Qu FBN, Inc., has just sold 100,000 shares in an initial public offering (IPO). The underwriter’s (usually investment bank) explicit fees were $70,000. The offering price for the shares was $50, but immediately upon issue the share price jumped to $53. a) What is your best guess as to the total cost to FBN of the share issue? Explicit cost: $70,000 Loss from undervaluing $53-$50 = $3 per share. Implicit cost: $3 * 100,000 shares = $300,000 Total cost: $370,000 b) Is the entire cost of the underwriting a source of profit to the underwriters? This is a classical example of the Principal-Agent problem, Moral Hazard, cannot verify effort undertaken by the agent, ic. the underwriter’s research effort. The underwriter’s profit is not linked to his effort. The less effort expended on research, the less the cost to the agent, the higher his profit. FBN will observe jump in price, but cannot blame the underwriter for not getting the share price exactly right, although it should be that the better the research, the closer theIPO price should be to the one paid in the market immediately after issue. Q2 Suppose you sell short, i.e. place bet shares will fall in value, 100 shares of IBX, now selling at $70 per share. a) What is the maximum possible loss? Unbounded, if P 00 b) What happens to the maximum loss if you simultaneously place a stop-buy order (of 100 shares) at $78? It is $8 per share assuming zero transaction cost, since purchased insurance for any movement above $78. Q3 Open brokerage account, and purchase 300 shares of Internet Dreams @ $40 per share. Borrow $4,000 from broker to help pay for the purchase. The interest rate on the loan is 8%. a) What is the margin in the account when first purchased the stock? Margin in A/C: $12,000 - $4,000 = $8,000 b) If the price falls to $30 per share by the end of the year, what is the remaining margin in the account? If the maintenance margin is 30%, will she receive a margin call?Year-end: Assets 300 shares at $30 > $9,000 Liabilities $4,000 * 1.08 => $4,320 Margin in A/C at year-end: $9,000 - $$4,320 = $4,680. % Margin: $4,680/$9,000 = 52% No margin call, 52% > 30% c) What is the rate of return on her investment? Return: (4,680 — 8,000)/8,000 = -0.415% (Note Margin is Equity, %Margin is Equity/Assets) Qi4 Suppose you sell short 500 shares of Intel, currently selling for $40 per share, and give your broker $15,000 to establish your margin account. a) If you earn 0% interest in the funds in your margin account, what will be your rate of return after one year if Intel stock is selling at i) $447 AP = $4 % gain: -($4 * 500)/15,000 = -13.33% ii) $407 AP = $0 % gain: -($0 * 500)/15,000 = 0% iii) $36? AP =-S4% gain: -(-$4 * 500)/15,000 ~ 13.33% b) If the maintenance margin is 25%, how high can Intel’s price rise before you get a margin call? Margin Call: 0.25 = (35,000 — 500 * P)/(500 * P) => P $56 c) Redo a) & b), now assuming that Intel’s dividend (paid at year-end) is $1 per share. For holding short position pay total of dividend payments of 500 * $1, i.e. $500. Rate of return: -(500 * AP — div.)/15,000 i) -16.7% ii) 3.3% iii) +10%. What P will a margin call happen at? Assets $35,000 - $500 = $34,500 Liabilities $500 *P [35,000 — 500) — 500 * PJ/(500 * P) = .25 => P=55.2