selling shareholders
an enviable reputation for backing new start-up businesses.
and the company. In addition, the company agreed to pay the un-
Pet.Com™s user-friendly system was designed to find buyers for
derwriters a spread of $1.25 per share.
unwanted pets. Within 3 years the company was generating rev-
The roadshow had confirmed the high level of interest in the
enues of $3.4 million a year, and, despite racking up sizable losses,
issue, and indications from investors suggested that the entire
was regarded by investors as one of the hottest new e-commerce
issue could be sold at a price of $24 a share. The underwriters,
businesses. The news that the company was preparing to go pub-
however, cautioned about being too greedy on price. They
lic therefore generated considerable excitement.
pointed out that indications from investors were not the same as
The company™s entire equity capital of 1.5 million shares was
firm orders. Also, they argued, it was much more important to
owned by the two founders and Ms. Sloberg. The initial public of-
have a successful issue than to have a group of disgruntled share-
fering involved the sale of 500,000 shares by the three existing
holders. They therefore suggested an issue price of $18 a share.
shareholders, together with the sale of a further 750,000 shares by
That evening Pet.Com™s financial manager decided to run
the company in order to provide funds for expansion.
538 SECTION FIVE


asked: “The underwriters want to see a high return and a high
through some calculations. First she worked out the net receipts
stock price. Would Pet.Com prefer a low stock price? Would that
to the company and the existing shareholders assuming that the
make the issue less costly?” Pet.Com™s financial manager was not
stock was sold for $18 a share. Next she looked at the various
convinced but felt that she should have a good answer. She won-
costs of the IPO and tried to judge how they stacked up against
dered whether underpricing was only a problem because the ex-

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