CHAPTER 15

How Corporations Issue Securities

 

 

Answers to Practice Questions

 

1.         a.         Zero-stage financing represents the savings and personal loans the company’s principals raise to start a firm.  First-stage and second-stage financing comes from funds provided by others (often venture capitalists) to supplement the founders’ investment.

 

b.                  An after-the-money valuation represents the estimated value of the firm after the first-stage financing has been received.

 

c.                  Mezzanine financing comes from other investors, after the financing provided by venture capitalists.

 

d.                  A road show is a presentation about the firm given to potential investors in order to gauge their reactions to a stock issue and to estimate the demand for the new shares.

 

e.                  A best efforts offer is an underwriter’s promise to sell as much as possible of a security issue.

 

f.                    A qualified institutional buyer is a large financial institution which, under SEC Rule 144A, is allowed to trade unregistered securities with other qualified institutional buyers.

 

g.                  Blue-sky laws are state laws governing the sale of securities within the state.

 

 

2.         a.         Management’s willingness to invest in Marvin’s equity was a credible signal because the management team stood to lose everything if the new venture failed, and thus they signaled their seriousness.  By accepting only part of the venture capital that would be needed, management was increasing its own risk and reducing that of First Meriam.  This decision would be costly and foolish if Marvin’s management team lacked confidence that the project would get past the first stage.

 

b.                  Marvin’s management agreed not to accept lavish salaries.  The cost of management perks comes out of the shareholders’ pockets.  In Marvin’s case, the managers are the shareholders.


 

3.                  Alternative procedures for initial public offerings of common stock include:

a.                  Firm commitment underwriting in which the investment bankers buy the entire issue before reselling it to the public.  The issuing company receives the money immediately, but at a price below the offering price.

b.                  Best efforts offers in which the investment banker tries to sell as much of the issue as possible.  The share price is higher but the entire issue may not be sold.

c.                  In some countries, the issue may be auctioned off.  In these cases, the firm may place a reserve (i.e., lowest acceptable) price, but both price and the number of shares sold are not known in advance.

d.                  In a fixed price offer, the price of the shares is fixed and the number of shares sold is in question.  If the price is too high, not enough shares will be sold; if the price is too low, the issue is oversubscribed and investors receive only a portion of their desired shares.

 

 

4.                  If he is bidding on under-priced stocks, he will receive only a portion of the shares he applies for.  If he bids on under-subscribed stocks, he will receive his full allotment of shares, which no one else is willing to buy.  Hence, on average, the stocks may be under-priced but once the weighting of all stocks is considered, it may not be profitable.

 

 

5.                  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.

 

 

6.                  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 increases the probability that the issue will be mis-priced and therefore increases the underwriter’s.

 

 

7.                  This is a one-time cost, not an annual cost, so it is not correct that flotation costs increase the cost of external equity capital by ten percentage points.  However, flotation costs do increase the cost of external equity capital.

 


8.         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).

 

b.                  Price pressure may be inconsistent with market efficiency.  It implies that the stock price falls when new stock is issued and subsequently recovers.

 

c.                  If a company’s stock is undervalued, managers will be reluctant to sell new stock, even if it means foregoing a good investment opportunity.  The converse is true if the stock is overvalued.  Investors know this and, therefore, mark down the price when companies issue stock.  (Of course, managers of a company with undervalued stock become even more reluctant to issue stock because their actions can be misinterpreted.)

 

                        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).

 

 

9.                  A private placement is preferable to a public issue for firms that face high public issue costs, and for firms that may later require a re-negotiation of the terms of the debt contract.

 

 

10.       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:

 

                                   

                        Note that new shareholders gain: (20 ´ $4.17) = $83, while old shareholders lose: (100 ´ $0.83) = $83.

 

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 new share price is $9.17.  If a shareholder sells his right, he receives $0.83 cash and the value of each share declines by $10 ‑ $9.17 = $0.83.  The shareholder’s total wealth is unaffected.

11.       [Note: The parts of this problem were labeled incorrectly in the first printing of the seventh edition.]

 

            a.         5 ´ (10,000,000/4) = $12.5 million

            b.        

            c.        

                        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 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: (10 million ´ $5) = $50 million

 

 

12.       ($12,500,000/$4) = 3,125,000 shares

($10,000,000/3,125,000) = 3.20 rights per share

           

           

            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 an 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) = $23.18 (difference due to rounding).


 

Challenge Questions

 

 

1.         a.         Venture capital companies prefer to advance money in stages because this approach provides an incentive for management to reach the next stage, and it allows First Meriam to check at each stage whether the project continues to have a positive NPV.  Marvin is happy because it signals their confidence.  With hindsight, First Meriam loses because it has to pay more for the shares at each stage.

 

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.

 

 

2.                  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.

 

 

3.                  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 + (0.08 ´ $80,000)/0.10 = -$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 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.  One can show that, if the proceeds of the stock issue are invested at 10%, then share price remains unchanged.

 

 

4.                  This question is a matter of opinion.  Students might discuss whether there are likely to be shortages of venture capital; for example, in some countries there might not be an active market for small firm IPOs.  Another issue to be discussed is whether there are side benefits to the rest of the economy from an active venture capital industry.