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CHAPTER 15
2. a. B; best efforts occur when the underwriter promises “only to try” and sell
the issue.
c. The difference between the offer price and the price paid to the issuer
4. a. A large issue
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Chapter 15 - How Corporations Issue Securities
b. A bond issue
Est. Time: 01 – 05
5. a. False. First stage financing is normally provided by family funds and bank
loans. Second, stage financing is sometimes provided by angel investors
or venture capital firms, but venture capital firms rarely provide funding for
all development expenses up front. Rather, they provide funding on a
stage-by-stage basis. Very few companies will continue on to the phase of
issuing an IPO to raise funds.
c. True
Est. Time: 01 – 05
b. To answer this question, we must now take into account the differing
interest rates. To do this, calculate the PV of the extra interest on the
private placement:
The extra cost of the higher interest on the private placement more than
outweighs the savings of $200,000 in issue costs, ignoring taxes.
c. Private placement debt can be custom tailored and the terms more easily
renegotiated than public debt.
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Chapter 15 - How Corporations Issue Securities
Est. Time: 06 – 10
Est. Time: 06 – 10
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Chapter 15 - How Corporations Issue Securities
g. Blue-sky laws are state laws governing the sale of securities within
the state.
Est. Time: 06 – 10
Est. Time: 01 – 05
10. If he is bidding on underpriced stocks, he will receive only a portion of the shares
he applies for. If he bids on undersubscribed stocks, he will receive his full
allotment of shares, which no one else is willing to buy. Hence, on average, the
stocks may be underpriced but once the weighting of all stocks is considered, it
may not be profitable. This is known as the winner’s curse.
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Chapter 15 - How Corporations Issue Securities
Est. Time: 01 – 05
11. There are several possible reasons why the issue costs for debt are lower than
those of equity, among them:
The cost of complying with government regulations may be lower for debt.
The risk of the security is less for debt and hence the price is less volatile.
This decreases the probability that the issue will be mispriced and therefore
decreases the underwriter’s risk.
Est. Time: 01 – 05
12. a. Inelastic demand implies that a large price reduction is needed in order to
sell additional shares. This would be the case only if investors believe that
a stock has no close substitutes (i.e., they value the stock for its unique
properties).
If (b) is the reason for the price fall, there should be a subsequent price
recovery. If (a) is the reason, we would not expect a price recovery, but
the fall should be greater for large issues. If (c) is the reason, the price fall
will depend only on issue size (assuming the information is correlated with
issue size).
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13. a. Example: Before issue, there are 100 shares outstanding at $10 per
share. The company sells 20 shares for cash at $5 per share. Company
value increases by: (20 x $5) = $100. Thus, after issue, each share is
worth:
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Chapter 15 - How Corporations Issue Securities
b. Example: Before issue, there are 100 shares outstanding at $10 per
share. The company makes a rights issue of 20 shares at $5 per share.
Each right is worth:
The shareholder’s total wealth is unaffected as the right can be sold for
$.83, in which case the shareholder will own a stock worth $9.17 and have
$.83 in cash. Thus, the shareholder will still have a value of $10.
.
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14. a. Number of new shares = existing shares / number of new shares per
existing share
Number of new shares = 10,000,000 / 4
Number of new shares = 2,500,000
A stockholder who previously owned four shares had stocks with a value
of: (4 €6) = €24. This stockholder has now paid €5 for a fifth share so
that the total value is: (€24 + €5) = €29. This stockholder now owns five
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Chapter 15 - How Corporations Issue Securities
shares with a value of: (5 €5.80) = €29, so that she is no better or worse
off than she was before.
d. The share price would have to fall to the issue price per share, or €5 per
share. Firm value would then be:
Est. Time: 11 – 15
At the €4 issue price, the number of shares needed to raise the same amount of
funds is:
A stockholder who previously owned 3.2 shares had stocks with a value
of: (3.2 €6) = €19.20. This stockholder has now paid €4 for one
additional share so that the total value is: (€19.20 + €4) = €23.20. This
stockholder now owns 4.2 shares with a value of: (4.2 €5.52) = €23.20,
so that she is no better or worse off than she was before. Thus, the
shareholder is the same position regardless of the issue price.
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Chapter 15 - How Corporations Issue Securities
d. The share price would have to fall to the issue price per share, or €4 per
share. Firm value would then be:
Est. Time: 06 – 10
16. Before the general cash offer, the value of the firm’s equity is:
Price per share after general cash offer = €72,500,000 / 13,125,000 = €5.5238
Existing shareholders have lost = €6.00 – 5.5238 = €.4762 per share
Total loss for existing shareholders = €0.4762 × 10,000,000 = €4,762,000
Except for the rounding error, we see that the gain for the new shareholders
comes at the expense of the existing shareholders.
Est. Time: 11 – 15
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Chapter 15 - How Corporations Issue Securities
c. Money left on table = number of shares × (end of day price – offer price)
Money left on table = 100 × ($160 – 50)
Money left on table = $11,000
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c. The price to the public was $80 per share, so if one day later they sold at
$105 per share, the degree of underpricing was $25 or 24% [= 1 – ($80 /
$105)]; this seems higher than the average underpricing of IPOs.
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19. Answers will vary. Some possible reasons for cost differences:
a. Large issues have lower proportionate costs.
b. Debt issues have lower costs than equity issues.
c. Initial public offerings involve more risk for underwriters than issues of
seasoned stock. Underwriters demand higher spreads in compensation.
Est. Time: 11 – 15
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Chapter 15 - How Corporations Issue Securities
b. The problem with this arrangement would be that, while Marvin would
have an incentive to ensure that the option was exercised, it would not
have the incentive to maximize the price at which it sells the new shares.
c. The right of first refusal could make sense if First Meriam was making a
large up-front investment that it needed to be able to recapture in its
subsequent investments. In practice, Marvin is likely to get the best deal
from First Meriam.
Est. Time: 11 – 15
21. In a uniform-price auction, all successful bidders pay the same price. In a
discriminatory auction, each successful bidder pays a price equal to his own bid.
A uniform-price auction provides for the pooling of information from bidders and
reduces the winner’s curse.
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22. Pisa Construction’s return on investment is 8%, whereas investors require a 10%
rate of return. Pisa proposes a scenario in which 2,000 shares of common stock
are issued at $40 per share, and the proceeds ($80,000) are then invested at
8%. Assuming that the 8% return is received in the form of a perpetuity, then the
NPV for this scenario is computed as follows:
−$80,000 + (.08 $80,000) / .10 = −$16,000
Share price would decline as a result of this project, not because the company
sells shares for less than book value, but rather due to the fact that the NPV is
negative.
Note that, if investors know the price will decline as a consequence of Pisa’s
undertaking a negative NPV investment, Pisa will not be able to sell shares at
$40 per share. Rather, after the announcement of the project, the share price
will decline to:
($400,000 − 16,000) / 10,000 = $38.40
Therefore, Pisa will have to issue: $80,000 / $38.40 = 2,083 new shares
If the proceeds of the stock issue could be invested at 10%, then the share price
would remain unchanged.
Est. Time: 11 – 15
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