1

CHAPTER 15 How Firms Raise Capital

Learning Objectives
1. 2. Explain what is meant by bootstrapping and why it is important. Explain the role o !ent"re #apital irms in the e#onomy$ and dis#"ss how they red"#e their ris% when in!esting in start&"p b"sinesses. '. (is#"ss the ad!antages and disad!antages o going p"bli#$ and be able to #omp"te the pro#eeds rom an )P*. +. Explain why$ when "nderwriting new se#"rity o erings$ in!estment ban%ers pre er that the se#"rities be "nderpri#ed$ and #omp"te the total #ost o an )P*. 5. Explain the #osts o bringing a general #ash o er to mar%et$ and be able to #omp"te the total #ost o iss"ing a general #ash o er. ,. Explain why a irm that has a##ess to the p"bli# mar%ets might ele#t to raise money thro"gh a pri!ate pla#ement. -. Re!iew some ad!antages o borrowing rom a #ommer#ial ban% rather than selling se#"rities in inan#ial mar%ets$ and dis#"ss ban% term loans.

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Chapter *"tline

15.1 .ootstrapping

A.

How New Businesses Get Started

2 Most businesses are started by an entrepreneur who has a vision for a new business or product and a passionate belief in the concepts viability. The entrepreneur often fleshes out his or her ideas and makes them operational through informal discussions with people whom the entrepreneur respects and trusts, such as friends and early investors. B. Initial Funding of the Firm The process by which many entrepreneurs raise seed money and obtain other resources necessary to start their businesses is often called bootstrapping. The initial seed money usually comes from the entrepreneur or other founders. !ther cash may come from personal savings, the sale of assets such as cars and boats, loans from family members and friends, and loans secured from credit cards. The seed money, in most cases, is spent on developing a prototype of the product or service and a business plan.

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/ent"re Capital The bootstrapping period usually lasts no more than one or two years. "t some point, the founders will have developed a prototype of the product and a business plan, which they can take on the road to seek venture capital funding to grow the business.

# /ent"re #apitalists are individuals or firms that help new businesses get started and provide much of their early$stage financing. %ndividual venture capitalists, angels 0or angel in!estors&, are typically wealthy individuals who invest their own money in emerging businesses at the very early stages in small deals. '(hibit 1).1 shows the primary sources of funds for venture capital firms from 1*** to 2++,. A. The Venture Capital Industry The venture capital industry as we know it today emerged in the late 1*-+s with the formation of the first venture capital limited partnerships. "ppro(imately .2) billion was invested in venture capital funds in both 2++) and 2++-. Today, the venture industry consists of several thousand professionals at about one thousand venture capital firms, with the biggest concentration of firms in /alifornia and Massachusetts. Modern venture capital firms tend to speciali0e in a specific line of business, such as hospitality, food manufacturing, or medical devices. " significant number of venture capital firms focus on high$technology investments.

, B. hy Venture Capital Funding Is !ifferent 1enture capital is important because entrepreneurs have only limited access to traditional sources of funding. Three reasons e(ist as to why traditional sources of funding do not work for new or emerging businesses2 The high degree of risk involved in starting a new business. Types of productive assets. 3ew firms whose primary assets are often intangibles, such as patents or trade secrets, find it difficult to secure financing from traditional lending sources. Informational asymmetry problems. "n entrepreneur knows more about his or her companys prospects than a lender does. C. !. The Venture Capital Funding Cy"le The venture capital funding cycle is summari0ed in '(hibit 1).2. How Venture Capitalists #edu"e Their #is$ 1enture capitalists know that only a handful of new companies will survive to become successful firms. They use a number of tactics when they invest in new ventures, including funding the ventures in stages, re4uiring entrepreneurs to make personal investments,

) syndicating investments, and maintaining in$depth knowledge about the industry in which they speciali0e. Staged Funding. The key idea behind staged funding is that each funding stage gives the venture capitalist an opportunity to reassess the management team and the firms financial performance. o The venture capitalists investments give them an e4uity interest in the company, which is typically in the form of preferred stock that is convertible into common stock at the discretion of the venture capitalist. %ersonal In&estment. 1enture capitalists often re4uire an entrepreneur to make a substantial personal investment in the business. Syndi"ation. %t is a common practice to syndicate seed$ and early$stage venture capital investments. o 5yndication occurs when the originating venture capitalist sells a percentage of a deal to other venture capitalists. o 5yndication reduces risk in two ways2 6irst, it increases the diversification of the originating venture capitalists investment portfolio.

 5econd, the willingness of other venture capitalists to share in the investment provides independent corroboration that the investment is a reasonable decision. In'depth (nowledge. "nother factor that reduces risk is the venture capitalists in$depth knowledge of the industry and technology. ). The )*it Strategy 1enture capitalists are not long$term investors in the companies, but usually e(it over a period of three to seven years. 'very venture capital agreement includes provisions identifying who has the authority to make critical decisions concerning the e(it process. Those provisions usually include the following2 o o o Timing 7when to e(it& The method of e(it 8hat price is acceptable

1enture capital firms e(it venture$backed companies in three principal ways2 selling to a strategic buyer, selling to a financial buyer, and offering stock to the public. Strategi" Buyer. " common way for venture capitalists to e(it is to sell part of the firms e4uity to a strategic buyer in the private market. -

9 Finan"ial Buyer. %n recent years, sales to financial buyers have become a common way for venture capitalists to e(it a firm. o !ccurs when a financial group buys the new firm with the intention of holding it for a period of time, usually three to five years, and then selling it for a higher price. Initial %u+li" ,ffering. " venture capitalist may also e(it an investment by selling common stock in an initial public offering 7%:!&. F. Venture Capitalists %ro&ide -ore Than Finan"ing The e(tent of the venture capitalists involvement in management of the firm depends on the e(perience and depth of the management team. !ne of their most important roles is to provide advice to entrepreneurs. ;ecause of their industry knowledge and their general knowledge about what it takes for a business to succeed, venture capitalists are able to provide counsel to entrepreneurs when a business is being started and during the early period of the businesss operation. G. The Cost of Venture Capital Funding The cost of venture capital funding is very high, but the high rates of return earned by venture capitalists are not unreasonable.

< " typical venture capital fund may generate annual returns of 1) to 2) percent on the money that it invests, compared with an average annual return for the 5=: )++ of about 12 percent.

15.' )nitial P"bli# * ering !ne way to raise larger sums of cash or to facilitate the e(it of a venture capitalist is through an initial p"bli# o ering$ or )P*, of the companys common stock. 6irst$time stock issues are given a special name 7)P*& because the marketing and pricing of these issues are distinctly different from those of seasoned offerings. A. Ad&antages and !isad&antages of Going %u+li" " firms decision to go public depends on an assessment of whether the advantages outweigh the disadvantages. >oing public has a number of potential advantages. The amount of e4uity capital that can be raised in the public e4uity markets is typically larger than the amount that can be raised through private sources. !nce an %:! has been completed, additional e4uity capital can usually be raised through follow$on seasoned public offerings at a low cost.

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* >oing public can enable an entrepreneur to fund a growing business without giving up control. "fter the %:!, there is an active secondary market in which stockholders can buy and sell its shares. :ublicly traded firms find it easier to attract top management talent and to better motivate current managers if a firms stock is publicly traded. There are several disadvantages to going public. !ne disadvantage of going public is the high cost of the %:! itself. The costs of complying with ongoing 5'/ disclosure re4uirements also represent a disadvantage of going public. The transparency that results from this compliance can be costly for some firms. 6inally, some investors argue that the 5'/s re4uirement of 4uarterly earnings forecasts and 4uarterly financial statements encourages managers to focus on short$term profits rather than long$term wealth ma(imi0ation. B. In&estment Ban$ing Ser&i"es To complete an %:!, a firm will need the services of investment bankers, who are e(perts in bringing new securities to market.

1+ %nvestment bankers provide three basic services when bringing securities to market?origination, underwriting, and distribution. %dentifying the investment banking firm that will manage the %:! process is an important task for the management of a firm because not all investment banks are e4ual. 5ecuring the services of an investment banking firm with a reputation for 4uality and honesty will improve the markets receptivity and help ensure a successful %:!. Origination includes giving the firm financial advice and getting the issue ready to sell. @uring the origination phase, the investment banker helps the firm determine whether it is ready for an %:!. !nce the decision to sell stock is made, the firms management must obtain a number of approvals. 5ince securities sold to the public must be registered in advance with the 5'/, the first step in this process is to file a registration statement with the 5'/. Underwriting is the risk$bearing part of investment banking. The securities can be underwritten in two ways2 71& on a firm$commitment basis or 72& on a best$effort basis. 1+

11 o %n the irm&#ommitment "nderwriting, which is more typical, the investment banker guarantees the issuer a fi(ed amount of money from the stock sale. The investment banker actually buys the stock from the firm at a fi(ed price and then resells it to the public. o The underwriter bears the risk that the resale price might be lower than the price the underwriter pays?this is called price risk. The investment bankers compensation is called the underwriters spread. o %n a firm$commitment offering, the spread is the difference between the investment bankers purchase price and the offer price. The underwriters spread in the vast maAority of initial public stock offerings in the Bnited 5tates is 9 percent. o 8ith a best&e ort "nderwriting, the investment banking firm makes no guarantee to sell the securities at a particular price. %n best$effort offerings, the investment banker does not bear the price risk associated with underwriting the issue, and compensation is based on the number of shares sold.

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12 To share the underwriting risk and to sell a new security issue more efficiently, underwriters may combine to form a group called an "nderwriting syndi#ate. :articipating in the syndicate entitles each underwriter to receive a portion of the underwriting fee as well as an allocation of the securities to sell to its own customers. !ne of the investment bankers most difficult tasks is to determine the highest price at which the bankers will be able to 4uickly sell all of the shares being offered and that will result in a stable secondary market for the shares. ;efore the shares are sold, representatives from the underwriting syndicate hold a due diligence meeting with representatives of the issuer. %nvestment bankers hold due diligence meetings to protect their reputations and to reduce the risk of investors lawsuits in the event the investment goes sour later on. Distribution involves reselling the securities to the public. !nce the due diligence process is complete, the underwriters and the issuer determine the final offer price in a pricing call.

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1# %f management finds the price acceptable, the issuer files an amendment to the registration statement with the 5'/, which contains the terms of the offering and the final prospectus. o !nce the securities are registered with the 5'/, they can be sold to investors. The syndicates primary concern is to sell the securities as 4uickly as possible at the offer price. "t the closing of a firm$commitment offering, the issuing firm delivers the security certificates to the underwriter and the underwriter delivers the payment for the securities, net of the underwriting fee, to the issuer. o The closing usually takes place on the third business day after trading has started.

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)P* Pri#ing and Cost A. The .nderpri"ing !e+ate The issuer prefers the stock price to be as high as realistically possible while the underwriters prefer some degree of underpricing. 1nderpri#ing is defined as offering new securities for sale at a price below their true value.

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1, %n a firm$commitment offering, the underwriters will suffer a financial loss if the offer price is set too highC under a best$effort agreement, the issuing firm will lose. %f the underpricing is significant, the investment banking firm will suffer a loss of reputation for failing to price the new issue correctly and raising less money for its client than it could have. B. I%,s Are Consistently .nderpri"ed @ata from the marketplace show that the shares sold in an %:! are typically priced between 1+ and 1) percent below the price at which they close at the end of the first day of trading. '(hibit 1)., shows recent information on the number of %:!s per year and the average first$day return to investors for the years 1**+D2++9. C. The average first$day return is a measure of the amount of underpricing.

The Cost of an I%, Three basic costs are associated with issuing stock in an %:!?"nderwriting spread$ o"t&o &po#%et expenses$ and "nderpri#ing.

'(hibit 1).) presents some market data on the cost of issuing an %:!.

15.5

2eneral Cash * er by a P"bli# Company

1,

1) %f a public firm has a high credit rating, the lowest$cost source of e(ternal funds is often a general #ash o er$ also referred to as a registered public offering. " general cash offer is a sale of debt or equity open to all investors, by a registered public company that has previously sold stock to the public. A. Competiti&e or Negotiated Sale %n a general cash offer, management must decide whether to sell the securities on a competitive or a negotiated basis. %n a competitive sale the firm specifies the type and amount of securities it wants to sell and hires an investment banking firm to do the origination work. !nce the origination is completed, the firm invites underwriters to bid competitively to buy the issue. %n a negotiated sale the issuer selects the underwriter at the beginning of the origination process. "t that time, the scope of the work is defined, and the issuer negotiates the origination and underwriters fees to be charged. 6or debt issues, most e(perts believe that competitive sales are the least costly method of selling so$called vanilla bonds when market conditions are stable. 6or e4uity securities, negotiated sales provide the lowest$cost method of sale.

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1B. Shelf #egistration 5ince 3ovember 1*<#, the 5'/ has allowed some two thousand large corporations the option of using shel registration. 5helf registration allows a firm to register an inventory of securities for a two$ year period. @uring that time, the firm can take the securities off the shelf and sell them as needed. /osts associated with selling the securities are reduced because only a single registration statement is re4uired. " shelf registration statement can cover multiple securities, and there is no penalty if authori0ed securities are not issued. /orporations gain two important benefits from shelf registration. 6irst is the greater fle(ibility in bringing securities to market in that securities can be taken off the shelf and sold within minutes. 5econd, shelf registration allows firms to periodically sell small amounts of securities, raising money as it is actually needed, rather than banking a large amount of money from a single security sale and spending it over time. C. The Cost of a General Cash ,ffer

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19 '(hibit 1).- shows the average underwriting spread, out$of$pocket e(penses, and total cost for common stock, preferred stock, and corporate bond issues of various si0es. /omparing '(hibits 1).) and 1).- reflects the greater risk involved in underwriting an %:! and the higher cost of distributing the %:!.

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Pri!ate 3ar%ets and .an% 4oans A. %ri&ate &ersus %u+li" -ar$ets 6or many smaller firms and firms of lower credit standing that have limited access, or no access, to the public markets, the cheapest source of e(ternal funding is often the private markets. 8hen market conditions are unstable, some smaller firms that were previously able to sell securities in the public markets no longer can do so. ;ootstrapping and venture capital financing are part of the private market as well. Many private companies that are owned by entrepreneurs, families, or family foundations and are si0able companies of high credit 4uality prefer to sell their securities in the private markets even though they can access public markets. Their choice of markets is a function of2 their desire to avoid the regulatory costs and transparency re4uirements.

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1< and their preference for a small group of sophisticated investors rather than the public at large. B. %ri&ate %la"ements Pri!ate pla#ement occurs when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals. "bout half of all corporate debt is sold through the private placement market. %nvestment banks and money center banks often assist firms with private placements. They help the issuer locate potential buyers for their securities, put the deal together, and do the necessary origination work, but they do not underwrite the issue. %n a traditional private placement, the issuer sells the securities directly to investors. :rivate placements have a number of advantages, relative to public offerings, for certain issuers. 3et of transaction costs, lower cost of funds. :rivate lenders are more willing to negotiate changes to a bond contract. %f a firm suffers financial distress, the problems are more likely to be resolved without going to a bankruptcy court.

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1* !ther advantages include the speed of private placement deals and fle(ibility in issue si0e. The biggest drawback of private placements involves restrictions on the resale of the securities. The 5'/ limits the sale of private placements to several do0en knowledgeable investors who have the capacity to evaluate the securities investment potential and risk. To compensate for the lack of marketability, investors in private placements re4uire a higher yield relative to a comparable public offering. %n "pril 1**+, the 5'/ adopted Eule 1,,", which allows large financial institutions to trade unregistered securities among themselves. 5ince 1**), about half of all private placement deals have been conducted under Eule 1,,". C. %ri&ate )/uity Firms Fike venture capitalists, private e4uity firms pool money from wealthy investors, pension funds, insurance companies, and other sources to make investments. :rivate e4uity firms invest in more mature companies, and they often purchase 1++ percent of a business.

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2+ :rivate e4uity firm managers look to increase the value of the firms they ac4uire by closely monitoring their performance and providing better management. !nce value is increased, they sell the firms for a profit after holding investments typically for three to five years. Farge public firms often sell businesses when they no longer fit the firms strategies or when they are offered a price they cannot refuse. :rivate e4uity firms establish private equity funds to make investments. These funds are usually organi0ed as limited partnerships or limited liability companies. :rivate e4uity investors focus on firms that have stable cash flows because they use a lot of debt to finance their ac4uisitions. 8hen a large amount of leverage is used to take over a company, the transaction is called a leveraged buyout. :rivate e4uity firms improve the performance of firms in which they invest by2 making sure that the firms have the best possible management teams. closely monitoring each firms performance and providing advice and counsel to the firms management team. facilitating mergers and ac4uisitions that help improve the competitive positions of the companies in which they invest.

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21 :rivate e4uity firms carry a much smaller regulatory burden and fewer financial reporting re4uirements than do public firms. They are able to avoid most of the 5'/s registration and compliance costs and other regulatory burdens, such as compliance with the 5arbanes$ !(ley "ct. !. %ri&ate In&estments in %u+li" )/uity !rivate investment in public equity 7:%:'& transactions are transactions in which a public company sells unregistered stock to an investor?often a hedge fund or some other institutional investor. :%:' transactions have been around for a long time, but the number of these transactions has increased greatly since the late 1**+s. %n a :%:' transaction, investors purchase securities 7e4uity or debt& directly from a publicly traded company in a private placement. The securities are virtually always sold to the investors at a discount to the price at which they would sell in the public markets to compensate the buyer for limits on the li4uidity associated with these securities and, often, for being able to provide capital 4uickly. ;ecause the securities sold in a :%:' transaction are not registered with the 5'/, they are restricted securities .

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22 Bnder federal securities law, they cannot be resold to investors in the public markets for a year or two unless the company registers them. "s part of the :%:' contract, the company often agrees to register the restricted securities with the 5'/, usually within *+ days of the :%:' closing. %f the registration is delayed past a deadline date, the issuer might be re4uired to pay the investor li4uidity damages, usually 1 or 1.) percent per month, as compensation for the loss of li4uidity. The maAor advantage of a :%:' transaction to issuers is that it gives them faster access to capital and a lower funding cost than a registered public offering. :%:' transactions involving a healthy firm can also be e(ecuted without the use of an investment bank, resulting in a cost saving of 9 to < percent of the proceeds. " :%:' transaction can be the only way for a small financially distressed company to raise e4uity capital. ). Commer"ial Ban$ 0ending "lmost every company has a working relationship with at least one bank, and smaller companies depend on them for funding and for financial advice. Prime&rate loans are loans in which the borrowing rate is based on the prime rate of interest which is historically the loan rate that banks charge their most creditworthy customers. 22

2# 5ome customers are able to borrow below the prime rate. :rime$rate loans are often used to finance working capital needs such as inventory purchases. ;anks often re4uire that the loan balance be brought to 0ero for a short time each year. The prime rate charged by a bank might be higher than other market borrowing rates. The cost of a prime$rate loan can includes the cost of the advisory services as well as the cost of the financing. The prime rate is not a market$determined interest rate, since bank management sets it. %n determining the interest rate to charge on a loan, the bank takes the prime rate plus two other factors into account. The calculation, called the bank loan pricing model, is shown in '4uation 1).1. Term loans are defined as business loans with maturities greater than one year. Term loans are the most common form of intermediate$term financing provided by commercial banks. ;ank term loans may be secured or unsecured, and the funds can be used to buy inventory or to finance plant and e4uipment.

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2, In determining the interest rate to charge on a loan, the bank takes the prime rate plus two other factors into account. ;efore making a loan, the bank conducts a credit analysis of the customer. To determine the customers credit category 7@E:&, banks usually look at five to seven credit risk categories, which look very much like bond ratings. Those with the highest credit rating borrow at the prime rate or below, while others have to pay a default risk premium over and the prime rate. The second step, if the customer wants a term loan, is to adAust for the term to maturity 7M"T&.

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5"ggested and Alternati!e Approa#hes to the 3aterial

This chapter is about how firms raise capital so that they can ac4uire the productive assets needed to grow and remain profitable. The chapter begins by e(amining how many new businesses ac4uire their first e4uity funding through bootstrapping and the role venture capitalists play in providing e4uity to help firms get started. !nce a firm is successfully launched, the venture capitalists Aob is done and they e(it the scene. "t this Auncture, management has a number of other funding optionsC we discuss those options in the remainder of the chapter. The chapter ne(t e(plains how firms sell their first issue of common stock in the public markets and the role of investment banks in completing these sales.. 6irst$time e4uity sales are known as initial public offerings, or %:!s. The role that private markets play in funding business firms and the factors that managers consider when deciding between a public and a private market sale are then discussed. The chapter closes with a discussion of the importance of commercial banks in providing short$term and intermediate$term financing. This chapter may be introduced right after the fundamental finance concepts have been covered. %t allows students to get a firm grasp of how firms can raise long$term capital in both public and private markets. 8hile finance maAors will receive more in$depth coverage in upper level courses, nonfinance, business students will benefit from the coverage of these topics in the basic finance courses. Material at the end of the chapter is structured to give students a good conceptual and 4uantitative understanding of the chapter.

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))). 5"mmary o 4earning *b6e#ti!es

1. Explain what is meant by bootstrapping and why it is important. ;ootstrapping is the process by which many entrepreneurs raise seed money and obtain other resources necessary to start new businesses. 5eed money often comes from the entrepreneurs savings and credit cards and from family and friends. ;ootstrapping is important because business start$ups are a significant factor in determining and sustaining long$term economic growth in a state or regional economy. %ndeed, some state and local governments have invested heavily in business incubators, hoping to foster new business formation.

2.

Explain the role o !ent"re #apital irms in the e#onomy$ and dis#"ss how they red"#e their ris% when in!esting in start&"p b"sinesses. 1enture capitalists speciali0e in helping business firms get started by advising management and providing early$stage financing. ;ecause of the high risk of investing in start$up businesses, venture capitalists finance proAects in stages and often re4uire the owners to make a significant personal investment in the firm. The owners e4uity stake signals their belief in the viability of the proAect and ensures that management actions are focused on building a successful business. Eisk is also reduced through syndication and because of the venture capitalists in$depth knowledge of the industry and technology.

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(is#"ss the ad!antages and disad!antages o going p"bli#$ and be able to #omp"te the net pro#eeds rom an )P*.

2-

29 The maAor advantages of entering public markets are that they provide firms with access to large 4uantities of money at relatively low cost, enable firms to attract and motivate good managers, and provide li4uidity for e(isting stockholders, such as entrepreneurs, other managers, and venture capitalists. @isadvantages include the high cost of the %:!, the cost of ongoing 5'/ disclosure re4uirements, and the need to disclose sensitive informationC possible incentives focus on short$term profits rather than on long$term wealth ma(imi0ation. 5ection 1).# and Fearning by @oing "pplication 1).1 provide practice in computing %:! proceeds.

+.

Explain why$ when "nderwriting new se#"rity o erings$ in!estment ban%ers pre er that the se#"rities be "nderpri#ed$ and #omp"te the total #ost o an )P*. 8hen underwriting new securities, investment bankers prefer that the issue be underpriced because it increases the likelihood of a successful offering. The lower the offering price, the more likely that the securities will sell out 4uickly?and the less likely that the underwriters will end up with unsold inventory. 6urthermore, many investment bankers will argue that some underpricing helps attract long$term institutional investors, who help provide stability for the stock price. The total cost of issuing an %:! includes three elements2 71& the underwriters spreadC 72& out$of$pocket e(penses, which include legal fees, 5'/ filing fees, and other e(pensesC and 7#& the cost of underpricing. 6or calculations of these costs, see 5ection 1).,, including Fearning by @oing "pplication 1).#. '(hibit 1).) gives average costs for %:!s in recent years.

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2< 5. Explain the #osts o bringing a general #ash o er to mar%et$ and be able to #omp"te the total #ost o iss"ing a general #ash o er. The total cost of bringing a general cash offer to market is lower than the cost of issuing an %:! because these seasoned offerings do not include a large underpricing cost and underwriting spreads are smaller. 5ection 1).) e(plains how to compute the total cost of a general cash offer, and some average costs are listed in '(hibit 1).-.

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Explain why a irm that has a##ess to the p"bli# mar%ets might ele#t to raise money thro"gh a pri!ate pla#ement. :rivate placement has a number of advantages, even for companies with access to the public markets. " private placement may be more cost effective and can be accomplished much more 4uickly. %n addition, some larger companies, especially those owned by entrepreneurs or families, may not wish to be e(posed to the public scrutiny that comes with public sales of securities.

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Re!iew some o the ad!antages o borrowing rom a #ommer#ial ban% rather than selling se#"rities in inan#ial mar%ets$ and dis#"ss ban% term loans. Most small$ and medium$si0e firms borrow from commercial banks on a regular basis. 5mall$ and medium$si0ed firms may have limited access to the financial markets. 6or these firms, banks provide not only funds but a full range of services, including financial advice. 6urthermore, if a firms financial circumstances change over time, it is much easier for the firm to borrow or renegotiate the debt contract with a bank than with other lenders. 6or many companies, bank borrowing may be the lowest$cost source of funds.

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2* ;ank term loans are business loans with maturities greater than one year. Most such loans have maturities from 1 to ) years, though the maturity may be as long as 1) years. The cost of the loans depends on three factors2 the prime rate, an adAustment for default risk, and an adAustment for the term to maturity.

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)/. 5"mmary o 7ey E8"ations

E8"ation (es#ription Form"la

15.1

;ank loan pricing model

kl G :E H @E: H M"T

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.e ore 9o" 2o *n :"estions and Answers

5e#tion 15.1
1. '(plain bootstrapping, and list the most common sources of seed money.

;ootstrapping refers to the securing of initial funding by entrepreneurs to start a new business. %t alludes to the idea of an individual or small group of entrepreneurs who keep their business idea barely alive by securing money to keep it going. The initial seed money usually comes from the entrepreneur or other founders. !ther cash may come from personal savings, the sale of assets such as cars and boats, loans from family members and friends, and loans secured from credit cards.

5e#tion 15.2
1. 8ho are venture capitalists, and what do they doI

1enture capitalists are individuals or groups of people that help new businesses to get started and provide much of their early financing. They pool money from various sources, such as wealthy individuals, insurance companies, pension funds, or large corporations and invest in start$up ventures. The primary types of businesses seeking the services of venture capitalists are high$tech firms.

2.

Jow do venture capitalists reduce the risk of their investmentsI

#1

#2 1enture capitalists reduce the risk of their investments in two ways2 71& stage funding, which gives the investors a chance to periodically reassess the proAect, the management team, and the firms financial performance, and to make necessary corrections throughout the duration of the proAect, and 72& personal investment by the entrepreneurs. Ee4uiring the entrepreneurs to make a substantial personal investment in the business is to make sure that they are highly motivated to succeed.

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'(plain the venture capital funding cycle.

The venture capital funding cycle starts with the development of a detailed business plan by the start$up company. !nce a venture capitalist 71/& that will fund the proAect is selected, they state their terms of funding?how much money will they supply in what stages, criteria of success, and so on. 6inally, e(it strategy is developed. 5ince 1/s are not long$term investors, it is important that a clear understanding of how the 1/ can e(it the deal is part of the initial agreement. This can involve taking the firm public or sometimes selling the new firm to another business.

5e#tion 15.'
1. 8hat is a seasoned offering, and why are these securities valued more highly than securities sold in an %:!I

" seasoned offering is a sale of securities by a firm that already has publicly traded securities outstanding. These are usually more e(pensive as they are viewed to be less

#2

## risky than %:! securitiesC since they are sold by firms that already established a reputation for 4uality with the investing public, many investors prefer them to new issues.

2.

'(plain the two ways a security issue can be underwritten.

" security can be underwritten in two ways2 71& firm$commitment basis?in this case the banker guarantees the issuer a fi(ed amount of money from the security sale, and 72& best$effort basis?whereby the banker makes no guarantee to sell the securities at a particular price, but instead promises to sell as much of the issue as possible above a certain price. The main difference between these two types of underwriting is who bears the risk. 8ith the firm$commitment basis, it is the banking firm that buys the securities first before selling them to public. !n the other hand, in a best$effort type of deal, the issuer is the risk bearer.

#.

Fist the steps in the %:! process.

The %:! process involves the following steps2 71& selection of the investment bank, 72& preparation of the registration paperwork and 5'/ process, 7#& determination of the structural features of the offering, 7,& valuation, 7)& marketing of the %:!, and 7-& sale of the securities.

5e#tion 15.+
1. 8hat is underpricing, and why is it a cost to the stockholders in a firmI

##

#,

Bnderpricing is defined as the offering of new securities for sale at an offer price below the true value of the security. %t is considered to be a cost to a firm, because if the stock sells at a low price, the issuer is essentially losing money, which goes in the pockets of investors that bought the issues for less than they are worth.

2.

8hat are the components of the cost associated with an %:!I

The cost of issuing an %:! includes the following2 71& underwriting spread, 72& out$of$ pocket e(penses, and 7#& underpricing.

5e#tion 15.5
1. '(plain why most firms sell their e4uity and complicated debt issues through negotiated sales.

3egotiated sales allow the investment bankers to form a closer relationship with the issuer and develop a better understanding of the firm. This enables them to form more effective selling teams. "s a result, this should allow the bankers to reduce uncertainty surrounding the issue, resulting in a lower issue cost.

2.

'(plain the importance of shelf registration.

#,

#) 5helf registration allows firms to register the inventory of securities for a two$year period. @uring this time the firm can take the securities and sell them as needed. This process simplifies the sale, as there are no flotation costs involved after the initial registration statement. The firm can also sell as many or as few securities at a time as it needs to, taking advantage of favorable market conditions. There is no penalty if authori0ed securities are not issued.

5e#tion 15.,
1. 8hat are the disadvantages of a private placement sale compared with a public saleI

:rivate placement has three main disadvantages compared to public sale. 6irst, because of the lack of li4uidity, nominal yields are higher. 5econd, since private placement securities are not registered, the covenants are stricter. "nd finally, compared to public securities, private placement securities are more difficult to sell in the secondary market.

2.

8hy do companies engage in :%:' transactionsI

5mall and midsi0e companies can find it difficult or costly to raise money in the public markets. %n these circumstances, it can be more efficient or cost effective to sell stock privately, even if the companys stock is already publicly traded. :%:' transactions bring several advantages to the issuing firm. They give the firm faster access to capital and a lower funding cost than a registered public offering. " :%:'

#)

#transaction can be completed in as short a time as two weeks, whereas a typical public offering underwritten by an investment bank takes several months. :%:' transactions involving a healthy firm can also be e(ecuted without the use of an investment bank, resulting in a cost saving of 9 to < percent of the proceeds. " :%:' transaction can be the only way for a small financially distressed company to raise e4uity capital.

#-

#9

/). 5el &5t"dy Problems

15.1

!akley, %nc., is planning to raise .1 million in new e4uity through a private placement. %f the sale price is .1< per share, how many shares does the company have to issueI

5ol"tion; To raise .1,+++,+++, !akley has to issue2 7.1,+++,+++ K .1<& G 55$55, shares

15.2

5uppose a firm does an %:! and the investment bank offers to buy the securities for .#, per share with an offering price of .,2. 8hat is the gross underwriters spreadI "ssume that the underwriters cost of bringing the security to the market is .) per share. 8hat is the net profitI

5ol"tion; The underwriters spread2 .,2 D .#, G .< 3et profit2 .< D .) G <' per share

15.'

The 5tride Eite /orporation, designer and marketer of athletic apparel, is planning an e(pansion into foreign markets and needs to raise .1+ million to finance this move. The company plans to do a general cash offering for .1# a share. The companys underwriters charge a ) percent spread. Jow many shares does the company need to sell to achieve its goalI

#9

#< 5ol"tion; Bnderwriters spread G )L :rice per share for the firm G M.1#N71$+.+)&O G <12.'5 To raise .1+ million, the company needs to issue2 7.1+,+++,+++ K .12.#)& G =>?$-1- new shares

15.+

@ean 6oods /o. needs to borrow .2# million for a factory e4uipment upgrade. The management decides that they will sell 1+$year bonds. They determine that the #$month Treasury bill yields ,.#2 percent, the firms credit rating is "", and the yield on 1+$year Treasury bonds is 1.+- percent higher than for #$month bills. @ouble " bonds are selling for 1.#) percent above the 1+$year Treasury bond rate. 8hat is the borrowing cost for this transactionI

5ol"tion; The borrowing cost for @ean 6oods can be calculated as follows2 kl G ,.#2 H 1.#) H 1.+- G ,.-'@ The approach used here is similar to that used in the bank loan pricing model.

15.5

Pou are considering starting a new online dating service, but you lack the initial capital. 8hat are your options for financingI

5ol"tion;

#<

#* :ossible sources of capital include your own family and friends, wealthy individuals, venture capital firms, and financial institutions.

#*

,+

/)). Criti#al Thin%ing :"estions

15.1

"ssume that you work for a venture capital firm and that a couple of recent college grads approach you to fund their new business. %f you are interested in the idea, what process will you followI

"fter setting up the initial meeting, you should carefully review their business plan and make sure that it contains all the important information a business plan should, such as industry and market analysis, vision and mission statements, management team description, and cost analysis along with the proposed budget. :roviding you like the plan and decide to fund the proAect, you should try to minimi0e your risk of investing and only fund the proAect in stages. %n addition, you should re4uire some personal investment from the candidates to ensure their serious interest in the proAect. 6inally, you should draft an e(it strategy, outlining the timing and calculation of the e(it price.

15.2

%dentify the three basic services an investment banker provides in order to help firms to bring new security issues to the market. @uring which stage of the %:! does the investment banker take on the risk of the offeringI %s there an alternative in which the risk remains with the company going publicI

The three services provided by an investment banker in an initial public offering are origination, underwriting, and distribution. The underwriter takes on the risk during the second stage of the %:! process, or underwriting, providing a firm$commitment

,+

,1 underwriting deal is in place. Bnder this scenario, the banker buys the securities from the firm at a fi(ed price and resells them to the public. Jence, the underwriter bears the risk that the securities may be sold for less than they paid for them. "n alternative arrangement is the best$alternative deal, where the investment banking firm makes no guarantee to sell the securities at a particular price, but instead promises only to make its best effort to sell as much issue as possible above a certain price. %n this scenario, the risk stays with the offering firm.

15.'

@efine underpricing, and discuss why the maAority of %:!s are underpriced. 8hat role do investment banks play in this processI

Bnderpricing is the difference between the offering price and the closing price at the end of the first day of the %:!. %t is the loss that the issue incurs from selling below its true market value. "symmetric information plays a big role in an %:! under$pricing, since both the bankers and the public know less about private companies going public than they do about already publicly traded firms. The lower offering price is to compensate the investors for taking on the risk of buying into a company for which not a lot of information is available. !ne way for companies to reduce underpricing is to choose a well$known investment bank to take them public. This will send a signal to the potential investors that the bank has done its due diligence and considers the firm to be creditworthy.

15.+

'(plain why a company might choose to remain privateI

,1

,2

;y remaining private, a company effectively avoids being subAected to 5'/ regulations. Many of the large private companies are family owned with a long history and prefer not to be subAected to public scrutiny. %n addition, the management of the company is not pressured by 8all 5treet to report short$term earnings, but can concentrate their efforts on long$term growth and strategy reali0ation.

15.5

%dentify the three cost components that make up the total cost for a company to issue securities. ;riefly e(plain each.

The total cost for a firm to issue securities is e4ual to the sum of the underwriting spread, out$of$pocket e(penses, and underpricing. The underwriting spread is the difference between the offering price and the price the firm receives from the stock sale, multiplied by the number of shares outstanding. !ut$of$pocket e(penses are usually administrative costs. 6inally, the total amount of underpricing is determined as the difference between the offering and closing price on the first day of the %:! times the number of shares.

15.,

8hat are the characteristics of a public bondI 7Think in terms of comparing it to private placement and bank term loans.&

" public bond is usually the most suitable for a large firm looking for a large loan. %t tends to have the lowest interest costs as well as the lowest default risk, but usually has a

,2

,# long maturity. 8hile it has very few restrictive covenants, it is also very difficult to renegotiate.

15.-

@iscuss the advantages of shelf registration. 8hat kinds of securities are most likely to be shelvedI

5helf registration allows the company to better time the market and thus sell the securities when market conditions are most favorable. %t can take the securities off the shelf and sell them within minutes. They can also sell securities on a periodic basis, whenever cash is needed. :lain vanilla bonds are most likely to be sold by shelf registration sales by competitive bidding.

15.=

%dentify whether each of the following factors will drive the price of the bond up or down2 a. Fow marketability of the security b. 5hort term to maturity # Fow credit rating of the issuer

d. 3o call provision

Fa#tor Fow marketability 5hort term to maturity Fow credit rating 3o call provision

.ond yield %ncrease @ecrease %ncrease @ecrease

.ond Pri#e @ecrease %ncrease @ecrease %ncrease

,#

,, 15.? '(plain why time might play a significant role during low interest periods in a decision whether to do a private placement deal or public sale.

:rivate placement deals tend to be much 4uicker than public sales. 5ince there is uncertainty about the future behavior of interest rates in the market, a firm might decide to go with private deal in order to lock in the favorable interest rates.

15.1> "ssume you are a large firm looking for medium$si0e loan with long term to maturity that has a low li4uidity. 8hich of the following types of debt would be the most appropriateI a. :ublic bond b. :rivate placement #. ;ank term loan

" large firm can have its pick of the three alternatives. " public offering of debt would be helpful to raise large amounts, but the terms of the bond contract may not be easily negotiated. :rivate placements have a number of advantages, relative to public offerings, for certain issuers. These include lower cost of funds, ability to negotiate changes to a bond contract, speed of private placement deals, and fle(ibility in issue si0e. ;ank loans are preferable when the loan term is short to medium term. " large firm may choose a bank loan only if it cannot raise funds publicly or through private placement. ;ank loans offer some similar advantages as private placements

,,

,)

/))). .A5)C
15.1

:"estions and Problems

/ent"re #apital; 8hat items in a business plan does a venture capitalist look for in deciding whether to provide initial financingI

5ol"tion; 'very business plan should contain the following information2 " description of the business and industry trends 1ision and key strategies for the business :rincipal products or services and any innovative features or patents The management team and their e(perience Market analysis and sales forecast Jow the products will be marketed and sold :roduction costs such as materials and labor 6acilities needed and estimated costs /apital re4uired and the use of the proceeds @etailed budget with si( years of proAected financial statements.

15.2

/ent"re #apital; Pou finally decide to act on your brilliant idea and start an online te(tbook rental company. Pou develop a detailed business plan and calculate that you will need about .#)+,+++ of initial funding to get the business going. Fuckily for you,

,)

,you have lined up two venture capital firms offering to supply the funding. 8hat criteria should guide your decision to select one firm over the otherI

5ol"tion; /riteria include knowledge of the business and technology, references, chemistry, access to additional capital, networking, e(it strategy, and pro(imity.

15.'

/ent"re #apital; 8hat are some viable e(it strategies for a start$up companyI

5ol"tion; " firm can choose to either sell the business at some period, take it public, or in some instances remain a private company with few shareholders.

15.+

)P*; ;riefly describe the %:! process.

5ol"tion; The %:! process has three phases2 origination, which is financial advising and getting the issue ready to sellC underwriting, which involves the investment banker buying the securities from the firmC and distribution, which is when the investment banker resells the securities to the public.

,-

,9 15.5 )P*; ;ased on your knowledge from previous chapters, what are some methods an investment banker uses to determine an %:! priceI 8hat factors will play a significant role in the calculationI

5ol"tion; %n order to determine the price of a new security, the investment banker can look at comparable companies and see what they are trading for. "nother approach is to do a discounted cash flow analysis, which is Aust like determining the price of a stock. Pou forecast future cash flows of the company, usually for a time hori0on of ) to 1+ years, and discount them back to the present in order to get the firm value. The discount rate will be a factor of both the cost of debt and cost of e4uity 7AACCB.

15.,

Cost o debt !ers"s e8"ity; 8hat are some of the possible reasons debt financing is cheaper than e4uity financingI

5ol"tion; @ebt issues that are comple( in nature andKor issued at times of uncertainty often tend to be brought to the market by negotiated sales. This approach allows the underwriter to better control the uncertain situation and better e(plain the firm to potential investors, thereby leading to lower issue costs.

15.-

)P* pri#ing2 TraAa(, %nc., a high$technology firm in :ortland, issues a .*1 million %:! priced at .29 per share, and the offering price to the public is .## per share. The firms

,9

,< legal fees, 5'/ registration fees, and other administrative costs are .,)+,+++. The firms stock price increases 19 percent on the first day. 8hat is the firms total cost of issuing the securitiesI

5ol"tion2 The total costs to issue the securities are as follows2 1. 1nderwriting 5pread2 Bnderwriters gross spread 7.## $ .29& G.- per share 3umber of shares outstanding G 7.*1 millionK.## per share& G 2,9)9,)9Bnderwriting cost G 7.- per share Q 2,9)9,)9-& G .1-,),),,)2. *"t&o &Po#%et Expenses2 !ut$of$pocket e(penses are .,)+,+++ #. 1nderpri#ing2 5tock price at end of first day G .##71.19& G .#<.-1 6irst$day underpricing G 7.#<.-1 $ .##.++& G .).-1 per share Total underpricing G 7.).-1 per share Q 2,9)9,)9- shares of stock& G .1),,9+,++1 Total cost to the firm of selling the %:! G .1-,),),,)- H .,)+,+++ H .1),,9+,++1 G <'2$+,5$+5-

15.=

)P* pri#ing; Myriad ;iotech plans a .11, million %:! priced at .,# per share, and the offering price to the public is .)1 per share. The firms legal fees, 5'/ registration fees, and other administrative costs total .)2),+++. The firms stock price increases 1, percent on the first day. 8hat is the firms total cost of issuing the securitiesI

,<

,*

5ol"tion2 The total costs to issue the securities are as follows2 1. 1nderwriting 5pread2 Bnderwriters gross spread 7.)1 $ .,#& G.< per share 3umber of shares outstanding G 7.11, millionK.)1 per share& G 2,2#),2*, Bnderwriting cost G 7.< per share Q 2,2#),2*, shares& G .19,<<2,#)2 2. *"t&o &Po#%et Expenses2 !ut$of$pocket e(penses are .)2),+++. #. 1nderpri#ing2 5tock price at end of first day G 7.)1 Q 1.1,& G .)<.1, 6irst$day underpricing G 7.)<.1, $ .)1& G .9.1, per share Total underpricing G 7.9.1, per share Q 2,2#),2*, shares of stock& G .1),*)*,*** Total cost to the firm of selling the %:! G .19,<<2,#)2H .)2),+++ H .1),*)*,*** G <'+$',-$'51

15.?

5hel registration; "re the following statements true or falseI a. 5helf registration allows firms to register an inventory of securities for an unlimited period of time. b. The securities can be taken off the shelf at any period of time and sold to the public. #. 5helf registration reduces flotation and other e(penses associated with registration.

,*

)+ d. e. There is a large penalty if the authori0ed securities are not issued. " shelf registration can cover multiple securities.

5ol"tion; a. 6alse b. True #. True d. 6alse e. True

15.1> 2eneral #ash o er; 8hat are the steps in a general cash offeringI '(plain each step.

5ol"tion; 71& @ecide what to issue. 72& "pprovals. 7#& Eegistration statement. 7,& 6inal price. and 7)& /losing.

15.11 )ss"ing se#"rities; '(plain what is meant by economies of scale in issuing securities.

5ol"tion; There are economies of scale in issuing securities, meaning that as the si0e of the offering increases, the total flotation costs as a percentage of the total issue decline. Jigh fi(ed costs get spread out over a larger sum.

15.12 .an% term lending; '(plain how term to maturity affects the price of a bank loan.

5ol"tion;

)+

)1 Term to maturity 7M"T& will essentially increase the borrowing rate. %t is calculated as the difference between the yield on a Treasury security with the same maturity as the loan minus and the #$month Treasury bill rate. Thus, the longer the loan, the higher the borrowing rate will be.

15.1' Pri!ate pla#ement !ers"s p"bli# debt o ering; 3alco Jolding is an international company that operates in 1#+ countries, has a market cap of .2.# billion, and reported net income of .,) million on .#.# billion in revenues last year. The company needs to raise .2++ million in debt and is deciding between private placement and public offering. 8hat are the advantages of either modeI

5ol"tion; :ublic market allows for higher security since 5'/ is involved, it offers more li4uidity, which might be important for a large issue, and most of the times higher yield. :rivate placement, on the other hand, offers faster speed to market, lower issuance cost, and ease of restructuring. >iven the si0e of the company, 3alco is better off choosing to sell debt in public market.

15.1+ Prime&rate lending; 5uppose two firms want to borrow money from a bank for a period of one year. 6irm " has e(cellent credit, whereas 6irm ;s credit standing is prime H 2. The current prime rate is -.9) percent, the #+$year Treasury bond yield is ,.#) percent, the three$month Treasury bill yield is #.), percent, and the 1+$year Treasury note yield is ,.22 percent. 8hat are the appropriate loan rates for each customerI

)1

)2

5ol"tion; 6irm " G :rime rate G ,.-5@ 6irm ; G :rime rate H 2L G =.-5@

15.15 Prime&rate lending; 3ow suppose that 6irm ; from :roblem 1).1, decides to get a term loan for 1+ years. Jow does this affect the companys borrowing costI

5ol"tion; Maturity risk premium G k1+$year D kT$bill G ,.22L $ #.),L G +.-<L ;orrowing rate for firm ; G k G :rime rate H 2L H ME: G -.9)L H 2L H +.-<L G ?.+'@

)CTER3E()ATE

15.1, /ent"re #apital; Pou work for a venture capital firm and are approached to finance a new high$tech start$up. 8hile you believe in the business idea, you feel it is very risky. 8hat strategies can help to mitigate the risk to your firmI '(plain how these measures would work.

5ol"tion;

)2

)# Pou can fund the proAect in stages. This will allow you to review the proAects profitability before you commit to further financing. Pou can also re4uire the entrepreneurs to invest some of their own capital, which will tie them to the proAect and make it harder for them to simply abandon the idea.

15.1- )P*; @eere and ;ros. is a broker that brings new issues of small firms to the market. Their most recent deal for @e(tra, %nc., had the following characteristics2 3umber of shares2 1,+++,+++ :roceeds to @e(tra2 .1#,)++,+++ The legal fees were .1)+,+++, printing costs were .)-,+++, and all the other e(penses were .92,+++. 8hat is the profit or loss for @eere and ;ros.I :rice to public2 .1) per share

5ol"tion2 Total proceeds from offer G .1) Q 1,+++,+++ shares G .1) million :roceeds to @e(tra G .1#.) million >ross underwriting spread to @eere G .1.) million Bnderwriting costs G .1)+,+++ H )-,+++ H .92,+++ G .29<,+++ 3et profit to underwriter G .1,)++,+++ $ .29<,+++ G <1$22>$>>>

15.1= )P*; 8hen >lobal :artners went public in 5eptember 2++<, the offer price was .22.++ per share and the closing price at the end of the first day was .2#.*+. The firm issued ,.* million shares. 8hat was the loss to the company due to underpricingI

)#

), 5ol"tion2 /hange in price on first day G .2#.*+ $ .22.++ G .1.*+ 3umber of shares outstanding G ,.* million Foss due to underpricing G .1.*+ Q ,,*++,+++ G <?$'1>$>>>

15.1? )P*; ;elle( Technologies issues an %:! sold on a best$effort basis. The companys investment bank demands a spread of 19 percent of the offer price, which is set at .#+ per share. Three million shares are issued. Jowever, the bank was overly optimistic and eventually is able to sell the stock for only .2< per share. 8hat are the proceeds for the issuer and the underwriterI

5ol"tion2 >ross proceeds from offer G .#+.++ Q #,+++,+++ G .*+,+++,+++ Bnderwriting spread G .*+,+++,+++ Q +.19 G <15$'>>$>>> :roceeds to issuer G 7.2< Q #,+++,+++& R .1),#++,+++ G <,=$->>$>>>

15.2> )P*; 5uppose a biotech company in ;oston, Massachusetts, issues an .<) million %:! priced at .92 per share. The offering price to the public is .9) per share. The out$of$ pocket e(penses are .#,+,+++. The stocks closing price at the end of the first day is .<,. 8hat is the firms total cost of issuing the securitiesI

5ol"tion2 The total costs to issue the securities are as follows2

),

)) >ross spread G .9) D .92 G .# per share 3o. of shares outstanding G .<),+++,+++ K .9) G 1,1##,### Total underwriting cost G .# Q 1,1##,### G .#,#**,*** Bnderpricing per share G .<, D .9) G .*.++ Total underpricing on day 1 G .*.++ Q 1,1##,### G .1+,1**,**9 Total underpricing G .1+,1**,**9 H .#,#**,*** H .#,+,+++ G <1'$?'?$??,

15.21

)P*; "n online medical advice company Aust completed an %:! with an investment bank on a firm$commitment basis. The firm issued ) million shares of common stock, and the underwriting fees were .,.2+ per share. The offering price was .2- per share. a. b. #. 8hat were the total proceeds from the common$stock saleI Jow much money did the company actually make from the dealI Jow much money did the investment bank makeI

5ol"tion2 a. b. c. Total proceeds from issue G .2-.++ Q ),+++,+++ G.1#+,+++,+++ 3et proceeds to firm G 7.2- D .,.2+& Q ),+++,+++ G .1+*,+++,+++ Bnderwriting spread G .,.2+ Q ),+++,+++ G .21,+++,+++

15.22 )P* "nderpri#ing; 5uppose that a biotech firm in ;altimore raises .12+ million in an %:!. The firm receives .2# per share, and the stock sold to the public at .2) per share. The firms legal fees, 5'/ registration fees, and other administrative costs are .29+,+++.

))

)The firms stock price increases 19.) percent on the first day. 8hat is the firms total cost of issuing the securitiesI

5ol"tion2 The total costs to issue the securities are as follows2 a. 1nderwriting Cost2 >ross spread G .2) $ .2# G .2 per share 3o. of shares outstanding G .12+,+++,+++ K .2) G ,,<++,+++ Total underwriting cost G .2 Q ,,<++,+++ G .*,-++,+++ b. 1nderpri#ing2 :rice of stock at end of first day G .2) Q 71.19)& G .2*.#9) Bnderpricing per share G .2*.#9) $ .2) G .,.#9) Total underpricing on day 1G .,.#9) Q ,,<++,+++ G .21,+++,+++ Total underpricing G .21,+++,+++ H .*,-++,+++ H .29+,+++ G .#+,<9+,+++

15.2' 4ong&term #orporate debt; The 2+$year Treasury rate is ,.-9 percent, and a firms credit rating is ;;. 5uppose the firm decides to raise .2+ million by selling 2+$year bonds. Management determines that since it has plenty of e(perience, it will not need an investment banker. "t present, 2+$year ;; bonds are selling for 1<) basis points above the 2+$year Treasury rate, and it is forecast that interest rates will not stay this low for long. 8hat is the cost of borrowingI 8hat role does timing play in this caseI

5ol"tion;

)-

)9 -.)2 percentC since the economy is supposed to improve, the interest rates are e(pected to go up in the near future, which could make the cost of borrowing more e(pensive. Time is of essence in this case.

)9

)<

5ample Test Problems

15.1

The ;right5tar /orporation, a solar cell maker, is planning an e(pansion and needs to raise .22 million to finance it. The company plans to raise the money through a general cash offering priced at .1<.)+ a share. ;right5tars underwriters charge a -.)+ percent spread. Jow many shares does the company have to sell to achieve its goalI

5ol"tion; Bnderwriters spread G -.)L :rice per share the firm gets G M.1<.)+ Q 71 R +.+-)&O G .19.2*9) Therefore, to raise .22 million, the company needs to issue2 .22,+++,+++ K .19.2*9) G 1$2-1$=,> new shares

15.2

/rescent, %nc., is planning an %:!, and the investment bank offers to buy the securities for .21.)+ per share and offer them to the public at .2#.++. 8hat is the gross underwriters spreadI "ssume that the underwriters cost of bringing the security to the market is .1.++ per share. 8hat is the net profitI

5ol"tion; %:! market price G .2#.++ :rice to issuer G .21.)+ The underwriters spread2 2#.++ D .21.)+ D .1 G .1.)+ /ost of bringing the security to the market G .1.++

)<

)* 3et profit2 .1.)+ D .1 G <>.5>

15.'

5elkirk 'lectronics issues an %:! sold on a best$effort basis. The companys investment bank demands a spread of 9 percent of the offer price, which is set at .2, per share. Two million shares are issued. Jowever, the bank was overly optimistic and eventually is able to sell the stock for an average price of .2#.-+ per share. 8hat are the proceeds for the issuer and the underwriterI

5ol"tion2 >ross proceeds from offer G .2#.-+ Q 2,+++,+++ G .,9,2++,+++ Bnderwriting spread G 7.2, Q 2,+++,+++& Q +.+9 G <'$',>$>>> :roceeds to issuer G .,9,2++,+++ D .#,#-+,+++ G <+'$=+>$>>>

15.+

5andlot /o. needs to borrow .19 million for a factory e4uipment upgrade. Management decides to sell 1+$year bonds. They determine that the #$month Treasury bill rate is #.<, percent, the firms credit rating is ;aa, and the yield on 1+$year Treasury bonds is 1.#percent higher that that for #$month bills. ;onds with a ;aa rating are selling for 9) basis points above the 1+$year Treasury bond rate. 8hat is the borrowing cost on this transactionI

5ol"tion2 The borrowing cost for @ean 6oods can be calculated as follows2 kl G #.<, H 1.#- H +.9) G 5.?5@

)*

-+

15.5

8hen >lobal :harma went public in Suly 2++*, the offer price was .2<.)+ per share and the closing price at the end of the first day was .2-.<). The firm issued #.- million shares. 8hat was the loss to the company due to underpricingI

5ol"tion2 /hange in price on first day G .2<.)+ $ .2-.<) G .1.-) 3umber of shares outstanding G #.- million Foss due to underpricing G .1.-) Q #,-++,+++ G <5$?+>$>>>

-+