CHAPTER 15
RAISING CAPITAL
Answers to Concepts Review and Critical Thinking Questions
1.
A company’s internally generated cash flow provides a source of equity financing. For a profitable
company, outside equity may never be needed. Debt issues are larger because large companies have
the greatest access to public debt markets (small companies tend to borrow more from private
lenders). Equity issuers are frequently small companies going public; such issues are often quite
small.
2.
From the previous question, economies of scale are part of the answer. Beyond this, debt issues are
simply easier and less risky to sell from an investment bank’s perspective. The two main reasons are
that very large amounts of debt securities can be sold to a relatively small number of buyers,
particularly large institutional buyers such as pension funds and insurance companies, and debt
securities are much easier to price.
3.
They are riskier and harder to market from an investment bank’s perspective.
4.
Yields on comparable bonds can usually be readily observed, so pricing a bond issue accurately is
much less difficult.
5.
It is clear that the stock was sold too cheaply, so Netscape had reason to be unhappy.
6.
No, but, in fairness, pricing the stock in such a situation is extremely difficult.
7.
It’s an important factor. Only 5 million of the shares were underpriced. The other 38 million were, in
effect, priced completely correctly.
8.
The evidence suggests that a non-underwritten rights offering might be substantially cheaper than a
cash offer. However, such offerings are rare, and there may be hidden costs or other factors not yet
identified or well understood by researchers.
9.
He could have done worse since his access to the oversubscribed and, presumably, underpriced issues
was restricted while the bulk of his funds were allocated to stocks from the undersubscribed and, quite
possibly, overpriced issues.
Solutions to Questions and Problems
Basic
1.
a.
b.
c.
d.
e.
new market value = 240,000($80) + 60,000($60) = $22,800,000
number of rights needed = 240,000 old shares/60,000 new shares = 4 rights per new share
PX = $22,800,000/300,000 shares = $76.00
value of a right = $80 – 76.00 = $4.00
A rights offering usually costs less, it protects the proportionate interests of existing shareholders and also protects against underpricing.
2.
a.
b.
maximum subscription price = current share price = $60; minimum is anything > $0
number of new shares = $60 million/$50 = 1.20 million shares
number of rights needed = 4,800,000 old shares/1,200,000 new shares = 4
PX = [4($60) + $50]/5 = $58.00; value of a right = $60 – 58.00 = $2.00
before offer:
portfolio = (1,000 shares)($60) = $60,000
after offer:
portfolio = (1,000 shares)($58) + (1,000 rights)($2) = $60,000
c.
d.
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3.
PX = $64.50 = [N($70) + $45]/(N + 1); N = 3.5454545
number of new shares = $13,500,000/$45 = 300,000;
number of old shares = 3.5454545 (300,000) = 1,063,636
4.
If you receive 1,000 shares of each, the profit is 1,000($9) – 1,000($5) = $4,000.
Expected profit = 500($9) – 1,000($5) = – $500. This is an example of the winner’s curse.
5.
X(1 – .08) = $20M; X = $21,739,130.43 required total proceeds from sale.
number of shares offered = $21,739,130.43/$28 = 776,398
6.
X(1 – .08) = $20.25M; X = $22,010,869.57 required total proceeds from sale.
number of shares offered = $22,010,869.57/$28 = 786,102
7.
net amount raised = (2M shares)($18) – $600,000 = $35.4M
total direct costs = $400,000 + ($19 – 18)(2M shares) = $2.4M
total indirect costs = $200,000 + ($23 – 19)(2M shares) = $8.2M
total costs = $2.4M + 8.2M = $10.6M
flotation cost percentage = $10.6M/$35.4M = 29.94%
8.
number of rights needed = 100,000 old shares/20,000 new shares = 5 rights per new share.
a.
PX = [5($80) + $80]/6 = $80.00; no change.
b.
PX = [5($80) + $70]/6 = $78.33; price drops by $1.67 per share.
c.
PX = [5($80) + $55]/6 = $75.83; price drops by $4.17 per share.
Intermediate
9.
a.
b.
number of shares after offering = 10M + $31M/$20 = 11.55M
new book value per share = [10M($40) + 1.55M($20)]/11.55M = $37.32
EPS0 = NI0/shares0 = $10M/10M shares = $1 per share; (P/E)0 = $20/$1 = 20
EPS1 = NI1/shares1 = $10.5M/11.55M shares = $0.909 per share;
P1 = (P/E)0(EPS1) = 20($0.909) = $18.18
old market-to-book = $20/$40 = 0.5; new market-to-book = $18.18/$37.32 = 0.4871
Accounting dilution has occurred because new shares were issued when the market-to-book
ratio was less than one; market value dilution has occurred because the firm financed a negative
NPV project: NPV = –$31M + [11.55M($18.18) – 10M($20)] = –$21,021,000
For the price to remain unchanged when the P/E ratio is constant, EPS must remain constant.
NI1 = (11.55M shares)($1 per share) = $11.55M
10. ROE0 = NI0/TE0 = $630,000/$3,600,000 = .1750
NI1 = (ROE0)(TE1) = .1750($3,600,000 + 1,100,000) = $822,500
EPS0 = $630,000/12,000 shares = $52.50; number of new shares = $1,100,000/$96 = 11,458
EPS1 =$822,500/23,458 shares = $35.06
(P/E)0 = $96/$52.50 = 1.8286
P1 = 1.8286($35.06) = $64.11
(P/E)1 = $64.11/$35.06 = 1.8286
BVPS0 = TE0/shares0 = $3,600,000/12,000 shares = $300.00 per share;
BVPS1 = TE1/shares1 = ($3,600,000 + 1,100,000)/23,458 shares = $200.36 per share
market-to-book0 = $96/$300 = 0.32; market-to-book1 = $64.11/$200.36 = 0.31997
NPV = –$1,100,000 + [$64.11(23,458) – $96(12,000)] = –$748,107.62
Accounting dilution takes place here because the market-to-book ratio is less than one. Market value
dilution has occurred since the firm is investing in a negative NPV project.
11. P1 = $96 = 1.8286(EPS1); EPS1 = $52.50. NI1 = EPS1(11,458 shares) = $601,545
ROE1 = $601,545/$1,100,000 = .5468
If the share price after the offering is $96, then the project NPV is:
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NPV = –$1,100,000 + [$96(23,458.3333) – $96(12,000)] = $0
Accounting dilution still takes place, as BVPS still falls from $300.00 to $200.36, but no market
dilution takes place because the firm is investing in a zero NPV project.
12. number of new shares = $60M/$PS ; N = # old shares/#new shares = 4M/($60M/$PS) = 0.0667PS
PX = $45 = [N($48) + $PS]/(N + 1) = [48(0.0667PS) + PS]/(0.0667PS + 1) = 4.2PS/(1 + 0.0667PS);
PS = $37.50
13. PX = [NPRO + PS]/(N + 1)
value of a right
= PRO – PX = PRO – { [NPRO + PS]/(N + 1) }
= [(N + 1)PRO – NPRO – PS]/(N+1) = [PRO – PS]/(N + 1)
14. net proceeds to company = $25(1 – .06) = $23.50 per share
new shares offered = $3.29M/$23.50 = 140,000
number of rights needed = 420,000 old shares/140,000 new shares = 3 rights per new share
PX = [3($30) + 25]/4 = $28.75
value of a right = $30 – 28.75 = $1.25
proceeds from selling rights = 6,000($1.25) = $7,500
15. PX = [4($70) + $35]/5 = $63; the stock is correctly priced.
value of a right = $70 – 63 = $7; the rights are underpriced.
You can create an immediate profit on the ex-rights day if the stock is selling for $63 and the rights
are selling for $6 by executing the following transactions:
Buy 4 rights in the market for 4($6) = $24. Use these rights to purchase a new share at the subscription price of $35. Immediately sell this share in the market for $63, creating an instant $4 profit.
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