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Chapter

15
Raising Capital
LEARNING OBJECTIVES

(Slide 15-2)

1. Describe the life cycle of a business.


2. Understand the different sources of capital available to a start-up business and to a
growing business.
3. Explain the funding available to a stable or mature business.
4. Explain how companies sell bonds in a capital market.
5. Explain how companies sell stocks in a capital market.
6. Examine some special forms of financing: commercial paper and bankers
acceptance.
7. Describe the options and regulations for closing a business.

IN A NUTSHELL
This chapter is about how entrepreneurs and firms go about raising funds for growth and
development. As a firm progresses through the various phases of its business cycle, its
needs, focus, and conditions change requiring it to use different sources of capital. Firms
typically sell bonds and stock to raise capital and so the author explains the process
followed by issuing companies. Besides bonds and stock, firms also borrow short-term
funds by issuing commercial paper and bankers acceptances. The chapter closes with a
discussion of the options and regulations that come into play when a firm decides to
cease operations and close permanently.

LECTURE OUTLINE
15.1 The Business Life Cycle

(Slide 15-3)

A firm typically goes through 5 stages in its life cycle: start-up, growth, maturity, decline,
and closing.

Each stage presents unique problems, opportunities, and funding requirements.


514
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Business life cycles vary considerably. Some firms go through the early stages fairly
rapidly and then settle into maturity for a long time, while others skip to the closing stage
in a few years.
The US Census Bureaus Business Information Tracking System estimates that roughly
60% of businesses that employ others besides the owners will close within their first 6
years.
The life cycle approach is a useful way to discuss financing opportunities and sources for
businesses.

15.2 Borrowing for a Start-up


and Growing Business

(Slides 15-4 to 15-12)

5 sources of capital can generally be used to start and grow a business:


1.
2.
3.
4.

Personal funds
Borrowed funds from family and friends
Commercial bank loans
Borrowed funds through business start-up programs like the U.S. Small Business
Administration (SBA)
5. Angel financing or venture capital
15.2 (A) Personal Funds and Family Loans: although limited in scope, are often good

starting points for most entrepreneurs and sole proprietorships.


Professional lenders like commercial banks and venture capitalists view funding by
family and friends as a sign that the business has potential.
After all, if you cant convince your family and friends that you have a good business
idea, how can you convince a stranger?
15.2 (B) Commercial Bank Loans: constitute the first source that people often seek after

they have run out of friends and in-laws to ask.


Banks tend to be very conservative lenders often requiring substantial collateral, income
history and evidence of stability.
Start-ups are rarely directly funded by commercial banks.
15.2 (C) Commercial Bank Loans through the Small Business Association (SBA): are

available to qualified small business applicants via a variety of loan programs, the most
common of which is the 7(a) Loan Guaranty Program.
The 7(a) Loan Guaranty Program administers business loans to individuals or businesses
that might not be eligible for a loan through the normal lending agencies.
Loan proceeds can be used for working capital and fixed assets, with repayment
schedules extending up to 25 years.
These loans are delivered through commercial lenders and guaranteed by the SBA.

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The interest rates tend to be quite competitive but the major advantage of this program
accrues to the banks since the loans are backed by the SBA.
15.2 (D) Angel Financing and Venture Capital: is generally sought by entrepreneurs and

businesses that would not qualify for commercial bank or SBA-backed financing.
Angel investors are wealthy individuals and groups that are interested in providing initial
funding for high-risk ideas. They typically have very short loan investment horizons (less
than 10 years) and upside limits of about $2 million.
Venture capitalist firms or funds are also willing to fund high-risk projects, but have
longer time horizons and higher funding limits. They generally provide the funding in
stages.
Table 15.1 presents some of the key differences between angel investors and venture
capitalists.

Table 15.2 provides an example of stages of financing provided by venture capital firms.

Entrepreneurs with strong, promising ideas could be in a position to choose from a group
of angel investors and venture capitalists.
Factors to look for when picking a financier or group of financiers include:
Financial strength i.e. Will the financier have the necessary funding ability to back the
project until its completion?

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Contacts: i.e. Can the financier provide valuable contacts to help the entrepreneur reach
his or her goal?
Exit strategy: i.e. how much equity is the investor looking to acquire as a condition of
providing the funding and how much of control is the entrepreneur willing to give up?
Given that there is a high probability of failure among start-ups, angel investors and
financiers commonly look for 60% 100% potential annual rates of return on their
successful ventures in order to provide funding.
Example 1: Expected rate of return for a venture capitalist
The Quick Start Funding Group is looking to fund only those projects which have the
potential to return $10 million dollars for every $1 million that they have invested within
a 5-year period. Calculate the firms expected rate of return on its investment.
FV = $10 million; PV = 1 million; N=5; CPT I% 58.49%

15.3 Borrowing for a Stable and


Mature Business: Bank Loans

(Slides 15-13 to 15-19)

Commercial banks provide much of the short-term financing required for the operating
needs of a business via straight loans, discount loans, and lines of credit with or without
compensating balances.
15.3 (A) Straight loans: represent the simplest of all types of bank loans, and are offered

with a quoted APR and pre-set payment amounts and intervals.


Example 2: Calculating payments and EAR of a straight loan
The Timken Company wants to borrow $2,000,000 from its local bank. The bank quotes
them a rate of 8.25% (APR) on a 5-year loan with payments due monthly. How much
will their monthly payment be and what is their EAR?
PV = 2,000,000; FV = 0; N=60; i=8.25; P/Y=12;C/Y=12; PMT40,792.5
EAR = (1 + (.0825/12)12 18.569%
15.3 (B) Discount Loans: are offered to firms with the interest amount being already

subtracted at the start.


The difference between the amount the firm can use and the amount that has to be paid
back at the end is the banks interest or discount earned.
The loan amount is the amount due at maturity
Example 3: Discount loan
Lets say that a firm needs $500,000 to fund the operations of its new expansion. It
approaches a commercial bank, which offers it a discount loan at 9.5% per year which
will have to be paid back in full in one payment at the end of twelve months. How much

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will the face value of the loan have to be set at and what rate of interest is the company
effectively paying?
Loan amount (face value) = Amount needed/(1-discount rate) $2m/.9 $2.209m.
Effective rate = discount paid/Amount used = 209,000/2000000 10.497%
15.3 (C) Letter of Credit or Line of Credit: is a preapproved borrowing amount that

works much like a credit card.


The company can borrow money at a preset rate from bank at any time without seeking
additional approval of the loan each time it needs funds.
The bank, however, is compensated based on the outstanding balance of the loan. The
compensation can be a fixed interest rate, but often is a floating interest rate tied to a
benchmark interest rate.
This borrowing style has changing balances and changing interest rates, so it is difficult
to state the effective rate on the loan.
15.3 (D) Compensating Balance: loans work like lines of credit except that a portion of

the loan is not available to the borrower, even though interest is paid on the full face
value of the loan. For example, if a firm takes a loan of $100,000 at a rate of 7.5% per
year and a compensating balance requirement of 15%, it will be able to use only $85,000
and be charge $7,500 in interest for the year. The effective rate of interest will therefore
be:
Effective rate = Interest paid/Amount used $7,500/$85,000 8.82%

15.4 Borrowing for a Stable and


Mature Business: Selling Bonds

(Slides 15-20 to 15-25)

Corporate bonds represent a major source of long-term financing for established


companies.
Bonds are typically sold in $1,000 units, and publicly auctioned or privately placed.
The public issue of bonds is regulated by the SEC and typically involves the following 5
steps
1. The company selects an investment bank to help design and market the bond. An
investment bank is an agent that works with the firm to meet all the listing
requirements of the bond issue, the design of the bond terms, the marketing of the
bond, and the auction of the bond.
2. The company and investment bank register the bond with the SEC, providing a
prospectus and referencing the indenture for the bond
3. The bond is rated by an agency such as Standard & Poors or Moodys to help
potential buyers determine an appropriate price for the bond..
4. The investment bank markets the bond to prospective buyers prior to the auction,
using the prospectus as the key information on the bond.

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5. An auction is conducted to sell the bond.


Two key documents that are required during the bond issuance process include the
prospectus and the indenture agreement.
The prospectus contains much of the information filed in the registration and is used to
inform potential buyers about the bond.
The indenture agreement is the formal contract for the bond between the issuing
company and the eventual buyer. It includes vital information about the bond such as the
coupon rate, payment schedule, maturity date, and par value as well as other restrictive
covenants i.e. provisions that restrict the activities of the issuing firm to increase the
safety of the bond in the eyes of potential buyers.
Firms that issue coupon bonds have to make periodic coupon payments and a large lump
sum payment at maturity.
Sinking funds or reserve accounts are often set up by bond issuers to put away funds
every year so as to have the necessary funds available to retire the bond when it matures.
Example 4: Bond proceeds
The Golden Corral Corporation is in the process of issuing a 30-year, 8% coupon (paid
semi-annually) AA1-rated corporate bond with $1000 par value. If by the time the bonds
receive SEC clearance, the market yield on this bond goes to 8.35%, and the company
sells 3000 of these bonds with the help of an investment banker who charges them a
commission rate of 3% on the proceeds, what will the total proceeds be for the issuing
company, and what is the cost of these bonds to the firm in terms of the cost of capital?
What are the firms future cash obligations?
P/Y=2;C/Y=2;N=60;PMT=40;FV=1000;I=8.35; PV$962
Gross proceeds from sale of bonds = 3000*$962=$2,885,058.18
Investment bankers commission = .03*$2,885,058.18= $86,551.75
Total proceeds received by the issuing company = $2,798, 506.43
Net proceeds per bond = $962*(1-.03) = $932.84
Cost of debt to Golden Corral based on net price:
P/Y=2; C/Y=2; PV=-932.84; N=60;PMT=40;FV=1000;I 9.01%
Future cash obligations:
Annual Coupon payments = $40*2*3000 = $240,000
Principal payment at maturity= $1000*3000 = $3,000,000

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15.5 Borrowing for a Stable and


Mature Business: Selling Stock

(Slides 15-26 to 15-37)

The other major source of capital for a firm to avail of is common stock or equity.
Equity holders get voting rights as part owners and share in the residual profits of the
firm.
Stocks are sold as initial public offerings (IPOs) when the firm first goes public and
seasoned offerings for subsequent issues.
15.5 (A) Initial Public Offerings and Underwriting: Firms sell stock to the public with

the help of investment banking firms, who perform due diligence and are experts in
marketing the issue.
Investment banks partner with issuing firms in exchange for compensation that can be set
up on a best-efforts basis or on a fixed-commitment basis.
Under a best-efforts arrangement the investment bank pledges to use its best efforts to
sell all the authorized shares and takes a cut on each individual share sold, but provides
no guarantee as to how many shares will be sold. The more shares sold, the higher the
payoff to the investment bank.
Under a fixed-commitment arrangement, also known as an underwriting arrangement,
the investment banker guarantees a fixed amount of proceeds to the issuer. The
investment banker makes up/keeps the difference between the actual selling price and the
guaranteed price.
Example 5: Best efforts versus fixed commitment underwriting
The Wed Link Inc. wants to raise capital by issuing common stock. They contact a few
investment bankers and the one with the best offer has presented them with 2 options:
1) A fixed commitment offer of $8,500,000
2) A best efforts arrangement in which the investment banker will receive $1.50 per
share for every share of stock sold up to $$1,500,000 for the 1,000.000 shares to be
offered to the public at $11 per share.
a) If 100% of the shares are sold, what are Wed Links proceeds? What is the
payment to the investment banking firm under each method of issuing securities?
b) What if 85% of the shares are sold? At what percentage of shares sold are the
proceeds to you the same under the two compensation arrangements?
c) At what percentage is the payment to the investment banking firm the same?
a) If 100% of the shares are sold i.e. 1,000,000 shares at $11 per share, to the public, the
proceeds are as follows:
1) With the firm commitment arrangement, the issuer gets $8,500,000
The investment banker gets $11,000,000 $8,500,000 = $2,500,000
2) With the best efforts arrangement, the issuer gets ($11$1.50)*1,000,000$9,500,000

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The investment banker gets $1.50*1,000,000$1,500,000


So, if the issue is 100% sold, the issuer is better off with the best efforts arrangement,
while the investment banker would be better off with the fixed commitment arrangement.
b) If 85% of the shares are sold, i.e. 850,000 shares at $11 per share, the proceeds are as
follows:
1) With the firm commitment arrangement, the issuer gets $8,500,000
The investment banker gets $9,350,000 $8,500,000 = $$850,000
2) With the best efforts arrangement, the issuer gets ($11$1.50)*850,000$8,075,000
The investment banker gets $$1.5*850,000$1,275,000
So if the issue is only 85% sold, the issuer is better off with a firm commitment
offer while the investment banker would be better off with the best efforts
arrangement.
c) Firm commitment offer = best effort $ per share sold
$8,500,000 = $9.50*1,000,000 * X% X% = $8,500,000/$9,500,000 89.47%
So, if 89.47% of the shares are sold, the payment to the investment banking firm will
be the same under either arrangement.

15.5 (B) Registration, Prospectus, and Tombstone: All new issues of shares have to be

registered with the SEC prior to being sold in the capital markets.
Once an application is filed, the approval process could take anywhere from 20 to 40
days (cool-off period.)
During the waiting period, the issuer can circulate a preliminary prospectus (red herring)
informing potential investors of the issue.
No commitments can be obtained from buyers until after SEC approval.
If information is missing, the SEC issues a comment letter, requiring corrections and a
new application to be filed.
Once re-filed, the cool-off period starts again.
During the waiting period the issuer and investment bank place large advertisements
(tombstone ads.) in newspapers and magazines, containing the name of the issuer, some
details about the issue, and a list of participating investment banks.
There are 2 exceptions to the usual SEC registration process requirement:
1. If the issue has a maturity of less than 270 days e.g. commercial paper issues.
2. If the issue is worth less than $5 million (Regulation A)
15.5 (C) The Marketing Process: Road Show: involves taking the issue on the road to

attract interest among potential investors.


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This process usually last about 2 weeks and enables the investment banker to get a feel
for what the price should be set at.
After a successful road show and marketing campaign, a price is set and the issue
proceeds forward to be auctioned off in the primary capital market.
15.5 (D) The Auction: takes place on a single trading day, during which time buyers

submit their bids at pre-set prices. If over-subscribed, the bids are filled on a pro-rata
basis until all the shares are sold.
15.5 (E) The Aftermarket: Dealer in the Shares: After completion of the auction the

outstanding shares trade in the secondary market and the investment banker typically
functions as a dealer in the stock for a minimum of 18 months, for which the bank is
given a green-shoe provision.
The green shoe provision allows the investment banker the right to purchase up to 15%
of additional shares over a thirty-day period beyond that offered to the public during the
auction so as to maintain inventory and fill any pent-up demand.
Another standard agreement is a lock-up agreement, which requires the original owners
of the firm to maintain their shares of stock for 180 days, so as to prevent dumping of
stock and free-fall in its price due to profit-taking on part of the original owners.

15.6 Other Borrowing Options for a Mature


Business
(Slides 15-38 to 15-41)
Commercial paper and bankers acceptances are two other popular financing options used
by mature businesses.
15.6 (A) Commercial paper is a discounted note sold by a company directly to an

investor with both principal and interest repaid within 270 days just like a treasury bill.
These issues typically have a face value of $100,000, putting them out of the reach of
most small investors. It is generally assumed institutions and sophisticated investors
purchase commercial paper.
The reason firms issue commercial paper over other forms of borrowing is that they can
get lower rates than through commercial banks and since they mature within 270 days,
they qualify for short-form registration with the SEC.
Example 6:
The Large-Scale Industrial Corporation, a large well established company, is about to
issue $6,000,000 worth of commercial paper. The paper has a maturity of 9 months (270
days), and commands a price worth 97.5% of par value in the market. The paper will be
sold with a face or par value of $100,000. How many commercial papers will be sold?
What is the cost of this borrowing to the firm?
Proceeds from the issue = Face Value *Discounted Value = $6m*.975=$5.85m
Cost of this borrowing over 270 days = ($6m-$5.85m)/$5.85m.02564
APR = .02564*365/270 = 0.034663.47%
EAR = (1.02564)365/270 13.48%
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Number of commercial papers issued = Total Face Value/Par Value of 1 =


$6,000,000/$100,000 = 60 papers
15.6 (B) A Bankers acceptance is a short-term credit arrangement created by a firm and

guaranteed by a bank, and it is ordinarily used to finance inventories or other assets that
will be self-liquidated over a relatively short period of time. Its specific purpose is to
promote trade.
It typically involves an importing firm having its invoice guaranteed (accepted) by a bank
and sent over to the exporter as assurance of payment in the next few months (typically
60-90 days). The exporter turns in the bankers acceptance to his bank in exchange for a
reduced payment and in return the bank in the exporting country takes title to the
exported goods until payment is received. The importing firm is able to finance its
purchases and releases funds as inventory is liquidated.

15.7 The Final Phase: Closing the Business (Slides 15-42 to 15-46)
Sometimes, successful solvent firms decide to cease operations, in which case they sell
off their assets, pay off all outstanding debts and expenses, and distribute the residual
value to the stockholders.
When firms are unsuccessful, they may decide to cease operations, declare bankruptcy,
and liquidate their assets; or they may decide to re-organize, attempt to re-establish
themselves, and try to re-emerge as stronger firms.
15.7 (A) Straight Liquidation: Chapter 7 of the Federal Bankruptcy Reform Act (1978)

deals with the process that has to be followed when a firm decides to close its business
and liquidate its assets.
Once a firm files for Chapter 7, the bankruptcy court judge appoints a trustee to oversee
the process of liquidation, the order of which is as follows:

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Note that common stockholders are last on the list and typically get little to nothing of the
proceeds from the sale of the remaining assets.
15.7 (B) Reorganization: Chapter 11 is what some firms file for if their managers feel

that there is a chance that they could re-structure the firm and be worth more alive than
dead. Ina typical re-organization the process is as follows:
First, a petition for Chapter 11 is filed by either the company or by a creditor, and a
bankruptcy court judge either accepts or denies the petition.
If accepted, a date is set by the judge for all claimants to show proof of their claims and
for the firm to establish who exactly the claimants are.
A reorganization plan is presented to the court and must be approved by a majority of the
members of a claimant class.
If the claimants cannot agree on the reorganization plan, the judge may issue a ruling on
all or parts of a plan and thus decree the reorganization plan.
If a minority of classes does not agree to the plan, the judge may listen to their objections
and alter the reorganization plan.
Often, the current managers continue to run the business while it operates under the
reorganization plan, but the court may also appoint a trustee to oversee the operations and
protect the rights of the claimants during this period of time.
The reorganization plan may allow the issuance of new securities and thus add another
set of claimants to the firm.
Old debt may be restructured in terms of both maturity and rates.
The plan itself holds off claimants while the company tries to reorganize and come out of
bankruptcy as a new operating firm.
If a firm fails to make the reorganization plan work, it will probably fall into Chapter 7
bankruptcy.

Questions
1. What are the five stages of a business life cycle? Do all companies go through all
five stages?
There are a number of classifications of the business life cycle; here we will use the
five active phases of startup, growth, maturity, decline, and closing. Not all
companies move through all five phases, some never get past the start-up phase.
2. According to the U.S. Census Bureaus Business Information Tracking System,
what is the failure rate of companies over the first six years?
According to the U.S. Census Bureaus Business Information Tracking System
(BITS), three out of every five employer businesses (businesses that employ others
besides the owners) will close within their first six years.
3. What is the function of the Small Business Administration in regard to business
loans? Who receives the guaranty on the loans?

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The 7(a) Loan Guaranty Program administers business loans to individuals or


businesses that might not be eligible for a loan through the normal lending agencies.
Loan proceeds can be used for working capital and fixed assets, with repayment
schedules extending up to 25 years. These loans are delivered through commercial
lenders and guaranteed by the SBA. The lending institution gets the guarantee not the
borrower.
4. What is the difference between an angel investor and a venture capitalist? What
event do these investors want to see happen? Why?
Angel investors are lenders who provide funding for new, high-risk ideas. The term
does not refer to a well-defined set of lenders but rather is a generic term applied to
individuals or groups that seek to support new start-up business ventures. As such, an
angel financier is usually a wealthy individual. Like angel investors, venture
capitalists are not a well defined group of lenders, but rather a general term applied to
groups or institutions that provide funding at a level higher (larger loans) than that of
most angel investors. Both these lenders want to see a liquidity event where they are
repaid their initial investment plus a large profit.
5. What is a letter of credit or line of credit? How does it work?
A letter of credit or line of credit is a preapproved borrowing amount that works
much like a credit card. The company can borrow money at a preset rate from the
bank at any time without seeking additional approval of the loan each time it needs
funds.
6. What is the role of an investment bank in selling bonds?
An investment bank is an agent that works with the firm to meet all the listing
requirements of the bond issue, the design of the bond terms, the marketing of the
bond, and the auction of the bond.
7. What is the role of an investment bank in selling stock?
The investment bank becomes a partner of the company as it guides the company
through the selling process. As part of their role as a partner in the process,
investment banks are required to perform due diligence in making sure that all
information released during the process is accurate and that all material information
has been released. Failing to perform this due diligence task puts the investment bank
and the company at risk for litigation after the sale of the stock.
8. What is commercial paper? Why does it not need SEC approval?
As its name implies, commercial paper is issued for commercial purposes; it is a
discounted note sold by a company directly to an investor with both principal and
interest repaid within 270 days. Because the standard face value of commercial paper
is typically $100,000, it is out of the reach of most small investors. One of the
exceptions to the requirement of registering with the SEC is if the maturity of the
issue is less than nine months, or 270 days.
9. Bankers acceptance supports lending for what type of activities? Explain how
collateral works in a bankers acceptance arrangement.
A bankers acceptance is a short-term credit investment created by a firm and
guaranteed by a bank, and is ordinarily used to finance inventories or other assets that
will be self-liquidated over a relatively short period of time. Its specific purpose is to
promote trade. As inventories are sold, the bankers acceptance is repaid.
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10. What is the difference between Chapter 7 and Chapter 11 bankruptcies? Why
might Chapter 11 be better for claimants than Chapter 7?
Chapter 7 of the Federal Bankruptcy Reform Act of 1978 deals with straight
liquidation the selling off of the assets of the firm. In Chapter 7 filings, the company
is ceasing all business operations, and the final act of selling off all remaining assets
and distributing these proceeds to the legal claimants is governed by a bankruptcy
court. A Chapter 11 filing entails reorganization of a companys business affairs and
restructuring of its debt. The company in effect asks the court to step between it and
its legal claimants in order to provide the company with an opportunity to work out its
financial difficulties without the claimants taking action. Chapter 11 is for a specific
time period only and is not a permanent solution to the financial difficulties of a
company.

Prepping for Exams


1. c
2. d
3. c
4. c
5. d
6. c
7. a
8. b
9. c
10. b

Problems
1. Venture capital required rate of return. Blue Angel Investors has a success ratio of
10% with its venture funding. Blue Angel requires a rate of return of 20% for its
portfolio of lending, and the average length on its loan is five years. If you were to
apply to Blue Angel for a $100,000 loan, what is the annual percentage rate you
would be required to pay for this loan?
ANSWER
Your loan rate means that if one out of ten succeed you need to cover the nine failures
after five years, so if Blue Angel makes 10 loans of $100,000 each, i.e. $1,000,000 and
requires a return of 20% on its lending portfolio, it will have to accumulate the following
amount after 5 years:
$1,000,000 (1.20)5 = $2,488,320. So given a success rate of 1 out of 10 loans, it will
charge you the following rate ($2,488,320 / $100,000)1/5 1 = 0.901872 or 90.1872%

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Chapter 15 n Raising Capital 527

2. Venture capital required rate of return. Red Devil Investors has a success rate of one
project for every four funded. Red Devil has an average loan period of two years and
requires a portfolio return of 25%. If you borrow from Red Devil, what is your annual
cost of capital?
ANSWER
Hint, do this on a per dollar borrowed basis per project funded.
Your loan rate means that if one out of four succeed you need to cover the three failures
after two years:
$4 (1.25)2 = $6.25
Your rate is ($6.25 / $1)1/2 1 = 1.50 or 150%

3. Straight bank loan. Left Bank has a standing rate of 8% (APR) for all bank loans,
and requires monthly payments. What is a monthly payment if a loan is for (a)
$100,000 for five years, (b) $250,000 for ten years, or (c) $1,000,000 for 25 years?
What is the effective annual rate of each of these loans?
ANSWER
For $100,000 over five years
Mode: P/Y = 12, C/Y =12
Input
60
8.0
Keys
N
I/Y
CPT

-100,000
PV

PMT
$2,027.64

0
FV

For $250,000 over ten years


Mode: P/Y = 12, C/Y =12
Input
120
8.0
Keys
N
I/Y
CPT

-250,000
PV

PMT
$3,033.19

0
FV

For $1,000,000 over twenty five years


Mode: P/Y = 12, C/Y =12
Input
300
8.0
Keys
N
I/Y
CPT

-1,000,000
PV

PMT
$7,718.16

0
FV

The EAR for all three loans is:


EAR = (1 + 0.08/12)12 1 = 8.299%
4. Straight bank loan. Right Bank offers EAR loans of 9.38% and requires a monthly
payment on all loans. What is the APR for these monthly loans? What is the monthly
payment for (a) a loan of $200,000 for six years, (b) a loan of $450,000 for twelve
years, or (c) a loan of $1,250,000 for thirty years?

2013 Pearson Education, Inc. Publishing as Prentice Hall

528 Brooks n Financial Management: Core Concepts, 2e

ANSWER
The APR = (1 + 0.0938)1/12 1 12 = 9.0%
For $200,000 over six years
Mode: P/Y = 12, C/Y =12
Input
72
9.0
Keys
N
I/Y
CPT

-200,000
PV

PMT
$3,605.11

0
FV

For $450,000 over twelve years


Mode: P/Y = 12, C/Y =12
Input
144
9.0
Keys
N
I/Y
CPT

-450,000
PV

PMT
$5,121.14

0
FV

For $1,250,000 over thirty years


Mode: P/Y = 12, C/Y =12
Input
360
9.0
Keys
N
I/Y
CPT

-1,250,000
PV

PMT
$10,057.78

0
FV

5. Discount loan. Up-Front Bank uses discount loans for all its customers who want
one-year loans. Currently, the bank is providing one-year discount loans at 8%. What
is the effective annual rate on these loans? If you were required to repay $250,000 at
the end of the loan for one year, how much would the bank give you on your loan at
the start of the loan?
ANSWER
Loan Size = $250,000 (1 0.08) = $230,000
Interest Rate = $20,000 / $230,000 = 8.6956522%
6. Discount loan. Up-Front Bank is now offering a two-year discount loan for 10%.
Working backwards, what are the available funds at the start of the loan and the
implied balance at the end of the first year if the total lump sum repayment at the end
of the second year is $400,000? What is the EAR on this loan?
ANSWER
Loan Size = $400,000 (1 0.10) (1 0.10) = $324,000
Implied Balance End of Year One: $324,000 / (1 0.10) = 360,000
EAR = ($400,000 / $324,000)1/2 1 = 11.11%%

2013 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 15 n Raising Capital 529

7. Letter of credit/line of credit. As We Go Bank offers its customers a line of credit


loan in which each months outstanding balance requires a 12% (APR). What are the
monthly interest payments required on the following loans and total interest paid for
the year on these loans with a $100,000 credit line?
Outstanding
Balance

Outstanding
Balance

Outstanding
Balance

Outstanding
Balance

Loan A

Loan B

Loan C

Loan D

January

$22,500

$68,000

$0

$53,500

February

$31,000

$82,500

$0

$0

March

$16,000

$96,000

$0

$40,300

April

$24,300

$45,000

$98,000

$0

May

$31,500

$13,200

$92,000

$80,100

June

$48,600

$0

$95,000

$0

July

$37,000

$0

$60,000

$65,900

August

$28,900

$0

$54,000

$0

September

$23,300

$22,000

$36,000

$48,000

October

$24,700

$36,700

$22,000

$0

November

$27,600

$48,200

$0

$46,100

December

$18,500

$55,900

$0

$0

ANSWER
Multiply each balance at the end of each month by 12% / 12 or 1% for that months
interest:
Example: Loan A for January is $22,500 0.01 = $225.00
Interest

Interest

Interest

Interest

Loan A

Loan B

Loan C

Loan D

January

$225.00

$680.00

$0

$535.00

February

$310.00

$825.00

$0

$0

March

$160.00

$960.00

$0

$403.00

April

$243.00

$450.00

$980.00

$0

May

$315.00

$132.00

$920.00

$801.00

June

$486.00

$0

$950.00

$0

July

$370.00

$0

$600.00

$659.00

2013 Pearson Education, Inc. Publishing as Prentice Hall

530 Brooks n Financial Management: Core Concepts, 2e

August

$289.00

$0

$540.00

$0

September

$233.00

$220.00

$360.00

$480.00

October

$247.00

$367.00

$220.00

$0

November

$276.00

$482.00

$0

$461.00

December

$185.00

$559.00

$0

$0

$3,339.00

$4,675.00

$4,570.00

$3,339.00

TOTAL

8. Letter of credit/line of credit. In Problem 7, Loan A and Loan D borrow the same
amount each year. However, Loan A borrows every month, and Loan D borrows
every other month (note that the borrowing for Loan D for January equals the
borrowing for Loan A for January and February). If As We Go Bank charges its
customers for the unused balance, which loan strategy is better if the unused balance
is charged 3% (APR) per month for the bank? Which loan borrowing strategy is
better for the customer?
ANSWER
First find the unused balance each month. Then total that balance and multiply by 0.03/12
for the annual charge on the unused balance.
Outstanding
Balance

Unused Balance
Loan A

Loan A

Outstanding
Balance

Unused Balance
Loan D

Loan D

January

$22,500

$77,500

$53,500

$46,500

February

$31,000

$69,000

$0

$100,000

March

$16,000

$84,000

$40,300

$59,700

April

$24,300

$75,700

$0

$100,000

May

$31,500

$68,500

$80,100

$19,900

June

$48,600

$51,400

$0

$100,000

July

$37,000

$63,000

$65,900

$34,100

August

$28,900

$71,100

$0

$100,000

Septembe
r

$23,300

$66,700

$48,000

$52,000

October

$24,700

$75,300

$0

$100,000

Novembe
r

$27,600

$72,400

$46,100

$53,900

2013 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 15 n Raising Capital 531

December
TOTAL

$18,500

$81,500

$0

$100,000

$333,900

$856,100

$333,900

$866,100

Interest
$3,339.00
$2,140.25
$3,339.00
$2,165.25
charge
Monthly borrowing under Option A is charged slightly less interest due to its lower
overall unused balance of $10,000.
9. Selling bonds. Astro Investment Bank has the following bond deals under way:
Company

Bond Yield

Commission

Coupon Rate

Maturity

Gravity Belts

8.0%

2% of Sale Price

8.0%

10 years

Invisible Rays

9.0%

3% of Sale Price

12.0%

10 years

Solar Glasses

7.0%

2% of Sale Price

5.0%

20 years

Space Ships

12.0%

4% of Sale Price

0%

20 years

10%

3% of Sale Price

10%

50 years

Lunar Vacations

Determine the net proceeds of each bond and the cost of the bonds for each company in
terms of yield. The bond yield in the table is the market yield before the commission is
charged. Assume that all bonds are semiannual and issued at a par value of $1,000.
ANSWER
For Gravity Belts the market price is:
Mode: P/Y = 2, C/Y =2
Input
20
8.0
Keys
N
I/Y
CPT

PV
$1,000.00

40
PMT

1000
FV

40
PMT

1000
FV

60
PMT

1000
FV

Net Price is $1,000.00 (1 0.02) = $980.00


Yield is:
Mode: P/Y = 2, C/Y =2
Input
20
Keys
N
I/Y
CPT
8.2982

-980.00
PV

Answer:
For Invisible Rays the market price is:
Mode: P/Y = 2, C/Y =2
Input
20
9.0
Keys
N
I/Y
CPT

PV
$1,195.12

2013 Pearson Education, Inc. Publishing as Prentice Hall

532 Brooks n Financial Management: Core Concepts, 2e

Net Price is $1,195.12 (1 0.03) = $1,159.27


Yield is:
Mode: P/Y = 2, C/Y =2
Input
20
Keys
N
I/Y
CPT
9.4981

-1,159.27
PV

60
PMT

1000
FV

25
PMT

1000
FV

25
PMT

1000
FV

0
PMT

1000
FV

0
PMT

1000
FV

50
PMT

1000
FV

50
PMT

1000
FV

For Solar Glasses the market price is:


Mode: P/Y = 2, C/Y =2
Input
40
7.0
Keys
N
I/Y
CPT

PV
$786.45

Net Price is $1,000.00 (1 0.02) = $770.72


Yield is:
Mode: P/Y = 2, C/Y =2
Input
40
Keys
N
I/Y
CPT
7.1769

-770.72
PV

For Space Ships the market price is:


Mode: P/Y = 2, C/Y =2
Input
40
12.0
Keys
N
I/Y
CPT

PV
$97.22

Net Price is $97.22 (1 0.04) = $93.33


Yield is:
Mode: P/Y = 2, C/Y =2
Input
40
Keys
N
I/Y
CPT
12.2165

-93.33
PV

Answer:
For Lunar Vacations the market price is:
Mode: P/Y = 2, C/Y =2
Input
100
10.0
Keys
N
I/Y
CPT

PV
$1,000.00

Net Price is $1,000.00 (1 0.03) = $970.00


Yield is:
Mode: P/Y = 2, C/Y =2
Input
100
Keys
N
I/Y

-970.00
PV

2013 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 15 n Raising Capital 533

CPT

10.3114

10. Selling bonds. Lunar Vacations needs to raise $6,000,000 for its new project (a golf
course on the moon). Astro Investment Bank will sell the bond for a commission of
2.5%. The market is currently yielding 7.5% on twenty-year semiannual bonds. If
Lunar wants to issue a 6% semiannual coupon bond, how many bonds will it need to
sell to raise the $6,000,000?
ANSWER
First find the price of each bond in the market and then discount the bond by the
commission. Take the net price to Lunar Vacations and divide this into the $6,000,000
for the number of bonds needed.
Market price is:
Mode: P/Y = 2, C/Y =2
Input
40
7.5
Keys
N
I/Y
CPT

PV
$845.87

30
PMT

1000
FV

Net Price is $845.87 (1 0.025) = $824.72


Number of bonds, $6,000,000 / $824.72 = 7,276 bonds (rounded up)
11. Selling bonds. Berkman Investment Bank has the following bond deals under way:
Company

Bond Yield

Commission

Coupon Rate

Maturity

Rawlings

7.0%

2% of Sale Price

0.0%

20 years

Wilson

7.5%

3% of Sale Price

8.5%

20 years

Louis Sluggers

7.5%

2% of Sale Price

9.0%

10 years

Spalding

8.0%

4% of Sale Price

7.0%

20 years

Champions

8.5%

3% of Sale Price

6.5%

30 years

Determine the net proceeds of each bond and the cost of the bonds for each company in
terms of yield. The bond yield in the table is the market yield before the commission is
charged. Assume that all bonds are semiannual and issued at a par value of $1,000.
ANSWER
For Rawlings the market price is:
Mode: P/Y = 2, C/Y =2
Input
40
7.0
Keys
N
I/Y
CPT

PV
$252.57

0
PMT

1000
FV

Net Price is $252.57 (1 0.02) = $247.52


2013 Pearson Education, Inc. Publishing as Prentice Hall

534 Brooks n Financial Management: Core Concepts, 2e

Yield is:
Mode: P/Y = 2, C/Y =2
Input
40
Keys
N
I/Y
CPT
7.1046

-247.52
PV

0
PMT

1000
FV

42.5
PMT

1000
FV

42.5
PMT

1000
FV

45
PMT

1000
FV

45
PMT

1000
FV

35
PMT

1000
FV

35
PMT

1000
FV

For Wilson the market price is:


Mode: P/Y = 2, C/Y =2
Input
40
7.5
Keys
N
I/Y
CPT

PV
$1,102.75

Net Price is $1,195.12 (1 0.03) = $1,069.67


Yield is:
Mode: P/Y = 2, C/Y =2
Input
40
Keys
N
I/Y
CPT
7.8061

-1,069.67
PV

For Louis Sluggers the market price is:


Mode: P/Y = 2, C/Y =2
Input
20
7.5
Keys
N
I/Y
CPT

PV
$1,104.22

Net Price is $1,104.22 (1 0.02) = $1,082.14


Yield is:
Mode: P/Y = 2, C/Y =2
Input
20
Keys
N
I/Y
CPT
7.8018

-1,082.14
PV

For Spalding the market price is:


Mode: P/Y = 2, C/Y =2
Input
40
8.0
Keys
N
I/Y
CPT

PV
$901.04

Net Price is $901.04 (1 0.04) = $864.99


Yield is:
Mode: P/Y = 2, C/Y =2
Input
40
Keys
N
I/Y
CPT
8.4056

-864.99
PV

2013 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 15 n Raising Capital 535

For Champions the market price is:


Mode: P/Y = 2, C/Y =2
Input
60
8.5
Keys
N
I/Y
CPT

PV
$784.07

32.5
PMT

1000
FV

32.5
PMT

1000
FV

Net Price is $784.07 (1 0.03) = $760.55


Yield is:
Mode: P/Y = 2, C/Y =2
Input
60
Keys
N
I/Y
CPT
8.7739

-760.55
PV

12. Selling bonds. Rawlings needs to raise $40,000,000 for its new manufacturing plant
in Jamaica. Berkman Investment Bank will sell the bond for a commission of 2.5%.
The market is currently yielding 7.5% on twenty-year zero-coupon bonds. If
Rawlings wants to issue a zero-coupon bond, how many bonds will it need to sell to
raise the $40,000,000?
ANSWER
First find the price of each bond in the market and then discount the bond by the
commission. Take the net price to Rawlings and divide this into the $40,000,000 for the
number of bonds needed.
Market price is:
Mode: P/Y = 2, C/Y =2
Input
40
7.5
Keys
N
I/Y
CPT

PV
$229.34

0
PMT

1000
FV

Net Price is $229.34 (1 0.025) = $223.60


Number of bonds, $40,000,000 / 223.60 = 178,888 bonds
13. Firm commitment versus best efforts. Astro Investment Bankers offers Lunar
Vacations the following options on its initial public sale of equity: (a) a best-efforts
arrangement whereby Astro will keep 2.5% of the retail sales or (b) a firmcommitment arrangement of $10,000,000. Lunar plans on offering 1,000,000 shares
at $12 per share to the public. If 100% of the shares are sold, which is the better
choice for Lunar Vacations? Which is the better choice for Astro Investment
Bankers?

2013 Pearson Education, Inc. Publishing as Prentice Hall

536 Brooks n Financial Management: Core Concepts, 2e

ANSWER
Proceeds for Lunar Vacations under each type of sales agreement:
Best Efforts 1,000,000 $12 (1 0.025) = $11,700,000
Firm Commitment $10,000,000
Best choice for Lunar Vacations is Best Efforts
Proceeds for Astro Investments under each type of sales agreement:
Best Efforts 1,000,000 $12 (0.025) = $300,000
Firm Commitment 1,000,000 $12 $10,000,000 = $2,000,000
Best choice for Astro Investments is Firm Commitment
14. Firm commitment versus best efforts. Using the information in Problem 13, what is
the break-even sales percentage for Lunar Vacations? What are the proceeds to Lunar
Vacations and Astro Investment Bankers at the break-even sales percentage?
ANSWER
Sales Units $12 (1 0.025) = $10,000,000
Sales Units = $10,000,000 / $11.70 = 854,700 shares
Best Efforts at 854,700 shares
To Lunar Vacations: 854,700 $12 (1 0.025) = $10,000,000
To Astro Investment: 854,700 ($12 $11.70) = $256,410
Firm Commitment at 854,000 sales:
To Lunar Vacations: $10,000,000
To Astro Investments: 854,700 $12 $10,000,000 = $256,410
15. Issuing securities. Bruce Wayne is going public with his new business. Berkman
Investment Bank will be his banker and is doing a best-efforts sale with a 4%
commission fee. Wayne has been authorized 5,000,000 shares for this issue. He plans
on keeping 1,000,000 shares for himself, holding back an additional 200,000 shares
for a green-shoe provision for Berkman Bank, paying off Venture Capitalists with
500,000 shares, and selling the remaining shares at $16 a share. Given the following
bids at the auction, distribute the shares to all bidders using a pro-rata share procedure
and assume Berkman Bankers takes its green-shoe provision. What is the total cash
flow to Wayne after the sale? To Berkman Bankers?
Bidder

Quantity Bid

Gotham Pension Fund

2,000,000

Clark Kent Investors

1,100,000

2013 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 15 n Raising Capital 537

Central City Insurance

600,000

Arthur Curry

400,000

Barry Allen

300,000

ANSWER
First determine the number of shares available for the auction:
Authorized:
5,000,000
minus Waynes Holdings 1,000,000
minus Venture Capitalists 500,000
minus green-shoe
200,000
Available
3,300,000
Total bid quantity is 4,400,000 so each bidder receives 3,300,000/4,400,000 or just under
75% of their bid
Gotham Pension gets (3.3 / 4.4) 2,000,000 = 1,500,000
Clark Kent gets (3.3 / 4.4) 1,100,000 = 825,000
Central City gets (3.3 / 4.4) 600,000 = 450,000
Arthur Curry gets (3.3 / 4.4) 400,000 = 300,000
Barry Allen gets (3.3 / 4.4) 300,000 = 225,000
Total Issued at auction is 3,300,000
Proceeds for Wayne is 3,300,000 $16 (1 0.04) = $50,688,000
Proceeds to Berkman Bankers is 3,300,000 $16 0.04 = $2,112,000
16. Issuing securities. Use the same information from Problem 15. What if the auction
bids total only 2,640,000 shares, as follows:
Bidder

Quantity Bid

XYZ Pension Fund

1,200,000

Clark Kent Investors

500,000

Central City Insurance

400,000

Arthur Curry

300,000

Barry Allen

240,000

What is the distribution of the shares and cash flow to Bruce Wayne if Berkman
Investment Bank declines its green-shoe provision?
ANSWER
First determine the number of shares available for the auction:
Authorized:
5,000,000
minus Waynes Holdings 1,000,000
minus Venture Capitalists 500,000
Available
3,500,000

2013 Pearson Education, Inc. Publishing as Prentice Hall

538 Brooks n Financial Management: Core Concepts, 2e

Total bid quantity is only 2,640,000 so each bidder receives their entire bid.
XYZ Pension gets 1,200,000
Clark Kent gets 500,000
Central City gets 400,000
Arthur Curry gets 300,000
Barry Allen gets 240,000
Total Issued at auction is 2,640,000 and Bruce Wayne (the company) keeps the
remaining shares (3,500,000 2,640,000 = 860,000) as authorized but unissued stock.
Proceeds for Wayne is 2,640,000 $16 (1 0.04) = $40,550,400
Proceeds to Berkman Bankers is 2,640,000 $16 0.04 = $1,689,600
17. Commercial paper. Criss-Cross Manufacturers will issue commercial paper for a
short-term cash inflow. The paper is for 91 days, has a face value of $50,000, and is
anticipated to sell at 96% of par value. Criss-Cross wants to raise $3,000,000, so what
is the cost of this borrowing (annual terms) and how many papers will be sold?
ANSWER
Selling price is 0.96 $50,000 = $48,000
The cost of this borrowing is:
Three-Month Interest Rate = ($50,000 $48,000) / $48,000 = 0.041667
Stated annually we have:
Annual Percentage Rate = 0.041667 4 = 16.67%
Effective Annual Rate = (1 + 0.04167)4 1 = 17.738%.
The total number of papers sold will be:
Number issued
= $3,000,000 / $48,000 = 63(must sell in whole units)
18. Commercial paper. Criss-Cross has decided that it will need to raise more than
$3,000,000 in commercial paper (see Problem 17). Criss-Cross must now raise
$5,000,000, and the paper will have a maturity of 182 days. If this paper has a
maturity value of $50,000 and is selling at an annual interest rate of 9%, what are the
proceeds from each paper, that is, what is the discount rate on the commercial paper?
ANSWER
Discount rate is the stated annual 9% APR but to determine the 182 rate (six month rate)
you need to divide 9% by 2 for the 4.5% or 95.5% of par selling price.
Selling price is $50,000 (1 0.045) = $47,750
Total number of sold is $5,000,000 / $47,750 = 105 (must sell in whole units)
19. Bankruptcy, Chapter 7. Gigantic Furniture is having its annual Going Out of
Business Sale. If Gigantic Furniture is filing under Chapter 7, will it be back next
year for another going out of business sale?

2013 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 15 n Raising Capital 539

ANSWER:
In a word, NO. Chapter 7 bankruptcy is for the selling off of the assets of the firm and
ceasing all business operations.
20. Bankruptcy, Chapter 7. A customer and an employee are waiting for payment from
Gigantic Furniture after the company has filed for bankruptcy under Chapter 7 of the
IRS bankruptcy laws. The employees claim against Gigantic Furniture is for $500
for health care benefits that were not paid to the health care carrier during the last
month of company operations, plus $300 for the pension plan. The customers claim
is for $400 for a deposit on a specialty sofa that was never shipped. In what order will
the bankruptcy courts pay these claims?
ANSWER
The claims will be paid in this order,
1. The $500 health care claim not paid to the health care carrier for used benefits.
2. The sofa deposit of $400.
3. The unfunded pension plan of $300.

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540 Brooks n Financial Management: Core Concepts, 2e

Solutions to Advanced Problems for Spreadsheet Application


1. Issuing stock with an undersubscribed or oversubscribed issue.
Price
Bids
Client
A
B
C
D
E
F
TOTAL
Allocation of Shares
A
B
C
D
E
F
McEwing
TOTAL
Cost of Shares
A
B
C
D
E
F
McEwing
TOTAL

19.00
Scenario 1
400,000
120,000
630,000
180,000
130,000
140,000
1,600,000

Scenario 2
400,000
160,000
630,000
220,000
160,000
230,000
1,800,000

Scenario 3
500,000
200,000
630,000
220,000
200,000
250,000
2,000,000

Scenario 4
500,000
200,000
630,000
280,000
240,000
350,000
2,200,000

Scenario 5
600,000
260,000
630,000
280,000
280,000
350,000
2,400,000

Scenario 6
650,000
350,000
630,000
370,000
400,000
400,000
2,800,000

400,000
120,000
630,000
180,000
130,000
140,000
400,000
2,000,000

400,000
160,000
630,000
220,000
160,000
230,000
200,000
2,000,000

500,000
200,000
630,000
220,000
200,000
250,000
0
2,000,000

454545
181818
572727
254545
218182
318182
0
2,000,000

500000
216667
525000
233333
233333
291667
0
2,000,000

464286
250000
450000
264286
285714
285714
0
2,000,000

$ 7,600,000.00
$ 2,280,000.00
$ 11,970,000.00
$ 3,420,000.00
$ 2,470,000.00
$ 2,660,000.00
$ 7,600,000.00
$ 38,000,000.00

$ 7,600,000.00
$ 3,040,000.00
$ 11,970,000.00
$ 4,180,000.00
$ 3,040,000.00
$ 4,370,000.00
$ 3,800,000.00
$ 38,000,000.00

$ 9,500,000.00
$ 3,800,000.00
$ 11,970,000.00
$ 4,180,000.00
$ 3,800,000.00
$ 4,750,000.00
$
$ 38,000,000.00

$ 8,636,363.64
$ 3,454,545.45
$ 10,881,818.18
$ 4,836,363.64
$ 4,145,454.55
$ 6,045,454.55
$
$ 38,000,000.00

$ 9,500,000.00
$ 4,116,666.67
$ 9,975,000.00
$ 4,433,333.33
$ 4,433,333.33
$ 5,541,666.67
$
$ 38,000,000.00

$ 8,821,428.57
$ 4,750,000.00
$ 8,550,000.00
$ 5,021,428.57
$ 5,428,571.43
$ 5,428,571.43
$
$ 38,000,000.00

2013 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 15 n Raising Capital 541

2. Firm commitment versus best efforts.

4,000,000
5.50

3,800,000

3,768,252

Shares Available
Price Per Share

Volume
3768252.5

350,000 $

900,000

$ 168,500
$ (168,500)

725,389 $

$ 20,000,000 $ 20,000,000 $ 20,000,000 $ 20,000,000 $ 20,000,000 $ 20,000,000


$ 16,500,000 $ 18,150,000 $ 19,800,000 $ 20,350,000 $ 20,725,389 $ 20,900,000

3,700,000

1,000,000
700,000
400,000
3.50
2.64
0.50
$ (3,500,000) $ (1,850,000) $ (200,000) $

3,600,000

Volume
Firm Commitment
Proceeds To Client
Proceeds from Sale
Compensation to McEwing:
Shares Purchased
Cost per Share
NET Compensation

3,000,000
3,300,000
3,600,000
3,700,000
3,768,252
3,800,000
$ 15,922,500 $ 17,514,750 $ 19,107,000 $ 19,637,750 $ 20,000,000 $ 20,168,500
$ 577,500 $ 635,250 $ 693,000 $ 712,250 $ 725,389 $ 731,500
$ 16,500,000 $ 18,150,000 $ 19,800,000 $ 20,350,000 $ 20,725,389 $ 20,900,000

3,300,000

Best Efforts
Volume
Proceeds To Client
Compensation to McEwing:
Total Proceeds from Auction

$ (4,077,500) $ (2,485,250) $ (893,000) $ (362,250) $


$ 4,077,500 $ 2,485,250 $ 893,000 $ 362,250 $

3,000,000

Difference
Best Efforts vs. Firm Commitment
Client Company
McEwing Investments Bankers
Break Even Quantity for McEwing/Client

2013 Pearson Education, Inc. Publishing as Prentice Hall

542 Brooks n Financial Management: Core Concepts, 2e

$1,500,000
$1,000,000
$500,000
$-
$(500,000)
$(1,000,000)

McEwing Firm Commitment

$(1,500,000)

McEwing Best Efforts

$(2,000,000)
$(2,500,000)
$(3,000,000)
$(3,500,000)
$(4,000,000)

Solutions to Mini-Case
AK Web Developers.com
This case reviews the life cycle of a successful business from angel financing, through
the venture capital stage, and IPO liquidity event. It also covers shorter-term borrowing
decisions and requires computations to determine the lowest cost of borrowing.
1. The 1-year Treasury bill rates for 2002 through 2006 are given below:
Year
2002

2.00%

2003

1.24%

2004

1.89%

2005

3.62%

2006

4.94%

How much interest did MR Venture Capital receive each year? What was the
average interest rate paid by AK Web Developers over the 5-year period?

2013 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 15 n Raising Capital 543

Loan Amount = $6,000,000; Interest rate = 5% + 1-year T-bill rate


Year

1 yr T-Bill

Rate on
loan

Interest paid

2002

2.00%

7.00%

$ 420,000.00

2003

1.24%

6.24%

$ 374,400.00

2004

1.89%

6.89%

$ 413,400.00

2005

3.62%

8.62%

$ 517,200.00

2006

4.94%

9.94%

$ 596,400.00

Average Rate =(1.07*1.0624*1.0689*1.0862*1.0994)


(1/5
)=

.077296

Or 7.73%

2. Brooks Brothers Investment Bankers has offered AK Web Developers 2 options


for its initial public offering. In addition to the 500,000 shares held by the
original angel and the 6,000,000 shares held by the venture capitalists, AK will
offer 5,000,000 shares to the public at $20 per share. Brooks Brothers is willing
either to make a best efforts offering and keep 4% of the retail sales, or make a
firm commitment offer of $95,000,000. If AK Web Developers expects to sell at
least 95% of the shares, which offer should it accept?
If AK chooses the best efforts arrangement, it will receive $20/1.04=$19.23 per share.
In order to realize $95,000,000, it would need to sell 4,940,000 shares, or 98.8% of
the total shares being offered. If the company believes it may actually sell as few as
95% of the shares, it would be better off accepting the firm commitment for
$95,000,000.
3. Describe the steps the investments bankers and the firm must take before and
after the initial public offering.
Student answers will vary, but the key steps include:
a. Registration with the Securities and Exchange Commission (SEC). This process
includes the preliminary prospectus or red herring.
b. After a 20 day cooling off period, the company and its investment bankers
make revisions to the registration as required by the SEC.
c. After another 20-day period, if the SEC rules that everything is in order, the
securities are approved for sale to the public.
d. A tombstone ad describing the offer and listing the participating dealers is
published (usually in the Wall Street Journal.)
e. The investment bankers conduct a road show to solicit interest in the offering.
f.

The investment bankers conduct an auction to set the price of the stock.

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544 Brooks n Financial Management: Core Concepts, 2e

g. Trading begins on NASDAQ. The investment bankers serve as dealers. A green


shoe provision is often included to allow the dealer to meet demand for the
shares.
h. After a lock-up period of 180 days, insiders -- including the angel, venture
capitalists, and company officers -- may begin to trade their shares.
4. The provider of the original angel financing lent AK Web Developers $2,000,000
at the end of 1994. At the end of 2001, AK repaid the $2,000,000 principal on the
loan and gave him 500,000 shares in lieu of interest. At the end of 2007, he sold
the 500,000 shares at an average price of $22. What was his rate of return on the
original loan? (Hint: construct a time line of the cash flows, and find the internal
rate of return.)
The time line is shown below:
end of
1994

2,000,000

1995

1996

1997

1998

1999

2000

2001

2,000,000

2002

2003

2004

2005

2006

2007

11,000,000

Solve for IRR: 0=2,000,000/(1+irr)7+11,000,000/(1+irr)13-2.000,000


The equation can be solved by trial and error, or more efficiently using EXCEL or a
financial calculator. IRR=17.49%.

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Chapter 15 n Raising Capital 545

5. If MR Venture Capital sold its shares at the end of 2007 for the same $22 price,
what
was the rate of return on its investment? Include the interest payments
calculated in question 1.
The cash flows and timeline are as follows:
end of year
2001

(6,000,000.00)

2002

420,000.00

2003

374,400.00

2004

413,400.00

2005

517,200.00

2006

596,400.00

2007

132,000,000.00

irr

70.17%

Using the same procedure as for question 5


0=420/(1+irr)1 + 374.4/(1+irr)2 +413.4/(1+irr)3 + 517.2/(1+irr)4 + 596.4/(1+irr)5 +
132,000/(1+irr)6 6,000
Using EXCEL, the IRR is 70.17%.
6. Assume that AK Web Developers is a typical investment for MR Venture
Capital, but only one investment in six is actually successful. What is MRs
average overall rate of return? For the sake of simplicity, assume that the 5 out
of 6 investments that fail never make any payments to MR.
If only 1 in 6 investments is successful and the 5 that fail produce no cash flows at all
(perhaps an unrealistic assumption), then it would take an investment of $36,000,000
to produce the cash flows obtained by financing AK Web Developers.
0=420/(1+irr)1 + 374.4/(1+irr)2 +413.4/(1+irr)3 + 517.2/(1+irr)4 + 596.4/(1+irr)5 +
132,000/(1+irr)6 36,000
Using EXCEL, the IRR is 24.88%.
7. AK Web Developers also needs to raise $2,000,000 in short-term loans for
working capital needs.
a) Interbank offers an annual percentage rate of 6%, but the loan must be
repaid in 12 equal monthly installments. This arrangement is acceptable to
AK because the need for working capital will decline during the year.
Compute the monthly payment and the EAR for this loan.
Using a financial calculator, N=12, i/y=6/12, PV=2,000,000, FV=0 Solve for
PMT=$172,132.86.
The EAR on this loan is (1+.06/12)12-1=6.17%

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546 Brooks n Financial Management: Core Concepts, 2e

b) Bancnet offers a one year loan discounted at 6%. How much would AK need
to borrow in order to meet its initial need for $2,000,000? What is the EAR
for this loan?
AK would need to borrow $2,000,000/(1 .06) = $2,127,659.57. The EAR is
.06/(1 .06) = 6.38%
c) Webster Bank offers a one year loan at 6% add-on interest with a
compensating balance of 10%. How much would AK need to borrow in order
to meet its initial need for $2,000,000? What is the EAR for this loan?
AK would need to borrow $2,000,000/(1 .10) = $2,222,222.22. The EAR is
.06/(1 .10) = 6.67%

Additional Problems with Solutions


1. Venture capital required rate of return. Risk R Us Investors has a success ratio of
15% with its venture funding. Their owners require a rate of return of 25% for their
portfolio of lending, and the average length on each loan is 4 years. If you were to
apply to Risk R Us for a $200,000 loan, what is the annual percentage rate you would
be required to pay for this loan?
ANSWER

(Slides 15-47 to 15-48)

First calculate how much $200,000 is 15% of? i. e. $200,000/.15$1,333,333


So, in essence for every $200,000 they are lending you they effectively would be looking
to earn 25% on an investment of $1.33m to achieve their objective.
i.e. The venture capitalist will expect to earn a rate of 25% per year for 4 years on
An investment if $1,333,333.
Calculate the FV of $1,333,333 at the rate of 25% per year for 4 years.
N=4; I=25; PV=1333333; PMT = 0; CPT FV $3,255,208.33
So they expect the $200,000 investment in your venture to return $3,255,208.33.
Calculate the expected rate of return as follows:
N=4; PV = -200,000, FV = 3,255,208,33; PMT =0; CPT I = 100.86% APR
2. Discount loan versus straight loan. You want to borrow $250,000 for 1 year from
your bank and are given the following 2 options:
1) Pay $35,000 per month for 12 months starting at the end of the 1st month.
2) Take a discount loan at the rate of 8% per year and pay the entire face value of the
loan at the end of 12 months.
ANSWER

(Slides 15-49 to 15-50)

Calculate the EAR under each option and indicate your choice with an explanation.

2013 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 15 n Raising Capital 547

Option 1 is a straight loan with PV = $250,000; N=12; PMT = -35,000; FV=0; i9.05%
APR; EAR(1 + (.0905/12))12 1 = 9.43%
Option 2 is an 8% discounted loan, so to have $250,000 we would have to take on a loan
with a face value of $250,000/0.92 = $271, 739.13 which is what we would owe at the
end of 12 months. So our APR = Interest paid/Amount used$21,739.13/$250,000
8.695% which is also our EAR
Option 2 is better!
3. Bond proceeds. The Fire-Keepers Casino is in the process of issuing a 25-year, 9%
coupon (paid semi-annually) AA2-rated corporate bond with $1000 par value. If by
the time the bonds receive SEC clearance, the market yield on this bond goes to
9.35%, and the company sells 25000 of these bonds with the help of an investment
banker who charges them a commission rate of 2.5% on the proceeds, what will the
total proceeds be for the issuing company, and what is the cost of these bonds to the
firm in terms of the cost of capital? What are the firms future cash obligations?
ANSWER

(Slides 15-51 to 15-52)

P/Y=2;C/Y=2;N=50;PMT=45;FV=1000;I=9.35; PV$966.38
Gross proceeds from sale of bonds = 2500*$966.38=$2,415,9468.13
Investment bankers commission = .025*$2,415,943.13= $60,398.65
Total proceeds received by the issuing company = $2,355,547.47
Net proceeds per bond = $966.38*(1-.025) = $942.22
Cost of debt to Golden Corral based on net price:
P/Y=2; C/Y=2; PV=-942.22; N=50; PMT=45; FV=1000; I 9.61%
Future cash obligations:
Annual Coupon payments = $45*2*25=00 = $225,000
Principal payment at maturity = $1000*2500 = $2,500,000
4. Firm commitment versus best efforts. Big Apple Investment Bankers offers Northern
Diagnostics the following options on its initial public sale of equity: (1) a best-efforts
arrangement whereby Big Apple will keep 2 % of the retail sales or (2) a firmcommitment arrangement of $6,000,000. Lunar plans on offering 1,000,000 shares at
$7.50 per share to the public. If 100% of the shares are sold, which is the better
choice for Northern Diagnostics? Which is the better choice for Big Apple Investment
Bankers? What is the break-even sales percentage for Northern Diagnostics (point of
indifference) and what will each party receive at the break-even sales percentage?
ANSWER

(Slides 15-53 to 15-55)

Proceeds for Northern Diagnostics under each type of sales agreement:

2013 Pearson Education, Inc. Publishing as Prentice Hall

548 Brooks n Financial Management: Core Concepts, 2e

Best Efforts 1,000,000 $7.5 (1 0.02) = $7,350,000


Firm Commitment $6,000,000
Best choice for Northern Diagnostics is Best Efforts
Proceeds for Big Apple Investments under each type of sales agreement:
Best Efforts 1,000,000 $7.50 (0.02) = $150,000
Firm Commitment 1,000,000 $7.50 $6,000,000 = $1,500,000
Best choice for Big Apple Investments is Firm Commitment
To calculate break-even sales:
Sales Units $7.50 (1 0.02) = $6,000,000
Sales Units = $6,000,000 / $7.35 = 816,327 shares
Best Efforts at 816,327 shares
To Northern Diagnostics: 816,327 $7.50 (1 0.02) = $6,000,000
To Big Apple Investment: 816,327 ($7.5-$7.35) = $122,450
Firm Commitment at 816,327 sales:
To Northern Diagnostics: $6,000,000
To Big Apple Investments: 816,327 $7.5 $6,000,000 = $122,450
5. Commercial paper. Cereal City Instruments will issue commercial paper for a shortterm cash inflow. The paper is for 182 days, has a face value of $50,000, and is
anticipated to sell at 94% of par value. Cereal City wants to raise $5,000,000, so what
is the cost of this borrowing (annual terms) and how many papers will be sold?
ANSWER:

(Slides 15-56 to 15-57)

Selling price is 0.94 $50,000 = $47,000


The cost of this borrowing is:
182-day interest rate = ($50,000 $47,000) / $47,000 = 0.06383
Stated annually we have:
Annual Percentage Rate = 0.06383 365/182 = 12.801%
Effective Annual Rate = (1 + 0.06383)365/182 1 = 13.21%
The total number of papers sold will be:
Number issued = $5,000,000 / $47,000 = 107 (must sell in whole units)

2013 Pearson Education, Inc. Publishing as Prentice Hall