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CHƯƠNG 2 PE VS VENTURE VS BUYOUT

Business Finance I (University of Windsor)

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 15
1. Money that is offered to finance a new business is known as:
A. A general cash offer
B. Venture capital
C. Private placement
D. A rights issue
2. An investor exercises her right to buy one additional share at $20 for every five shares held. How much
should each share be worth after the rights issue if they previously sold for $50 each?
A. $35.00
B. $41.67
C. $45.00
D. $46.00
3. A firm's first offering of stock to the general public is known as:
A. first-stage financing
B. An IPO
C. A general cash offer
D. A seasoned offering
4. A secondary offering IPO occurs when:
A. New shares are sold to provide the company with additional funds
B. The second public issue of equity becomes available
C. The company's founders or venture capitalists market a portion of their shares
D. Not all of the shares in a primary IPO were sold
5. the most important function of an underwriter is to:
A. Assess the firm's capital needs
B. Approve the prospectus before distribution to the public
C. Provide private placement of the firm's debt
D. Buy the issue of securities from the firm and resell to the public
6. When underwriters issue securities on a best efforts basis, they:
A. Sell as much of the stock as possible, but with no guarantee
B. Submit a bid for purchase, which the issuer compares to other bids
C. Buy the entire issue from the firm
D. Guarantee that the issuer will receive the spread
7. If an underwriter charges the public $40 per share for a new issue after having promised the issuer $38
per share, the spread per share is:
A. $1.00
B. $2.00
C. $38.00
D. $40.00
8. When underwriters are unsure of the demand for a new offering, they:
A. Reduce their spread
B. Undertake the issue on a firm commitment basis
C. Undertake the issue on a best efforts basis
D. Provide shelf registration for the issue
9. A major purpose of the prospectus is to:
A. Inform investors of the security's rate of return
B. Advise investors of the security's potential risk
C. Distribute stock warrants to prospective investors
D. List the security's dividend payment dates
10. Studies have shown that, on average, new security issues are:
A. subject to flotation costs of approximately 32%
B. Overpriced by the amount of the spread
C. Underpriced
D. Overpriced to reward venture capitalists
11. The most likely reason that underpricing of new issues occurs more frequently than overpricing is
the:
A. Underwriters' desire to reduce the risk of a firm commitment
B. Demand for a new issue is typically too high
C. Underwriters earn low rates of return
D. Issuing firms demand that equity be underpriced
12. How much will a firm receive in net funding from a firm commitment underwriting of 250,000 shares
priced to the public at $40 if a 10% underwriting spread has been added to the price paid by the
underwriter? Additionally, the firm pays $600,000 in legal fees.
A. $8,400,000
B. $8,460,000
C. $8,490,000
D. $8,545,455
13. The primary reason for an underwriters' syndication is to:
A. Monitor the actions of the different underwriters
B. Reduce the risk of selling a large issue
C. Increase the size of the spread
D. Avoid the scrutiny of the Securities and Exchange Commission
14. Studies show that recent returns on venture capital investments have been:
A. Negative, on average
B. Zero, on average
C. Nearly 20%, on average
D. At least 50%, on average
15. Major international commercial banks are:
A. Responsible for most underwriting in the U.S
B. Not allowed to engage in any form of underwriting
C. Not able to compete with U.S. investment banks
D. Engaged in underwriting a significant portion of securities
16. The consent of a corporation's shareholders must be received prior to any:
A. Issue of new securities
B. Selection of an underwriter
C. Increase in authorized capital
D. Private placement of securities
17. When securities are issued under a rights issue:
A. Existing shareholders have the opportunity to expand their holdings
B. Shares are offered to the public at a discount
C. The existing shares will increase in price
D. Current shareholders have the right to resell their stock to the issuer
18. What would you expect to be the market price of stock after a sold-out rights issue if each existing
shareholder purchases one new share at $60 for each three that they currently hold and the current share
price is $100?
A. $75.00
B. $80.00
C. $85.00
D. $90.00
19. What was the market price of a share of stock before a rights issue if one share of new stock could be
purchased at $100 for every four shares that were previously owned? The stock price after the successful
rights issue was $200.
A. $150
B. $225
C. $241
D. $250
20. When a public company offers shares to the general public, it does so under a(n):
A. Rights issue
B. Initial public offering
C. Shelf registration
D. General cash offer
21. Shelf registration in the U.S. was enacted to allow:
A. The Department of Justice to prosecute those guilty of insider trading
B. The prospectus to be distributed after the sale of securities begins
C. Underwriters to join together in syndication
D. Single registration of limited future financing plans
22. Which one of the following would not be included among the benefits of shelf registration?
A. Reduction of lead time for security issuance
B. No additional registration necessary for five years
C. Issuer can take advantage of favourable conditions
D. Issuer can search for best underwriting terms
23. The allowance of POP registration in Canada is likely to have increased:
A. The cost of issuing new securities
B. The profits of venture capitalists
C. Competition among underwriters
D. The underpricing of securities
24. If a corporation's management, with its superior knowledge of proposed investments, considers a security
issue to be underpriced, it may react by:
A. Withdrawing the issue
B. Lowering the price of the existing shares to equal the new shares
C. Increasing the number of shares to be sold
D. Adopting POP registration, which automatically raises the issue price
25. If the announcement of a new equity offering causes current equity values to drop, then signaling theory
would predict that:
A. Supply of equity will outstrip demand
B. Management knows the issue to be overpriced
C. The firm has no attractive investment opportunities
D. Underwriters charge too high a spread
26. Issue costs for equity are higher than those for debt for all of the following reasons except:
A. Equity issues have higher administrative costs
B. Underwriting stock is riskier than underwriting bonds
C. Equity issues involve significantly more time to sell
D. Equity issues have lower economies of scale
27. A firm has just issued $250 million of equity, which caused its stock price to drop by 3%. Calculate
the loss in value of the firm's equity given that its market value of equity was $1 billion before the new
issue.
A. $7.5 million
B. $30.0 million
C. $33.3 million
D. $37.5 million
28. Companies making smaller security issues may prefer to issue them through:
A. A private placement because lower rates of return can be offered
B. A private placement because it is cheaper than a public issue
C. A public issue because it is cheaper than a private placement
D. A public issue because more exposure will be achieved
29. Which of the following statements is incorrect concerning private placements?
A. Terms of the financing can be custom-tailored
B. The securities are not made available to the public
C. The securities are often less marketable
D. Only a small amount of corporate debt is financed in this manner
30. Private placement of debt securities occurs more frequently in:
A. smaller-sized firms
B. larger-sized firms
C. Firms that are using venture capitalists
D. Combination with convertible bonds
31. In return for providing funds, venture capitalists receive:
A. Long-term bonds of the firm
B. Short-term bonds of the firm
C. An equity position in the firm
D. Ownership of the entire firm
32. Which of the following is least likely to explain why entrepreneurs contribute their personal funds to
start-up projects? Their contribution:
A. Acts as a signal to venture capitalists
B. Repays debt held by the venture capitalist
C. Retains a portion of the firm's equity
D. Provides incentive to expend efforts
33. What is the market value placed on a firm in which an entrepreneur invests $1 million and a venture
capitalist invests $3 million in first-stage financing for a 50% interest in the firm?
A. $4 million
B. $6 million
C. $7 million
D. $8 million
34. Second-stage financing occurs:
A. prior to the initial public offering
B. When company founders sell a portion of their shares
C. After the best efforts of the underwriters
D. When the IPO does not raise sufficient cash
35. One of the primary reasons for disbursing venture-capital funds in installments is to:
A. Avoid tax liability
B. Identify and cut losses early
C. Increase the importance of the venture capitalist
D. Take advantage of the time value of money
36. The difference between an IPO and a secondary offering is that:
A. The secondary offering does not incur direct costs
B. Venture capitalists fund the secondary offering
C. Additional, non-outstanding shares are issued in an IPO
D. Shares may be repurposed by the underwriter in a secondary offering
37. Stock underwriters are:
A. Investors seeking low prices
B. Regulatory agencies that evaluate equity offerings
C. The firm's founders who guarantee a stock's performance
D. Investment banking firms that coordinate equity offerings
38. When underwriters offer a firm commitment on a stock issue, they:
A. Employ their best efforts in selling the stock
B. Guarantee the proceeds to the issuing firm
C. Agree to purchase the venture capitalists' shares
D. Assure purchasers that the stock will appreciate
39. Which of the following is correct for stock issued under a firm commitment where the underwriter is to
receive an 8% spread?
A. The underwriter's profits are guaranteed to be 8%
B. The underwriter must sell at least 92% of the shares
C. The underwriter receives 8% of all shares
D. The underwriter may suffer a loss on the issue
40. An underwriter issues a firm commitment to sell 1 million shares at $20 each, including a $2 spread. How
much does the issuing firm receive if only 500,000 shares are sold?
A. $9 million
B. $10 million
C. $18 million
D. $20 million
41. Which of the following is correct if an underwriter is selling stock to the public at $40 per share, the
underwriter receives a $3 per share spread, 2 million shares are sold, and the issuing firm receives $111
million from the underwriter?
A. The underwriter's spread was greater than $3
B. The issue appreciated in price immediately
C. The issue included 3 million shares
D. The stock was issued on a best efforts basis
42. Provincial securities regulations exist in order to:
A. Protect stock underwriters from fraudulent firms
B. Restrict the amount of profit from IPOs
C. Control the amount of stock owned by one investor
D. Protect investors from deceptive firms
43. Securities exchanges will not permit securities to be sold:
A. If they have been overpriced
B. prior to approval of the registration statements
C. Unless the issuer guarantees their value
D. Until a shelf registration exists
44. Prospective investors are advised of a stock's potential risks by the:
A. underwriter
B. Underpricing laws
C. Prospectus
D. Initial public offering
45. One strategy that appears to be used by certain underwriters to reduce the risk of marketing a stock is
to:
A. Offer a firm commitment on the issue
B. Set the initial stock price below its true value
C. Sell the securities in foreign countries
D. Offer price rebates on the stock purchases
46. The "winner's curse" is a reminder that:
A. Successful bidders may often overpay for an object
B. Underwriters charge excessive fees
C. Stocks are much riskier than bonds
D. Underpricing an issue is a cost to existing owners
47. The direct expense of a stock issue includes the:
A. Cost of underpricing the stock
B. Underwriting spread and other expenses
C. Underwriting spread, other expenses, and cost of underpricing
D. Underwriting spread
48. What%age of direct expense is required to market stock if the issuer incurs $1 million in other expenses
to sell 3 million shares at $34 each to an underwriter and the underwriter sells the shares at $40 each?
A. 6.98%
B. 7.19%
C. 7.75%
D. 8.33%
49. What %age of direct expense is required to market stock if the issuer incurs $1 million in other expenses
to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each?
A. 6.98%
B. 7.19%
C. 7.75%
D. 8.33%
50. Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an
underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the
issuing company's stock price had risen to $70. What is the cost of underpricing?
A. 81 million
B. 91 million
C. 101 million
D. 111 million
51. Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an
underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the
issuing company's stock price had risen to $70. What is the total cost (direct expenses plus underpricing
cost)?
A. 81 million
B. 91 million
C. 101 million
D. 111 million
52. Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an
underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the
issuing company's stock price had risen to $70. In %age terms, how much market value is absorbed by
the total cost (direct expenses plus underpricing cost)?
A. 13.33%
B. 23.33%
C. 33.33%
D. 43.33%
53. Stock that is sold through a rights issue:
A. Is offered for cash to the general investing public
B. Will not affect the market price of the shares
C. is limited for sale to existing shareholders
D. Must be sold on a firm commitment basis
54. What is the primary reason for a reduction in share value after a successful rights issue? The new
shares:
A. Have higher underwriting expense
B. Are offered at attractive prices
C. Reduce the firm's return on equity
D. Do not include voting rights
55. A rights issue offers the firm's shareholders one new share of stock at $40 for every three shares of stock
they currently own. What should be the stock price after the rights issue if the stock sells for $80 per
share before the issue?
A. $56.67
B. $60.00
C. $70.00
D. $71.33
56. The POP system allows firms to:
A. Purchase securities for up to two years without registration
B. Incur only short time delays in selling securities
C. Wait for two years before paying for securities
D. Offer rights issues to non-existing shareholders
57. Which of the following statements is generally true concerning the costs of security issue?
A. Underpricing is rarely a significant cost
B. Equity is cheaper to issue than debt
C. Debt is cheaper to issue than equity
D. There are no economies of scale in security issuance
58. Some investors believe that the decision by management to issue equity as opposed to issuing debt is a
signal that:
A. The stock is currently undervalued
B. The stock is currently overvalued
C. The firm will avoid dilution of stock value
D. A shelf registration of securities will occur
59. Which of the following security issues might have the lowest direct costs?
A. Bonds
B. Convertibles
C. Seasoned equity offerings
D. IPOs
60. A private placement avoids which of the following costs?
A. Depression in the stock price
B. Administration costs
C. Registration with the SEC
D. Fixed costs
61. Private placement of securities involves:
A. Selling only to the firm's current investors
B. Non-disclosure of the issuing firm's name until after the sale
C. The exchange of convertible bonds for equity
D. Non-public sale of securities to a limited number of investors
62. Which of the following methods may be particularly cost effective to smaller issuers of securities?
A. Seasoned offerings
B. Private placement
C. General cash offer
D. Best efforts underwriting
63. To be successful, a start-up business will require:
A. Taking a big risk, even if the payoff is only mediocre
B. Funds from a venture capitalist
C. Large amounts of debt financing
D. An initial public offering
64. If an investor can earn 20% on underpriced IPOs, but will lose 10% on overpriced IPOs in which he was
awarded $2,000 worth of the overpriced issue, how much of the underpriced issue must he be awarded in
order to gain $500?
A. $1,500
B. $2,500
C. $3,500
D. $10,000
65. When issuing new stock, a firm received $50 million while the underwriting spread was $4 million and
total direct expenses were $6 million. The %age of the proceeds absorbed by direct expenses was:
A. 7.14%
B. 8.00%
C. 10.71%
D. 12.00%
66. All of the following are advantages of shelf registration except:
A. The issuing firm can avoid competition from underwriters
B. Securities can be issued with short notice
C. Securities can be issued in small amounts without excessive costs
D. It allows the firm to take advantage of market conditions
67. Second-stage financing:
A. Involves a substantial increase in leverage
B. Immediately precedes first-stage financing for every new business
C. Involves issuing more stock
D. Occurs when the company is in danger of bankruptcy
68. Firms go public to:
A. Raise additional capital
B. Diversify public debt holders' risk
C. Avoid second stage financing
D. Increase their leverage
69. In a firm commitment, the underwriter:
A. Encounters virtually no risk because the spread is fixed
B. Is allowed to sell the shares at any price they choose
C. Is protected against being stuck with unsold shares
D. Is allowed to sell the shares at a price slightly higher than the price they paid to the company
70. Those subject to the winner's curse are:
A. underwriters
B. uninformed investors
C. firms issuing IPOs
D. venture capitalists
71. Plasti-tech Inc. has decided to go public and has sold 2 million of its shares to its underwriter for $20
per share. The underwriter then sold them to the public for $22 each. Plasti-tech also encountered $0.5
million in administrative fees. Soon after the issue, the stock price rose to $25. Find Plasti-tech Inc.'s total
cost of this issue.
A. $4.5 million
B. $9.5 million
C. $10.5 million
D. $14.5 million
72. Underwriters are used for all of the following except:
A. Selling securities to the public
B. Making initial public offerings
C. Assisting a company in raising cash
D. Providing equity capital for young businesses
73. Currently, M & S Inc. has 2 million shares outstanding selling at $70 a share. A rights issue will be made
that allows 1 share to be purchased for every 5 shares currently held by stockholders for $40 each. Which
of the following is true?
A. The number of shares outstanding will fall to 1.6 million
B. The firm will raise $13.33 million
C. The stock price will fall to $65
D. The total value of the firm will equal $124 million
74. In regards to new issues of common stock, economists have found that the announcement of a new
issue:
A. Results in the stock price falling
B. Causes the stock price to rise
C. Has no effect on the stock price
D. Increases the market value of the stock temporarily
75. Venture capital is traded for an equity interest rather than a debt interest in the new firm.
True False
76. When securities are issued under a firm commitment, the underwriter bears the risk of low sales.
True False
77. The costs of underpricing an equity issue are borne mostly by the underwriter.
True False
78. Underwriters are guaranteed to profit by at least the amount of the spread.
True False
79. Rights offerings are gaining in popularity in Canada although they are declining on a foreign basis.
True False
80. Bought deals are more common in the U.S. than in Canada.
True False
81. Economies of scale are apparent in the issuance of securities.
True False
82. Issue costs for debt are considerably lower than issue costs for equity securities.
True False
83. The evidence indicates that stock prices decrease by approximately 3%, on average, when new equity
issues are announced.
True False
84. Firms are attracted to the private placement of debt because of the lower average interest rates.
True False
85. A prospectus certificate indicates equity ownership in a firm.
True False
86. IPOs are generally overpriced in order to raise large amounts of cash.
True False
87. The winner's curse theory assumes that the informed investor receives the majority of the underpriced
IPOs.
True False
88. Underwriters are commercial banking firms that act as financial midwives to a new issue.
True False
89. Underwriters usually play a triple role—first providing the company with procedural and financial
advice, then buying the stock, and finally reselling it to the public.
True False
90. Sometimes new issues are dramatically underpriced.
True False
91. Underwriters typically try to overprice the initial public offering.
True False
92. Privately placed securities may be difficult to remarket.
True False
93. A rights issue is one in which a public company offers shares only to existing shareholders in order to
raise additional cash.
True False
94. According to the efficient market hypothesis, large issues of new stock may depress the stock price
temporarily.
True False
95. A general cash offer is necessary when issuing a private placement.
True False
96. Private placement contracts may be custom tailored for each individual investor.
True False
97. One advantage to private placements is the low cost associated with its issue.
True False
98. Typical firms that engage in private placements usually have a low degree of risk.
True False
99. Why is it likely that venture capital is disbursed in installments, rather than issuing all necessary funds at
once?

100.How do firms make initial public offerings and what are the costs of such offerings?
101.Discuss the functions conducted by security underwriters.

102.What risk is assumed by an underwriter when issuing a firm commitment to a corporation? Will the
corporation be better off with the firm commitment?

103.Why do provincial securities commissions deem it necessary to require the issuance of a prospectus prior
to security issuance?

104.The Ajax Corporation has received a firm commitment from its underwriter to purchase 1 million shares
of stock that will be marketed to the general public at $23 per share. The underwriter's spread is $1.90
per share and the issuing firm will pay an additional $1.65 million in legal and other fees. The issue was
fully sold on the first day and the stock closed at $27.50 on that day. Calculate both the direct expense
of issuance and the indirect (i.e., underpricing) expense. What% of the market value of the shares is
represented by these costs?

105.The liquidity of Baja Corporation has been heading south, and it contemplates a rights issue. There are
currently 2 million shares outstanding with a market value of $60 each. The firm needs to raise $24
million and wants you to design a rights issue that will allow the new stock price to be no lower than $55
and for there to be no more than 2.5 million shares outstanding after the issue. How many shares must be
held to obtain the right to one new share, and what will be the price of the new share?
106.Discuss the potential benefits to a corporation of POP registration, coupled with bought deals.

107.Discuss the potential agency issue with managers' issuance of new equity.

108.Why does private placement of securities appear to be more popular with small- or medium-sized firms?

109.What is a security?

110.What is venture capital?

111.My investment record indicates the following sample of IPO's

What is the average underpricing of this sample of IPO's?

112.MaDonna's has just completed an initial public offering. The firms sold 6 million shares at an offer price
of $16 per share. The underwriting spread was $.50 per share. The price of the stock closed at $22 per
share at the end of the first day of trading. The firm incurred $200,000 in legal, administrative, and other
costs. What were flotation costs as a fraction of funds raised?

113.Midlands marketing research cost is $300 million. The firm issues an additional $50 million of stock,
but as a result the stock price falls by 2%. What is the cost of the price drop to existing shareholders as a
fraction of the funds raised?

114.What is the total amount of new money raised?

115.What is the expected stock price after the rights are issued?

A South African group needs to raise $4 million to pay for its diamonds in the near future. It will raise
the funds by offering rights of 400,000 each, and which entitles the owner to buy one new share. The
company currently has one million shares outstanding priced at $40 each.
116.What must be the subscription price on the rights the company plans to offer?
117.What will be the share price after the rights issue?

118.A firm decides to raise $1 million with a rights issue. The issue will be based on a subscription price of
$20, with 50,000 shares to be issued. Assume the shares outstanding currently trade for $35. Calculate the
Ex-rights price of the company stock.

119.Stanfield Inc. needs to raise $12.5 million in capital. The company's investment bankers recommend
an offer price (or gross proceeds) of $15 per share; and Stanfield will receive $14 per share. How many
shares of stock will Don's need to sell in order to receive the $12.5 million they need? Calculate the
underwriter's spread on the issue.

120.Xerat Corporation issued 5 million shares of new stock. The offer price on the stock was $12.50 per share
and the company received a total of $57.5 million from the offering. Calculate the net proceeds and the
underwriter's spread charged by the underwriter. What%age of the gross proceeds is the investment bank
charging for underwriting the stock issue?

121.What is a shelf registration? Why would a public firm want to issue securities using a shelf registration?
122.Detail the difference between a prospectus and a red herring prospectus?

123.What are the net proceeds, gross proceeds and underwriter's spread? How does each affect the funds
received by a public firm when debt or equity securities are issued?

124.What are the advantages and disadvantages to a new or small firm of getting capital funding from a
venture capital firm?

125.Differentiate between regular underwriting, firm commitment underwriting, and best efforts
underwriting.

126.Tetus Corporation went public with an initial public offering of 2.5 million shares of stock. The
underwriter used a firm commitment offering in which the net proceeds was $8.05 per share and the
underwriter's spread was 8% of the gross proceeds. Tetus also paid legal and other administrative costs of
$250,000 for the IPO. Calculate the gross proceeds and the total funds received from the sale of the 2.5
million shares of stock.
127.Ying Corporation, Inc. plans to issue 10 million additional shares of its stock. The investment bank
recommends net proceeds of $19.90 per share and will charge an underwriter's spread of 5.5% of the
gross proceeds. In addition, Ying Corporation must pay $2 million in legal and other administrative
expenses. Calculate the gross proceeds and the total funds received by Ying Corporation from the sale of
the 10 million shares of stock.

128.LiveBetter can choose between the two following issues:

a. A public issue of $10 million face value of 10-year debt. The interest rate on the debt would be 8.5%
and the debt would be issued at face value. The underwriting spread would be 1.5% and other expenses
would be $80,000.
b. A private placement of $10 million face value of 10-year debt. The interest rate on the debt would be
9% and the total issuing expenses would be $30,000.
Which deal should LiveBetter choose?
 15 Key
1. B

2. C

3. B

4. C

5. D

6. A

7. B

8. C

9. B

10. C

11. A

12. C

13. B

14. C

15. D

16. C

17. A

18. D

19. B

20. D

21. D

22. B

23. C

24. A

25. B

26. D

27. B

28. B

29. D

30. A

31. C

32. B

33. B

34. A

35. B

36. C
37. D

38. B

39. D

40. C

41. C

42. D

43. B

44. C

45. B

46. A

47. B

48. B

49. C

50. A

51. B

52. D

53. C

54. B

55. C

56. B

57. C

58. B

59. A

60. C

61. D

62. B

63. B

64. C

65. C

66. A

67. C

68. A

69. D

70. B

71. C

72. C

73. C

74. A
75. TRUE

76. TRUE

77. FALSE

78. FALSE

79. FALSE

80. FALSE

81. TRUE

82. TRUE

83. TRUE

84. FALSE

85. FALSE

86. FALSE

87. TRUE

88. FALSE

89. TRUE

90. TRUE

91. FALSE

92. TRUE

93. TRUE

94. FALSE

95. FALSE

96. TRUE

97. TRUE

98. FALSE

99. Venture capitalists are unlikely to issue all necessary funds at once for at least two reasons. First of all, the majority of individual projects that
receive venture capital funding do not succeed. Thus, it is more likely for the venture capitalist to be able to cut losses earlier if fewer funds have
been distributed. The next reason relates to potential agency problems. Specifically, the entrepreneur may feel fewer ties to the venture capitalist
if all funds are distributed at the beginning of the project. This may even cause the entrepreneur—whether consciously or subconsciously—to be
less cautious than is optimal. Finally, the venture capitalist may receive better accountability for the spending of the funds if they are disbursed in
installments.

100. The initial public offering is the first sale of shares in a general offering to investors. The sale of the securities is usually managed by an
underwriting firm which buys the shares from the company and resells them to the public. The underwriter helps to prepare a prospectus, which
describes the company and its prospects. The costs of an IPO include direct costs such as legal and administrative fees, as well as the underwriting
spread—the difference between the price the underwriter pays to acquire the shares from the firm and the price the public pays the underwriter for
those shares. Another major implicit cost is the underpricing of the issue—that is, shares are typically sold to the public somewhat below the true
value of the security. This discount is reflected in abnormally high average returns to new issues on the first day of trading.

101. There are three basic functions performed by underwriters. First, they operate as advisor to firms that contemplate new security issues. It is
rather doubtful in this function that there exists much of an agency problem; reputation is quite important to the underwriter and if they encouraged
issues that were ultimately unsuccessful, they would rapidly see their business going to other underwriters. Next, underwriters, acting either on
a firm commitment or best efforts basis, will purchase the issue of securities from the firm. This is without recourse under the firm commitment
basis. Finally, the underwriter will sell the securities to the general public. This effort is conducted either alone or in syndication with other
underwriters in the case of a large issue. A portion of the success of the sale can come from that which the underwriter has selected, which of
course deals with issues such as reputation and sales network. In return for these services, the underwriter earns a spread on the securities that are
underwritten.
102. The firm commitment obligates the underwriter to purchase the entire issue from the firm at the agreed price. The responsibility for selling
the issue then lies entirely with the underwriter; the firm has already received its funds. Is this method a sure gain to the firm? Not necessarily,
since underwriters should be assumed rational. It would seem logical that the underwriter will increase the spread in response for taking on the
added risk. Further, the underwriter may be inclined to set the price to the public lower than it would have been on a best efforts basis. If there is
more underpricing with a firm commitment, then the firm might have been better off to accept a best efforts bid from the underwriter. Finally, the
underwriter takes on conceivably even more risk when there is a syndication, since the price to the public cannot be reduced unless the syndication
is broken. It is unclear whether the firm receives more funds with a firm commitment.

103. In the case of newly issued securities being purchased by experienced financial analysts, it is doubtful that a prospectus would have
been necessary. However, it is not always the case that experienced financiers are purchasing the issue, and the commissions therefore feels
an obligation to protect an unsuspecting public from potentially unscrupulous firms. The prospectus informs the prospective investor that the
regulatory agency is reviewing the firm's upcoming issue—not to issue a stamp of approval to the project itself—but rather to verify that the firm
has complied with all legal requirements of disclosure. The prospectus will further attempt to warn the investor of the investment's risk. More
specifically, if the prospectus is taken at face value, it may prove difficult to sell any of the new issue. The issue boils down to the observation that
in the complicated world of finance, it may be difficult for prospective investors to evaluate the riskiness of a project for themselves. Thus, the
prospectus attempts to inform them of potential downfalls associated with this investment.

which represents 29.27% of the $27.5 million in market value of the issue.

104.104.

Note that students could use other issue ratios as long as $24 million is raised, no more than 500,000 shares are issued, and price does not fall more
than $5 per share. At least 400,000 shares must be issued, and that would not allow the price per share to drop below $60.
Thus, the terms of the right issue are one share priced at $48 for every four held. The price will stay above the floor of $55, and will specifically be
$57.60.
$57.60 = new stock price
240 + 48 = 5 × new stock price
4(60) + 48 = 5 × new stock price
To raise $24 million with no more than 500,000 new shares, the price must be set at $48 per share. Then,
105. Since no more than 500,000 shares are to be raised, a 'one share for every four currently held' would be feasible.

106. POP registration allows short-form filing since much of the information contained in a regular prospectus is already expected to be filed
annually. Regulators clear the POP registration in about five days, rather than in several weeks in the case of regular registration. Bought deals
involve presold share blocks to large investment dealers who decide how to market these shares strategically to their customers. So POP and
bought deals work well together to satisfy regulators about market making and security and disclosure. So a quick regulatory commitment is
combined with a quick purchase commitment from the market, saving the issuing firm time and risk in two ways, while safeguarding markets.

107. The potential agency issue provides a different rationale for the observed decrease in share price that occurs when a new equity issue
is announced. Originally, this decrease was explained in terms of supply and demand; the increased supply of shares will result in a lower
equilibrium value for each share in the market. However, when it is remembered that managers are privy to all information concerning the use
for newly acquired funds and the returns that will be generated, it is speculated that managers would not be as likely to issue equity unless the
equity is overpriced. Thus, the mere announcement of a new equity issue signals to prospective investors that the issue is overpriced, and they will
accordingly reduce the value of shares in the market to compensate. This explanation, then, does not rely on supply and demand to explain the
reduction in value.

108. This observation is due to the fact that larger firms, assumed to be more stable, are likely to have better bargaining power with underwriters
and literally more avenues available to them for debt issuance. Furthermore, it is more likely that larger firms will be raising a large enough
amount of funds to take advantage of economies of scale present in the issuance of securities. Also important may be the fact that there are fewer
analysts following small firms. Information about these smaller firms may be less reliable, which makes their debt issues riskier and may require
more individualized terms of lending or debt covenants.

109. To obtain cash for 90 days, a business firm would most probably go to the money market in which it would sell a 90-day security. To obtain
cash for 10 years, a firm would sell a security in the capital market.

110. A unique service that is provided to firms by a venture capitalist.

111. (8+16)/2 = 12%

Flotation cost/funds raised = 21.2/96 = 22%
Funds raised = $16 x 6 million = $96 million

112. Underwriting costs for MaDonna's:

113. The lost value to the original shareholders is 2% of $300 million = $6 million. This is 6% of the value of the funds raised.

114. The number of new shares is 5 million/2 = 2.5 million. Each share is sold for $2.50, so new money raised is $6.25 million.

115. After the issue there are 6.25 million shares. The total value of the firm is $30 million plus $6.25 million. The new share price is $36.25
million/$6.25 million shares = $5.80 per share.

116. $4 million/400,000 = $20.

117. The current value of the firm is $40 million, and there are 1 million shares outstanding. When the rights are exercised, the firm will raise $4
million, and total value will increase to $44 million. Share outstanding will increased to 2.2 million. Price per share will be $22/2.2 = $10

= $32.
(4 × $35 + $20)/5 = $160/5
The expected ex rights price is
Feedback: Ex rights price = 1/(N + 1) × (N × initial stock price + subscription price)
118. A

= $15 - $14 = $1
Underwriter's spread = Gross proceeds - Net proceeds
Number of shares sold = $12.5 million/$14 = 892,857 shares
119. Funds needed = $12.5 million = $14 x Number of shares sold

Investment bank's %age of gross = $1.000/$12.50 = .08 or 8%

Underwriter's spread = $5,000,000/5,000,000 = $1.000
Underwriter's funds = $62,500,000 - $57,500,000 = $5,000,000
Gross funds received = $12.50 x 5,000,000 = $62,500,000
120. Net proceeds = $57,500,000/5,000,000 = $11.50

121. To reduce registration time and costs, and still protect the public by requiring issuers to disclose information about the firm and the security
to be issued, the US Securities & Exchange Commission passed a rule in 1982 allowing for "shelf registration." A shelf registration allows firms
that plan to offer multiple issues of stock over a two-year period to submit The registration statement summarizes the firm's financing plans for
the two-year period. Thus, the securities are shelved for up to two years until the firm is ready to issue them. Once the issuer and its investment
bank decide to issue shares during the two-year shelf registration period, they prepare and file a short form statement with the SEC. Upon SEC
approval, the shares can be priced and offered to the public usually within one or two days of deciding to take the shares "off the shelf." Thus, shelf
registration allows a firm to get stocks into the market quickly if the firm feels conditions (especially the price they can get for the new stock) are
right, without the time lag generally associated with full SEC registration.

122. At the same time that the issuing firm and its investment bank prepare the registration statement to be filed with the Securities Commission,
they must also prepare a preliminary version of the public offering's prospectus called the red herring prospectus. The red herring prospectus
is similar to the registration statement, but is distributed to potential equity buyers. Once the Securities Commission registers the issue, the red
herring prospectus is replaced with the official or final prospectus.

123. In a firm commitment underwriting, the investment bank purchases stock from the issuing firm for a guaranteed price (called the net
proceeds) and resells them to investors at a higher price (called the gross proceeds). The difference between the gross proceeds and the net
proceeds on an issue (called the underwriter's spread) is compensation for the expenses and risks incurred by the investment bank.
124. Venture capital firms receive unsolicited proposals for funding from new and small firms. The venture capital firms reject the majority of
these requests. Venture capital firms look for two things in making their decisions to invest in a firm. The first is a high return. Venture capital
firms are willing to invest in high-risk new and small firms. However, they require high levels of returns to take on these risks. The second is an
easy exit. Venture capital firms realize a profit on their investments by eventually selling their firm interests. They want a quick and easy exit
opportunity when it comes time to sell. Venture capital firms provide equity funds to new, unproven, and young firms. This willingness separates
venture capital firms from commercial banks and investment firms, which prefer to invest in existing, financially secure businesses.

125. Regular underwriting is the purchase of securities from the issuing company by an investment banker for resale to the public. With a firm
commitment, the underwriter buys the entire issue of securities at an agreed upon price from the issuer, and assumes responsibility for reselling
them. With best efforts, the underwriter promises to sell as much as possible at the offer price, but unsold securities are returned to the issuer.

Gross proceeds = $8.05/(1 - .08) = $8.75 x 2,500,000 = $21,875,000

(.08 x Gross proceeds) + $8.05 = Gross proceeds = > Gross proceeds - (.08 x Gross proceeds) = $8.05
Underwriter's spread + Net proceeds = Gross proceeds
126. 2,500,000 x $8.05 = $20,125,000 = Total funds received

Gross proceeds = $21.27 x 10,000,000 = $212,700,000

((.055 x Gross proceeds) + $0.20) + $19.90 = Gross proceeds => Gross proceeds - (.055 x Gross proceeds) = 19.90 + $0.20 => Gross proceeds =
$20.10/(1 - .055) = $21.27
Underwriter's spread + Net proceeds = Gross proceeds
Legal and other admin expenses per share = $2,000,000/10,000,000 = $0.20
127. 10,000,000 x $19.90 = $199,000,000 = Total funds received by Howett Pockett

This exceeds the savings in direct issue costs ($200,000) so the public issue appears to be the better deal in monetary terms. However, the private
placement has the advantages that the terms of the debt can be custom-tailored and that the terms can be more easily renegotiated. (Note that we
use a discount rate of 8.5%, rather than 9%, because 8.5% is the yield to maturity at which public investors are willing to invest in the bond when
the company pays the cost of the issue directly to the underwriters. In the private placement, part of the 9% coupon rate should be considered
compensation for issuance costs that are not charged for explicitly.)
Net proceeds of private placement = $9,970,000; The extra interest paid on the private placement is: 0.005 x $10 million = $50,000 per year The
present value of 5 payments of $50,000 for 10 years at 8.55% = $328,067
128. Net proceeds of public issue = $10,000,000 - $150,000 - $80,000 = $9,770,000
 15 Summary
Category # of Questions
Brealey - Chapter 15 129
Difficulty: Easy 25
Difficulty: Hard 12
Difficulty: Medium 91
Learning Objective: 15.1 41
Learning Objective: 15.2 20
Learning Objective: 15.3 49
Learning Objective: 15.4 18
Type: Multiple Choice 74
Type: Short Answer 30
Type: True False 24