This Document Contains Chapters 14 to 15 Chapter 14 Discussion Questions 14-1. The major competitors are the federal government, federal crown corporations, the provinces, provincial crown corporations, municipalities, and the private sector. 14-2. When the economy is healthy and growing, tax revenues increase causing the government deficit to shrink and therefore reduce the amount of funds the finance department must raise. However, when the economy is in a recession, tax revenues decline, and deficits increase. If the government tries to stimulate the economy by increasing spending, the likely effect will be to create larger deficits in the short run and a much greater need for financing. 14-3. The average maturity on the federal government debt by 2011 had increased to about 6 years from under 4 years in 1989. Shorter terms cause a regular rollover of the debt and may cause a certain amount of market instability. 14-4. As the federal government reduces its accumulated debt we had seen the corporate sector (and individuals) step into the vacuum and increase their debt loads. There also has been decreased pressure on interest rates and we have seen rates decline. For investors and corporate treasurers there has been a decreased supply of government obligations. This has caused some disruptions in the financial markets and caused investors to accept the greater risk of corporate securities. As governments returned to borrowing competition for funds increased but with limited corporate activity no impact on interest rates had yet occurred by late 2011. 14-5. On average bonds and stocks have been used in equal proportions to fund external debt of Canadian corporations although there has been a wide variance from year to year and more use of debt in the last few years (Figure 14-6). Preferreds although significant have been a less significant source of funds to corporations during this period. 14-6. On average internally generated funds have provided between 60 to 80 percent of corporate funding requirements. Borrowed funds for expansion have tended to be balanced between debt and equity although the last decade has seen more significant debt borrowings. 14-7. In a three-sector economy consisting of business, households, and government, financial intermediaries such as banks, trust companies, insurance companies, mutual funds, pension funds, and credit unions provide the mechanism for reallocating funds from one surplus sector to a deficit sector. These institutions indirectly invest excess funds in areas of the economy where funds are needed. 14-8. First, they enable corporations to raise funds by selling new issues of securities rapidly and at fair competitive prices for reinvestment in real assets. Second, they allow the investor who purchases securities to sell them with relative ease and speed and thereby to turn a paper asset into cash (they provide liquidity). Third, the market allocates capital to the most efficient users (some would argue that governments get allocated capital regardless of efficiency) and as such provide a barometer as to which companies are managing their assets best. Price will reflect that judgment. 14-9. The organized exchanges have one central location and operate as auction markets. The over-the-counter markets have no central location; instead a network of dealers all over the country is linked by computer display terminals, telephones, and teletypes. 14-10. Listing requirements provide some assurance to the investor that corporations trading on a specific exchange can meet demonstrated requirements as to income, number of shareholders, total asset value, and number of shares outstanding. The TSX has the strictest listing requirements as identified in the chapter. 14-11. Markets that: (1) are liquid, (2) have prices that react quickly to new information and (3) have prices that to a great extent reflect all available information. (NPV = 0). Proper compensation for risk assumed. 14-12. The weak form of efficient markets simply states that past price information is unrelated to future prices and that since no trends are predictable, investors cannot take advantage of them. The semi-strong form states that prices reflect all public information, while the strong form states that all information, both public and private, is reflected in the stock prices. 14-13. By abnormal profits (losses) we describe returns above (below) what the market anticipates given the risk assumed in a financial investment. NPV is greater (or less than) zero. 14-14. Discussion could center on the number of buyers and sellers, liquidity, degree of analysis, newspaper reporting, securities regulation, minimal transaction costs, and perceptions of a fair game by investors. Anything that aids information flow and its reflection in share prices. 14-15. Any tests the student suggests that relate abnormal profits to a theory are worth discussing. Included could be insider trading, the January effect, corporate announcements such as share repurchases, the crash of 1987, the speculative bubbles of the late 1990s, 2008 and so on. 14-16. The ‘four pillars of finance’ structure was an attempt to reduce the possibility of conflict of interest when managing other people’s money. However, changes in the rules governing the separation of functions have been made as a concession to the reality of a globalized market. Whether the historically feared conflicts can be avoided remains to be seen. 14-17. The implications of the changing financial structure are enormous, with large financial institutions in all facets of the capital, money and retail markets. There are smaller boutique investment dealers and foreign-based institutions with large capital backing. Investment dealers have merged to raise substantial amounts of new capital or have specialized. Banks for example are in all areas of what formerly were the “four separate pillars”. 14-18. This is a library or internet assignment. It is likely that the business pages of any current newspaper would have noteworthy information on the changing financial environment. The regulatory environment has been strengthened to deal with the accounting scandals of the last number of years. Internet Resources and Questions 1. http://www.tsx.com/en/listings/listing_with_us/index.html www.nyse.com https://listingcenter.nasdaqomx.com/Show_Doc.aspx?File=listing_information.html a. b. c. 2. No. Discuss the changes that have occurred related to the consolidation of exchanges in Canada and the pressures brought to bear in the international markets. Listing requirements including costs are less onerous. Also perceived as a more “with it” exchange, particularly in the hi-tech area. Greater liquidity and access to the broader capital market. Also many Canadian firms do most of their business on the world stage and often their cash flows are in $U.S. http://www.cipf.ca/Public/CIPFCoverage/WhatCoverageDoesCIPFProvide.aspx http://www.cdic.ca/e/coveredornot/coveredornot.html Chapter 15 Discussion Questions 15-1. The investment dealer is a risk taker (underwriter) when it agrees to buy the securities from the corporation and resell them to other security dealers and the public. 15-2. Market stabilization activities are managed in an attempt to insure that the market price will not fall below a desired level during the distribution process. Syndicate members committed to purchasing the stock at a given level could be in trouble if there is a rapid decline in the price of the stock. Precisely that happened in the British Petroleum privatization in October of 1987. The severe market correction during October 19 and 20 left four Canadian investment dealers facing the prospect of losing many millions on their share of the new issue distribution. 15-3. By forming a syndicate of many underwriters rather that just one, the overall risk is diffused and the capabilities for widespread distribution are enhanced. In the British Petroleum example, Canadian and U.S. securities firms faced huge losses because they formed only small syndicates to serve their national markets. On the other hand, the British syndicate consisted of many hundred firms so that no one faced enormous losses. 15-4. Common stocks often carry a larger underwriting spread than bonds because the market reaction to stocks is more uncertain. Bonds also may be offered in larger units, and thus carry economies of scale. 15-5. The price is determined by the firm’s industry, its financial characteristics, and the firm’s anticipated earnings and dividend-paying capability. Based on appropriate valuation techniques, a price will be tentatively assigned and will be compared to that enjoyed by similar firms in a given industry. If the industry’s price-earnings ratio is 12, the firm should not stray too far from the norm. Anticipated public demand will also be a major factor in pricing a new issue. 15-6. Due to underpricing by the investment dealer, there is often a positive excess return immediately after the offering. With the passage of time, the efficiency of the market begins to become evident and long-term sustainable performance is very much dependent on the quality of the issue and market conditions. 15-7. Unlike most other countries, in Canada the major investment dealers have vertically integrated for a long time. However, for firms which had weak representation in the retail end of the business, mergers with firms that were particularly strong in retail and weak in underwriting have made sense. Foreign subsidiaries, traditionally operating on the retail side of the business, are now poised to move into underwriting. The chartered banks have operations in retail and the lucrative area of investment underwriting. 15-8. The benefits of having a publicly traded security are: a. Greater ability to raise capital. b. Additional prestige and visibility that can be helpful in bank negotiations, executive recruitment, and the marketing of products. c. Increased liquidity for existing shareholders. d. Ease in estate planning for existing shareholders. e. An increased capability to engage in the merger and acquisition process. 15-9. The disadvantages to being public are: a. All information must be made available to the public through securities commission filings. This can be very expensive for a small company. b. The president must be a public relations representative to the investment community. c. Tremendous pressure is put on the firm for short-term performance. d. Large downside movement in the stock can take place in a bear market. e. The initial cost of going public can be very expensive for a small firm. 15-10. Funds for private placement can be found through insurance companies, pension funds, and wealthy individuals. 15-11. The use of a leveraged buyout implies that either management or some other investor group borrows the needed cash to repurchase all the shares of the company. After the repurchase, the company exists with a lot of debt and therefore heavy debt servicing charges. To reduce the debt load, assets may be sold off to generate cash. Also, returns from asset sales may be redeployed into higher return areas. 15-12. Because of the extremely heavy debt load associated with leveraged buyouts, management must initiate strategies aimed at generating cash flow quickly in order to pay down the debt before its economic sector goes into recession (by their nature leveraged buyouts happen in mature, recession prone sectors of the economy). Thus, the strategy is usually short-term, efficiency oriented. 15-13. Unresolved discussion question. There have been spectacular failures with wasted resources but there have been reorganizations for increased efficiencies and the removal of entrenched conservative management. Internet Resources and Questions 1. www.tsx.ca/HttpController?GetPage=ListedCompaniesViewPage&ListedCompanyTab=Rec entlyListed www.sedar.com/new_docs/new_en.htm Problems 15-1. Midas and Company a. $15.60 15.00 $ 0.60 Return = b. c. Monies received (spread) $0.60 = = 0.04 = 4.00% Capital invested $15.00 $16.00 15.00 $ 1.00 Return = Broker's price Managing investment dealer's price Differential Monies received (spread) $1.00 = = 0.0667 = 6.67% Capital invested $15.00 $16.50 15.00 $ 1.50 Return = Selected dealer group's price Managing investment dealer's price Differential Public price Managing investment dealer's price Differential Monies received (spread) $1.50 = = 0.10 = 10.00% Capital invested $15.00 15-2. Walton and Company a. $18.80 18.00 $ 0.80 Monies received (spread) $0.80 = = 0.0444 = 4.44% Capital invested $18.00 Return = b. $19.20 18.00 $ 1.20 Return = c. Broker's price Managing investment dealer's price Differential Monies received (spread) $1.20 = = 0.0667 = 6.67% Capital invested $18.00 $19.50 18.00 $ 1.50 Return = Selected dealer group's price Managing investment dealer's price Differential Public price Managing investment dealer's price Differential Monies received (spread) $1.50 = = 0.0833 = 8.33% Capital invested $18.00 15-3. Maple Ridge Slugger Bat Company a. Spread = $16.75 – $16.00 = $0.75 Spread = $0.75 = 0.0448 = 4.48% $16.75 b. Spread = $1,001 – $993 = $8 Spread = $8.00 = 0.0080 = 0.8% $1,001 c. The shares have the larger spread which is normal given the greater risk to the underwriter inherent in an equity issue. 15-4. Solar Energy Corp. Earnings per share (eps) = $5,000,000 = $2.50 2,000,000 eps × price earnings multiplier = suggested price to public $2.50 × 18 = $45 The underwriting spread does not alter the suggested price to the public, only what the firm nets. Public Price 5% Spread Net amount received 15-5. $45.00 – 2.25 $42.75 Tiger Golf Supplies Earnings per share (eps) = $15,000,000 = $3.75 4,000,000 eps × price earnings multiplier = suggested price to public $3.75 × 22 = $82.50 The underwriting spread does not alter the suggested price to the public, only what the firm nets. Public Price 2.8% Spread Net amount received $82.50 – 2.31 $80.19 15-6. Safeguard Detective Company a. Spread = $50.00 – $46.10 = $3.90 Underwriting spread = $3.90 = 0.0780 = 7.80% $50.00 b. Spread = $50.00 – $46.80 = $3.20 Underwriting spread = $3.20 = 0.0640 = 6.40% $50.00 c. Spread = $50.00 – $48.15 = $1.85 Underwriting spread = $1.85 = 0.0370 = 3.70% $50.00 The principle demonstrated is the larger the offer size, the lower the underwriting spread. 15-7. Power Temporaries a. Earnings per share (eps) = $4,500,000 = $2.50 1,800,000 b. Earnings per share (eps) = $4,500,000 = $2.05 2,200,000 15-8. Hamilton Corporation a. Earnings per share (eps) = $6,000,000 = $1.50 4,000,000 Earnings per share (eps) = $6,000,000 = $1.20 5,000,000 Dilution = $1.50 – $1.20 = $0.30 per share. b. Net income = $6,000,000 + 0.105 ($1,000,000 × $30) = $6,000,000 + 0.105 ($30,000,000) = $6,000,000 + $3,150,000 = $9,150,000 Earnings per share after additional income: Earnings per share (eps) = $9,150,000 = $1.83 5,000,000 Based on the current year’s results, the public offering should be undertaken. E.P.S. will increase from $1.50 to $1.83. Of course, other variables may also be considered. 15-9. Hamilton Corporation (Continued) Net income = $6,000,000 + 0.06 ($1,000,000 × $23) = $6,000,000 + $1,380,000 = $7,380,000 Earnings per share after additional income $7,380,000 Earnings per share (eps) = = $1.48 5,000,000 No, E.P.S. would decline by 2 cents from $1.50 to $1.48. 15-10. Carma S. Diego Travelers Corp. a. Earnings per share before share issue: $18,000,000 Earnings per share (eps) = = $1.80 10,000,000 Earnings per share after share issue: $18,000,000 Earnings per share (eps) = = $1.64 11,000,000 Dilution = $1.80 – $1.64 = $0.16 per share. b. Net income = $18,000,000 + 0.12 (1,000,000 × $9) = $18,000,000 + 0.12 ($9,000,000) = $19,080,000 Earnings per share after additional income $19,080,000 Earnings per share (eps) = = $1.73 11,000,000 Do not undertake the public offering as EPS decreases ($1.80 to $1.73). c. Net income = $18,000,000 + 0.12 (1,000,000 × $16) = $19,920,000 Earnings per share (eps) = $19,920,000 = $1.81 11,000,000 Undertake the public offering as EPS increases ($1.80 to $1.81). 15-11. Macho Tool Company a. Earnings per share before share issue $48,000,000/12,000,000 = $4.00 Earnings per share after share issue $48,000,000/$16,000,000 = $3.00 Note only four million new corporate shares were issued. The other two million belonged to founding shareholders and do not increase the number of shares outstanding. b. EPS P/E Share price $ 3.00 × 20 $60.00 c. The founding shareholders will probably not be pleased. They received a net price of $50 and the stock has a value of $60.00 immediately after the offering. They may wish the initial offering price had been higher. 15-12. Winston Sporting Goods a. Spread = $18.00 – $16.50 = $1.50 Underwriting spread = $1.50 = 0.0833 = 8.33% $18.00 b. Total expenses = ($1.50 × 600,000 shares) + $150,000 (out-ofpocket) = $900,000 + $150,000 = $1,050,000 = 600,000 shares × $18 = $10,800,000 Total value Total spread = Total expenses $1,050,000 = = 0.0972 = 9.72% Price to public $10,800,000 c. Amount needed (net) = $18,000,000 $18,000,000 + issue costs Net price per share $18,150,000 = = 1,100,000 shares $16.50 Needed shares = 15-13. DUR? Semiconductors a. Spread = $18.00 – $16.55 = $1.45 Spread = $1.45 = 0.0806 = 8.06% $18.00 b. Spread = $0.85 = 0.0472 = 4.72% $18.00 c. Public Price 3% Spread $18.00 – 0.54 Net amount received 15-14. $17.46 Becker Brothers Original Distribution: 10% × 1,000,000 = 100,000 $ 1.40 $140,000 shares for Becker profit per share profit on original distribution Market Stabilization: 40,000 $ 2.75 $110,000 Gain on original distribution Loss on market stabilization Net gain 15-15. shares for Becker loss per share ($25.75 – $23.00) loss on market stabilization $140,000 110,000 $ 30,000 Ashley Homebuilding 80% of the S&P/TSX Composite Index = 80% × 15 = 12 Industry Comparisons: Growth rate in earnings per share: superior Consistency of performance: superior Debt to total assets: inferior Turnover of product: inferior Quality of management: superior Initial P/E ratio = 12 + 0.5 = 12.5 + 0.5 + 0.5 – 0.5 – 0.5 + 0.5 + 0.5 15-16. A. Einstein & Co. a. P0 = D1 $1.44 $1.44 = = = $36.00 K e − g 0.12 − 0.08 .04 b. Public price Underwriting spread (6%) Net price to the corporation $36.00 2.16 $33.84 c. Net price (1 − underwriting spread ) $34.50 = = $36.70 (1 − 0.06) Necessary public price = 15-17. Saskatchewan Cloud Inc. a. P0 = D1 $1.20 $1.20 = = = $24.00 K e − g 0.12 − 0.07 .05 b. Public price Underwriting spread (6%) Net price to the corporation $24.00 1.44 $22.56 c. Net price (1 − underwriting spread ) $23.50 = = $25.00 (1 − 0.06) Necessary public price = 15-18. The Landry Corporation Private Placement $1,000,000 – 30,000 $ 970,000 debt out-of-pocket costs net amount to Landry interest payments (semiannually) = 11%/ 2 = interest payments = 5.5% × $1,000,000 = $55,000 5.5% Present value of future interest payments PV A = A × PV IFA (N = 50, %I/Y = 6%) (Appendix D) PV A = $55,000 × 15.762 = $866,910 Present value of lump-sum payment at maturity PV = FV × PV IF (N = 50, %I/Y = 6%) (Appendix B) PV = $1,000,000 × 0.054 = $54,000 Total present value of interest and maturity payments: $866,910 + 54,000 $920,910 total present value Calculator: PV =? FV = $1,000,000 %I/Y = 6% N = 50 Compute PV = $921,191 PMT = $55,000 The net present value equals the net amount to Landry minus the present value of future payments. $ 970,000 – 921,191 $ 48,809 net amount to Landry present value of future payments net present value (private offering) Public Issue $1,000,000 – 40,000 – 100,000 $ 860,000 debt 4% spread out-of-pocket costs net amount to Landry interest payments (semiannually) = 10%/ 2 = 5% interest payments = 5% × $1,000,000 = $50,000 Present value of future interest payments PV A = A × PV IFA (N = 50, %I/Y = 6%) (Appendix D) PV A = $50,000 × 15.762 = $788,100 Present value of lump-sum payment at maturity PV = FV × PV IF (N = 40, %I/Y = 6%) (Appendix B PV = $1,000,000 × 0.054) = $54,000 Total present value of interest and maturity payments: $788,100 + 54,000 $849,300 total present value Calculator: PV =? FV = $1,000,000 %I/Y = 6% Compute PV = $842,381 PMT = $50,000 N = 50 Net present value equals the net amount to Landry minus the present value of future payments. $ 860,000 – 842,381 $ 17,619 net amount to Landry present value of future payments net amount to Landry The private placement has the higher net present value: ($48,809 vs. $17,619) 15-19. Midland Corporation a. $21,660,000 net amount to be raised. Net price to the corporation: Shares to be sold: $38.00 – 1.90 $36.10 # shares = public price 5% spread net price $21,660,000 = 600,000 $36.10 b. The new shares will increase the total number of shares outstanding and dilute EPS. This dilution effect may reduce the stock price in the market temporarily until income from the new assets becomes included in the price the market is willing to pay for the stock. By selling at below market value, the investment dealer is attempting to attract investors into this temporarily dilutive situation. The investment firm is also reducing its own underwriting risk by pricing the issue at the lower value. c. Earnings per share (eps) = $15,000,000 = $2.50 6,000,000 Price earnings ratio (P/E) = Earnings per share (eps) = $40 = 16 × $2.50 $15,000,000 = $2.27 6,600,000 Price = P/E × EPS = 16 × $2.27 = $36.32 d. Net income = $15,000,000 + 15% ($21,660,000) = $15,000,000 + $3,249,000 =$18,249,000 EPS after contribution = $18,249,000 = $2.77 6,600,000 Price = P/E × EPS = 16 × $2.77 = $44.32 e. In the long run, it appears that the company is better off because of the additional investment. Earnings per share are $0.27 higher and the share price also increased. If the firm had used debt financing or a combination of debt and shares, they would have increased earnings per share even more, but would have created additional financial obligations in the process. 15-20. Presley Corporation a. $20 price × 95% = $19 net price $19 net price × 600,000 new shares $11,400,000 proceeds before out-of-pocket costs – 200,000 out-of-pocket costs $11,200,000 net proceeds b. EPS before share issue = c. EPS after share issue = $7,500,000 = $3.00 2,500,000 $7,500,000 = $2.42 3,100,000 d. There are now 3,100,000 shares outstanding. To maintain earnings of $3 per share, total earnings must be $9,300,000. This would imply an increase in earnings of $1,800,000 ($9,300,000 – $7,500,000). incremental earnings $1,800,000 = = 0.1607 = 16.07% net proceeds $11,200,000 16.07% must be earned on the net proceeds to produce EPS of $3.00. e. $3.00 (1.05) = $3.15 (5% increase in EPS) Total earnings = $3.15 × 3,100,000 shares = $9,765,000 Incremental earnings = $9,765,000 – $7,500,000 = $2,265,000 incremental earnings $2,265,000 = = 0.2022 = 20.22% net proceeds $11,200,000 20.22% would have to be earned to produce EPS of $3.15. 15-21. Northern Airlines a. $18 price × 96% = $17.28 net price $17.28 net price × 300,000 new shares $5,184,000 proceeds before out-of-pocket costs – 100,000 out-of-pocket costs $5,084,000 net proceeds b. EPS before share issue = c. EPS after share issue = $6,000,000 = $1.50 4,000,000 $6,000,000 = $1.40 4,300,000 d. There are now 4,300,000 shares outstanding. To maintain earnings of $1.50 per share, total earnings must be $6,450,000 (4,300,000 × $1.50). This would imply an increase in earnings of $450,000 ($6,450,000 – $6,000,000). incremental earnings $450,000 = = 0.0885% = 8.85% net proceeds $5,084,000 8.85% must be earned on the net proceeds to produce EPS of $1.50. e. $1.50 (1.10) = $1.65 (10% increase in EPS) Total earnings = $1.65 × 4,300,000 shares = $7,095,000 Incremental earnings = $7,095,000 – $6,000,000 = $1,095,000 incremental earnings $1,095,000 = = 0.2154 = 21.54% net proceeds $5,084,000 21.54% would have to be earned to produce EPS of $1.65. 15-22. I.B. Michaels – Hi-Tech Microcomputers a. Mr. Michael’s purchase = 1.5% × 15,000 shares = 225 shares Dollar profit or loss 1 week 225 shares × ($33 – $30) = $ 675.00 1 month 225 shares × ($34.75 – $30) = $1,068.75 1 year 225 shares × ($28.75 – $30) = $ 281.25 b. Percentage profit or loss 1 week $3.00/ $30 = 1 month $4.75/ $30 = 1 year – $1.25/ $30 = profit profit loss 10.00% 15.83% – 4.17% The results are in line with prior research. The shares went up one week and one month after issue, but actually provided a negative return for one year after issue. This is consistent with the research of Reilly (footnote 1), which showed excess returns of 10.9 percent, 11.6 percent and – 3.0 percent over comparable periods of study. Actually, the shares were a bit stronger than that indicated by the Reilly research for one month after issue. c. A new public issue may be expected to have a strong aftermarket because investment dealers often underprice the issue to insure the success of the distribution. 15-23. Webster Labs a. 3 million shares × $18.50 = $55.5 million (cost to go private) b. Proceeds from sale of the divisions Petroleum research division Fiber technology division Synthetic products division $ 16.0 million 9.5 million 20.0 million $45.5 million Current value of the 3 million shares 3 million shares × (P/E × EPS) 3 million × (14 × $1.50) 3 million × $21 Total value to the company c. Total value to the company - Cost to go private Profit from restructuring % profit = $63.0 million $108.5 million $108.5 million 55.5 million $53.0 million profit from restructuring $53.0 million = = 0.9550 = 95.50% cost to go private $55.5 million Comprehensive Problem 15-24. Bailey Corporation a. Earnings per share (eps) after = $3,162,000 = $1.22 1,800,000 + 800,000 Initial market price = P/E × EPS = 12 × $1.22 = $14.64 b. 800,000 shares × $14.64 = $11,712,000 – 585,600 – 300,000 $ 10,826,400 c. Earnings per share (eps) before = gross proceeds 5% spread out-of-pocket costs net proceeds $3,162,000 = $1.76 1,800,000 In order to earn $1.76 after the offering, the return on $10,826,400 must produce new earnings equal to X. $3,162,000 + X = $1.76 1,800,000 + 800,000 $3,162,000 + X = $1.76 2,600,000 $3,162,000 + X = $1.76 × (2,600,000) X = $4,576,000 − $3,162,000 X = $1,414,000 Proof: EPS = $3,162,000 + $1,414,000 $4,576,000 = = $1.76 1,800,000 + 800,000 2,600,000 Thus: Return = $1,414,000 New earnings = = 0.1306 = 13.06% New proceeds $10,826,400 The firm must earn 13.06% on net proceeds to equal earnings per share before the offering. This is greater than current return on assets of 11.04%. Return = Net income $3,162,000 = = 0.1104 = 11.04% New proceeds $28,650,000 d. Earnings per share (eps) after = Initial market price = e. 400,000 × $17.28 = $3,162,000 = $1.44 1,800,000 + 400,000 P/E × EPS = 12 × $1.44 = $17.28 $6,912,000 – 345,600 – 300,000 $ 6,266,400 gross proceeds 5% spread out-of-pocket costs net proceeds f. $1.76 represents earnings per share before the offering. In order to earn $1.76 after the offering, the return on $6,266,400 must produce new earnings equal to X. $3,162,000 + X = $1.76 1,800,000 + 400,000 $3,162,000 + X = $1.76 2,200,000 $3,162,000 + X = $1.76 × (2,200,000) X = $3,872,000 − $3,162,000 X = $710,000 Proof: EPS = $3,162,000 + $710,000 $3,872,000 = = $1.76 1,800,000 + 400,000 2,200,000 Thus: Return = New earnings $710,000 = = 0.1133 = 11.33% New proceeds $6,266,400 This is greater than the current return on assets of 11.04%. Return = Net income $3,162,000 = = 0.1104 = 11.04% New proceeds $28,650,000 MINI CASES Robert Boyle and Associates, Inc. (Going Public and Investment Dealers) Purpose: The pros and cons of going public are considered in this case. Although the firm is a fictitious company, it is compared to a number of companies in the Real Estate Investment Trust (REIT) industry in order to establish the initial evaluation. The problem of capital shortage for the small private firm is the catalyst for considering the new offering. The potential dilution of new stock issues on earnings per share is carefully considered. In order to bring added interest to the case, there is a slightly nagging spouse who serves as a devil’s advocate. a. Computation of Robert Boyle & Associates P / E ratio: Return on Equity: Return on assets: Debt to assets: Asset Turnover: Net Profit Margin: Industry P/E Boyle Industry 35.5% 12.8% 14.0 +.5 Boyle 19.5% Industry 8.7% +.5 Boyle .45 Industry .31 –.5 Boyle .30 Industry .22 +.5 Boyle 64.1% Industry 37.5% +.5 Boyle Industry 9.7% 5.3% +.5 Net Additions and Subtractions: +2.0 Minus 1 to ensure a good sale: –1.0 Final P / E Ratio for Robert Boyle & Associates: 15.0 5-Yr EPS growth: b. Total size of the share issue necessary to yield $10 million in net proceeds: The size of the issue – the size times the spread percentage – out-of-pocket expenses = net proceeds X = the size of the issue X – .065(X) – $60,000 .935(X) X round to $10,800,000 = = = $10,000,000 $10,060,000 $10,759,358.29 c. Required rate of return on net proceeds: Let X = the amount of income necessary to be earned: (Old Net Income + X) / Total number of shares outstanding = old EPS ($4,100,000 + X) / 4,699,029* = $1.03 $4,100,000 + X = $1.03 x 4,699,029 $4,100,000 + X = $4,840,000 X = $740,000 *4,00,000 old shares + 699,029 new shares = 4,699,029 Next compute the percent dollar return on the next proceeds. $740,000 / $10,800,000 = 6.85% Note that Robert Boyle & Associates earned a 19.5% return on assets in 2004, so we would expect that the company should have no problems producing an 6.85% return on the new assets to be obtained. d. The total number of shares to be issued will be the two million from the existing shareholders plus the 699,029 originally planned. The decision by some of the existing shareholders to sell some of their shares makes no difference in this case—the company still needs to issue enough new shares to net $10,000,000. The two million shares from the existing shareholders are simply transferred from one set of people to another; the total number outstanding is not affected. e. Summary of the advantages of going public: • Provides access to capital, which, in this case, appears difficult to obtain in any other way. • Provides a method by which the existing shareholders may liquidate their holdings to raise cash or to buy other securities (in order to diversify their portfolios). • Establishes a market value for the firm. Summary of the disadvantages: • Relatively high cost (over $700,000 in this case to raise $10 million). • Additional paperwork and reporting requirements. • Necessity to deal with the public (Mr. Boyle will spend more of his time in public relations). • Pressure for short-term results. • Possible loss of control of the firm if enough shares are issued, or if a hostile suitor attempts a takeover. Conclusion: Robert Boyle & Associates is doing perfectly well as it is, and could conceivably continue doing so without getting involved in the new shopping center on Saltspring Island. However, the need to provide a market for the firm’s shares and the need to provide a way for the existing shareholders to diversify their portfolios are strong arguments for going public (the shopping center development business is, after all, not without risk). Further, if the investors have any desire for growth, it appears they must go public to obtain the needed capital. From the limited information we have, the Saltspring Center project appears to be attractive. Therefore, it is probable that Robert Boyle and Associates will not be able to take the conservative approach—save up for years until they have enough to build it—because another firm will step in and build it themselves. All in all, it appears that the time for Robert Boyle & Associates to go public may have arrived. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015
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