This Document Contains Chapters 14 to 15 Chapter 14 Capital Markets Discussion Questions 14-1. In addition to U.S. corporations, what government groups compete for funds in the U.S. capital markets? The federal government, government agencies, and state and local governments all compete for funds. 14-2. What foreign industry has privatization been most important in? Telecommunications 14-3. How does foreign investment help the U.S. government? It helps finance the deficit. 14-4. What is a key tax characteristic associated with state and local (municipal) securities? They are tax exempt, meaning the interest paid is normally exempt from federal income taxes and from state income taxes in the state of issue. 14-5. What are three forms of corporate securities discussed in the chapter? Corporate bonds, preferred stock, and common stock are the three forms of corporate securities discussed in the chapter. 14-6. Do corporations rely more on external or internal funds as sources of financing? Corporations rely more heavily on external funds as sources of financing. Sixty percent of corporate funds came from external sources during the time period under study. 14-7. Explain the role of financial intermediaries in the flow of funds through the three-sector economy. In a three-sector economy consisting of business, households, and government, financial intermediaries such as commercial banks, mutual saving banks, 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. What are electronic communication networks (ECNs)? Generally speaking, are they currently part of the operations of the New York Stock Exchange and the NASDAQ Stock Market? ECNs are electronic trading systems that automatically match buy and sell orders at specific prices via computers. They are now part of the operations of the two major markets (at one time they competed with them). 14-9. Why is secondary trading in the security markets important? It provides liquidity and keeps prices competitive among alternative investments. 14-10. How would you define efficient security markets? Markets are efficient when (1) prices adjust rapidly to new information; (2) there is a continuous market in which each successive trade is made at a price close to the previous price; and (3) the market can absorb large dollar amounts of securities without destabilizing the price. 14-11. The efficient market hypothesis is interpreted in a weak form, a semi-strong form, and a strong form. How can we differentiate its various forms? 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. 14-12. What was the primary purpose of the Securities Act of 1933? The primary purpose of the Securities Act of 1933 was to provide full disclosure of all pertinent information whenever a corporation sold a new issue of securities. 14-13. What act of Congress created the Securities and Exchange Commission? The Securities Exchange Act of 1934 created the Securities and Exchange Commission. 14-14. What was the purpose of the Sarbanes–Oxley Act of 2002? The intent was to restore confidence in the integrity of the financial markets through insuring accuracy in financial reporting. Chapter 15 Investment Banking: Public and Private Placement Discussion Questions 15-1. In what way is an investment banker a risk taker? The investment banker is a risk taker (underwriter) in that the investment banking house agrees to buy the securities from the corporation and resell them to other security dealers and the public at an agreed upon price. If they can’t sell the securities at the initial offering price, they suffer a loss. 15-2. What is the purpose of market stabilization activities during the distribution process? 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 price could be in trouble if there is a rapid decline in the price of the stock. 15-3. Discuss how an underwriting syndicate decreases risk for each underwriter and at the same time facilitates the distribution process. By forming a syndicate of many underwriters rather than just one, the overall risk is diffused and the capabilities for widespread distribution are enhanced. A syndicate may comprise as few as two or as many as 50 investment banking houses. 15-4. Discuss the reason for the differences between underwriting spreads for stocks and bonds. Common stocks often carry a larger underwriting spread than bonds because the market reaction to stocks is more uncertain. 15-5. What is shelf registration? How does it differ from the traditional requirements for security offerings? Shelf registration permits large companies to file one comprehensive registration statement (under SEC Rule 415). This statement outlines the firm’s plans for future long-term financing. Then, when market conditions appear to be appropriate, the firm can issue the securities without further SEC approval. Shelf registration is different from the traditional requirement that security issuers file a detailed registration statement for SEC review and approval each and every time they plan a sale. 15-6. Discuss the benefits accruing to a company that is traded in the public securities markets. 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 stockholders. d. Ease in estate planning for existing stockholders. e. An increased capability to engage in the merger and acquisition process. 15-7. What are the disadvantages to being public? The disadvantage of being public are: a. All information must be made available to the public through SEC and state 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. f. There are high reporting compliance costs. 15-8. If a company was looking for capital by way of a private placement, where would it look for funds? Funds for private placement can be found through insurance companies, pension funds, mutual funds, and wealthy individuals. 15-9. How does a leveraged buyout work? What does the debt structure of the firm normally look like after a leveraged buyout? What might be done to reduce the debt? The use of a leveraged buy-out 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 exits with a lot of debt and heavy interest expense. 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. 15-10. How might a leveraged buyout eventually lead to high returns for companies? Companies may restructure their companies and once again take them public at a large profit. 15-11. What is privatization? In the international markets, investment bankers sell companies to the public that were previously owned by the government. Since the new owners are the private sector rather than the public sector, the process of distributing the shares to the private sector is called privatization. Chapter 15 Problems 1. Dilution effect of stock issue (LO15-3) Louisiana Timber Company currently has 5 million shares of stock outstanding and will report earnings of $9 million in the current year. The company is considering the issuance of 1 million additional shares that will net $40 per share to the corporation. a. What is the immediate dilution potential for this new stock issue? b. Assume the Louisiana Timber Company can earn 11 percent on the proceeds of the stock issue in time to include it in the current year’s results. Should the new issue be undertaken based on earnings per share? 15-1. Solution: Louisiana Timber Company a. Earnings per share before stock issue $9,000,000/5,000,000 = $1.80 Earnings per share after stock issue $9,000,000/6,000,000 = $1.50 Dilution $1.80 1.50 $ .30 per share b. Net income = $9,000,000 + .11 ($1,000,000 $40) = $9,000,000 + .11 ($40,000,000) = $9,000,000 + $4,400,000 = $13,400,000 Earnings per share after additional income EPS = $13,400,000/$6,000,000 = $2.23 Yes, the EPS of $2.23 is higher than $1.80. 2. Dilution effect of stock issue (LO15-3) The Hamilton Corporation Company has 4 million shares of stock outstanding and will report earnings of $6,910,000 in the current year. The company is considering the issuance of 1 million additional shares, which can only be issued at $30 per share. a. Assume the Hamilton Corporation Company can earn 7.00 percent on the proceeds. Calculate the earnings per share. b. Should the new issue be undertaken based on earnings per share? 15-2. Solution: a. Earnings per share before stock issue $6,910,000/4,000,000 = $1.73 b. Net income = $6,910,000 + .070 (1,000,000 $30) = $6,910,000 + .070 ($30,000,000) = $6,910,000 + $2,100,000 = $9,010,000 Earnings per share after additional income EPS = $9,010,000/5,000,000 = $1.80 Yes, EPS would increase by 7 cents from $1.73 to $1.80. 3. Dilution effect of stock issue (LO15-3) American Health Systems currently has 6,400,000 shares of stock outstanding and will report earnings of $10 million in the current year. The company is considering the issuance of 1,700,000 additional shares that will net $30 per share to the corporation. a. What is the immediate dilution potential for this new stock issue? b. Assume that American Health Systems can earn 9 percent on the proceeds of the stock issue in time to include them in the current year’s results. Calculate earnings per share. Should the new issue be undertaken based on earnings per share? 15-3. Solution: American Health Systems a. Earnings per share before stock issue $10,000,000/6,400,000 = $1.56 Earnings per share after stock issue $10,000,000/8,100,000 = $1.23 Dilution 1.56 1.23 .33 per share b. Net income = $10,000,000 + .09 (1,700,000 $30) = $10,000,000 + .09 ($51,000,000) = $10,000,000 + $4,590,000 = $14,590,000 Earnings per share after additional income EPS = $14,590,000/8,100,000 = $1.80 Yes, the EPS of $1.80 is higher than $1.56 4. Dilution effect of stock issue (LO15-3) American Health Systems has 6,400,000 shares of stock outstanding and will report earnings of $10 million in the current year. The company is considering the issuance of 1,700,000 additional shares, which can only be issued at $18 per share. a. Assume that American Health Systems can earn 6 percent on the proceeds. Calculate earnings per share. b. Should the new issue be undertaken based on earnings per share? 15-4. Solution: American Health Systems Earnings per share before stock issue $10,000,000/6,400,000 = $1.56 Net income = $10,000,000 + .06 (1,700,000 $18) = $10,000,000 + .06 ($30,600,000) = $10,000,000 + $1,836,000 = $11,836,000 Earnings per share after additional income EPS = $11,836,000/8,100,000 = $1.46 No, the EPS of $1.46 is lower than $1.56. 5. Dilution and pricing effect of stock issue (LO15-3) Jordan Broadcasting Company is going public at $50 net per share to the company. There also are founding stockholders that are selling part of their shares at the same price. Prior to the offering, the firm had $26 million in earnings divided over 11 million shares. The public offering will be for five million shares; three million will be new corporate shares and two million will be shares currently owned by the founding stockholders. a. What is the immediate dilution based on the new corporate shares that are being offered? b. If the stock has a P/E of 30 immediately after the offering, what will the stock price be? c. Should the founding stockholders be pleased with the $50 they received for their shares? 15-5. Solution: Jordan Broadcasting Company a. Earnings per share before stock issue $26,000,000/11,000,000 = $2.36 Earnings per share after stock issue $26,000,000/14,000,000 = $1.86 Dilution 2.36 1.86 .50 per share Note only three million new corporate shares were issued. The other two million belonged to founding stockholders and do not increase the number of shares outstanding. b. EPS $ 1.86 P/E 30 Stock Price $55.80 c. The founding stockholders will probably not be pleased. They received a net price of $50 and the stock has a value of $55.80 immediately after the offering. They may wish the initial offering price had been higher. 6. Underwriting Spread (LO15-2) Solar Energy Corp. has $4 million in earnings with four million shares outstanding. Investment bankers think the stock can justify a P/E ratio of 21. Assume the underwriting spread is 5 percent. What should the price to the public be? 15-6. Solution: Solar Energy Corp. Earnings per share = $4 million / 4 million = $1.00 Stock price (prior to underwriting spread) P/E EPS = 21 $1.00 = $21 Price to public (with 5% spread) $21 95% = $19.95 7. Underwriting Spread (LO15-2) Tiger Golf Supplies has $25 million in earnings with 7 million shares outstanding. Its investment banker thinks the stock should trade at a P/E ratio of 31. Assume there is an underwriting spread of 7.8 percent. What should the price to the public be? 15-7. Solution: Tiger Golf Supplies Earnings per share = $25 million / 7 million = $3.57 Price to the public (prior to underwriting spread) P/E EPS = 31 $3.57 = $110.67 Proceeds to the firm (with 7.8% spread) $110.67 92.20% = $102.04 8. Underwriting Spread (LO15-2) Assume Sybase Software is thinking about three different size offerings for issuance of additional shares. Size of Offer Public Price Net to Corporation a. 1.1 million $30 $27.50 b. 7.0 million $30 28.44 c. 28.0 million $30 29.15 What is the percentage underwriting spread for each size offer? 15-8. Solution: Sybase Software a. Spread = $30 – $27.50 = $2.50 (on $1.1 million) % underwriting spread = $2.50/$30 = 8.33% b. Spread = $30 – $28.44 = $1.56 (on $7.0 million) % underwriting spread = $1.56/$30 = 5.20% c. Spread = $30 – $29.15 = $.85 (on $28 million) % underwriting spread = $.85/$30 = 2.83% 9. Underwriting spread (LO15-2) Walton and Company is the managing investment banker for a major new underwriting. The price of the stock to the investment banker is $23 per share. Other syndicate members may buy the stock for $24.25. The price to the selected dealers group is $24.80, with a price to brokers of $25.20. Finally, the price to the public is $29.50. a. If Walton and Company sells its shares to the dealer group, what will the percentage return be? b. If Walton and Company performs the dealer’s function also and sells to brokers, what will the percentage return be? c. If Walton and Company fully integrates its operation and sells directly to the public, what will its percentage return be? 15-9. Solution: Walton and Company a. $24.80 Selected Dealer Group’s Price 23.00 Managing Investing Banker’s Price $ 1.80 Differential $ 1.80 = 7.83% Return $23.00 b. $25.20 Broker’s Price 23.00 Managing Investing Banker’s Price $2.20 Differential $ 2.20 = 9.57% Return 23.00 c. $29.50 Public Price 23.00 Managing Investing Banker’s Price $ 6.50 Differential $ 6.50 = 28.26% Return 23.00 10. Underwriting spread (LO15-2) The Wrigley Corporation needs to raise $44 million. The investment banking firm of Tinkers, Evers, & Chance will handle the transaction. a. If stock is utilized, 2,300,000 shares will be sold to the public at $20.50 per share. The corporation will receive a net price of $19 per share. What is the percentage underwriting spread per share? b. If bonds are utilized, slightly over 43,700 bonds will be sold to the public at $1,009 per bond. The corporation will receive a net price of $994 per bond. What is the percentage of underwriting spread per bond? (Relate the dollar spread to the public price.) c. Which alternative has the larger percentage of spread? Is this the normal relationship between the two types of issues? 15-10. Solution: Wrigley Corporation a. Spread = $20.50 – $19.00 = $1.50 % underwriting spread = $1.50/$20.50 = 7.32% b. Spread = $1,009 – $994 = $15 % underwriting spread = $15/$1,009 = 1.49% c. The stock alternative has the larger percentage spread. This is normal because there is more uncertainty in the market associated with a stock offering and investment bankers want to be appropriately compensated. 11. Secondary offering (LO15-2) Kevin’s Bacon Company Inc. has earnings of $9 million with 2,100,000 shares outstanding before a public distribution. Seven hundred thousand shares will be included in the sale, of which 400,000 are new corporate shares, and 300,000 are shares currently owned by Ann Fry, the founder and CEO. The 300,000 shares that Ann is selling are referred to as a secondary offering and all proceeds will go to her. The net price from the offering will be $16.50 and the corporate proceeds are expected to produce $1.8 million in corporate earnings. a. What were the corporation’s earnings per share before the offering? b. What are the corporation’s earnings per share expected to be after the offering? 15-11. Solution: Kevin’s Bacon Company Inc. a. Earnings per share before the stock issue $9,000,000/2,100,000 = $4.29 b. Earnings per share after the stock issue Total Earnings Before Offering $9,000,000 Incremental Earnings 1,800,000 Earnings after Offering $10,800,000 Corporate Shares Outstanding Before Offering 2,100,000 Incremental Shares 400,000* Shares after Offering 2,500,000 * The 300,000 secondary shares are not included as new corporate shares. Earnings/Share = $10,800,000/2,500,000 EPS = $4.32 12. Market stabilization and risk (LO15-2) Becker Brothers is the managing underwriter for a 1.45-million-share issue by Jay’s Hamburger Heaven. Becker Brothers is “handling” 10 percent of the issue. Its price is $27 per share and the price to the public is $28.95. Becker also provides the market stabilization function. During the issuance, the market for the stock turned soft, and Becker is forced to purchase 50,000 shares in the open market at an average price of $27.50. They later sell the shares at an average value of $27.20. Compute Becker Brothers’ overall gain or loss from managing the issue. 15-12. Solution: Becker Brothers Original Distribution 10% 1,450,000 = 145,000 Shares for Becker $ 1.95 Profit per Share $282,750 Profit on Original Distribution Market Stabilization 50,000 Shares for Becker $ 0.3 Loss per Share ($27.20 – $27.50) $15,000 Loss on Market Stabilization Gain on Original Distribution $282,750 Loss on Market Stabilization 15,000 Net Gain $ 267,750 13. Underwriting costs (LO15-2) Trump Card Co. will issue stock at a retail (public) price of $32. The company will receive $29.20 per share. a. What is the spread on the issue in percentage terms? b. If the firm demands receiving a new price only $2.20 below the public price suggested in part a, what will the spread be in percentage terms? c. To hold the spread down to 2.5 percent based on the public price in part a, what net amount should Trump Card Co. receive? 15-13. Solution: Trump Card Company a. $ Spread / Public Price = $2.80/$32 = 8.75% b. $ Spread / Public Price = $2.20/$32 = 6.88% c. Public Price $32.00 2.5% Spread .80 Net Amount Received $31.20 14. Underwriting costs (LO15-2) Winston Sporting Goods is considering a public offering of common stock. Its investment banker has informed the company that the retail price will be $16.85 per share for 550,000 shares. The company will receive $15.40 per share and will incur $180,000 in registration, accounting, and printing fees. a. What is the spread on this issue in percentage terms? What are the total expenses of the issue as a percentage of total value (at retail)? b. If the firm wanted to net $15.99 million from this issue, how many shares must be sold? 15-14. Solution: Winston Sporting Goods a. $16.85 – $15.40 = $1.45 spread $1.45/$16.85 = 8.61% spread Total Expenses = ($1.45 × 550,000 shares) + $180,000 (out-of-pocket) = $797,500 + $180,000 = $977,500 Total Value = 550,000 Shares $16.85 = $9,267,500 Total Expenses / Total Value = $977,500/9,267,500 = 10.55% b. Amount Needed = $15,990,000 Total shares to be sold to net $15,990,000 = ($15,990,000 + Issue Costs) / Net Price per Share = $16,170,000/$15.40 per Share = 1,050,000 Shares 15. P/E ratio for new public issue (LO15-2) Richmond Rent-A-Car is about to go public. The investment banking firm of Tinkers, Evers, and Chance is attempting to price the issue. The car rental industry generally trades at a 20 percent discount below the P/E ratio on the Standard & Poor’s 500 Stock Index. Assume that index currently has a P/E ratio of 25. The firm can be compared to the car rental industry as follows: Richmond Car Rental Industry Growth rate in earnings per share 15% 10% Consistency of performance Increased earnings Increased earnings 4 out of 5 years 3 out of 5 years Debt to total assets 52% 39% Turnover of product Slightly below Average average Quality of management High Average Assume, in assessing the initial P/E ratio, the investment banker will first determine the appropriate industry P/E based on the Standard & Poor’s 500 Index. Then, a half point will be added to the P/E ratio for each case in which Richmond Rent-A-Car is superior to the industry norm, and a half point will be deducted for an inferior comparison. On this basis, what should the initial P/E be for the firm? 15-15. Solution: Richmond Rent-A-Car 80% of the S&P 500 Stock Index = 80% × 25 = 20 Industry Comparisons Growth rate in Earnings per Share-superior + ½ Consistency of Performance-superior + ½ Debt to Total Assets-inferior – ½ Turnover of Product-inferior – ½ Quality of Management-superior + ½ Quality of Management-superior + ½ Initial P/E Ratio = 20 + ½ = 20½ 16. Dividend valuation model for new public issue (LO15-1) The investment banking firm of Einstein & Co. will use a dividend valuation model to appraise the shares of the Modern Physics Corporation. Dividends (D1) at the end of the current year will be $1.64. The growth rate (g) is 8 percent and the discount rate (Ke) is 13 percent. a. What should be the price of the stock to the public? b. If there is a 7 percent total underwriting spread on the stock, how much will the issuing corporation receive? c. If the issuing corporation requires a net price of $31.30 (proceeds to the corporation) and there is a 7 percent underwriting spread, what should be the price of the stock to the public? (Round to two places to the right of the decimal point.) 15-16. Solution: Einstein & Co. a. P0 = D1 / Ke – g = $1.64/0.13 – 0.08 = $1.64/0.05 = $32.8 b. Public Price $32.80 Underwriting Spread (7%) 2.30 Net Price to the Corporation $30.50 c. Necessary = Net Price / (1 – Underwriting Spread) Public Price $31.30/(1 – .07) = $31.30/.93 = $33.66 17. Comparison of private and public debt offering (LO15-1) The Landers Corporation needs to raise $1.60 million of debt on a 20-year issue. If it places the bonds privately, the interest rate will be 10 percent. Twenty thousand dollars in out-of-pocket costs will be incurred. For a public issue, the interest rate will be 9 percent, and the underwriting spread will be 2 percent. There will be $120,000 in out-of-pocket costs. Assume interest on the debt is paid semiannually, and the debt will be outstanding for the full 20-year period, at which time it will be repaid. For each plan, compare the net amount of funds initially available—inflow—to the present value of future payments of interest and principal to determine net present value. Assume the stated discount rate is 12 percent annually. Use 6 percent semiannually throughout the analysis. (Disregard taxes.) 15-17. Solution: Landers Corporation Private Placement $1,600,000 Debt – 20,000 Out-of-Pocket Costs $ 1,580,000 Net Amount to Landers Present value of future interest payments Interest Payments (semiannually) = 10%/2 = 5.00% Interest Payments = 5.00% $1,600,000 = $80,000 PVA = A PVIFA (n = 40, i = 6.0%) PVA = $80,000 15.046 (Appendix D) PVA = $1,203,680 Present value of lump-sum payment at maturity PV = FV PVIF (n = 40, i = 6.0%) PV = $1,600,000 .097 (Appendix B) PV = $155,200 Total present value of interest and maturity payments $1,203,680 + 155,200 $1,358,880 The net present value equals the net amount to Landers minus the present value of future payments. $1,580,000 Net Amount to Landers –1,358,880 Present Value of Future Payments $ 221,120 Net Present Value (private offering) Public Issue $1,600,000 Debt –32,000 2% Spread –120,000 Out-of-Pocket Costs $1,448,000 Net Amount to Landers Present value of future interest payments Interest Payments (semiannually) = 9%/2 = 4.50% Interest Payments = 4.50% $1,600,000 = $72,000 PVA = A PVIFA (n = 40, i = 6%) PVA = $72,000 15.046 (Appendix D) PVA = $1,083,312 Present value of lump-sum payment at maturity PV = FV PVIF (n = 40, i = 6%) PV = $1,600,000 .097 (Appendix B) PV = $155,200 Total present value of interest and maturity payments $1,083,312 + 155,200 $1,238,512 Total Present Value Net present value equals the net amount to Landers minus the present value of future payments. $1,448,000 Net Amount to Landers –1,238,512 Present Value of Future Payments $ 209,488 Net Present Value (public offering) The private placement has the higher net present value ($221,120 versus $209,488). Calculator Solution: Private Placement N I/Y PV PMT FV 40 6 CPT PV −1,359,259.25 80,000 1,600,000 Answer: $1,359,259 The net present value equals the net amount to Landers minus the present value of future payments. $ 1,580,000 Net Amount to Landers –1,359,259 Present Value of Future Payments $ 220,741 Net Present Value (private offering) Public issue N I/Y PV PMT FV 40 6 CPT PV −1,238,888.88 72,000 1,600,000 Answer:$ 1,238,889 $ 1,448,000 Net Amount to Landers –1,238,889 Present Value of Future Payments $ 209,111 Net Present Value (public offering) The private placement has the higher net present value ($220,741 versus $209,111). 18. Features associated with a stock distribution (LO15-3) Midland Corporation has a net income of $19 million and 4 million shares outstanding. Its common stock is currently selling for $48 per share. Midland plans to sell common stock to set up a major new production facility with a net cost of $21,120,000. The production facility will not produce a profit for one year, and then it is expected to earn a 13 percent return on the investment. Stanley Morgan and Co., an investment banking firm, plans to sell the issue to the public for $44 per share with a spread of 4 percent. a. How many shares of stock must be sold to net $21,120,000? (Note: No out-of-pocket costs must be considered in this problem.) b. Why is the investment banker selling the stock at less than its current market price? c. What are the earnings per share (EPS) and the price-earnings ratio before the issue (based on a stock price of $48)? What will be the price per share immediately after the sale of stock if the P/E stays constant? d. Compute the EPS and the price (if the P/E stays constant) after the new production facility begins to produce a profit. e. Are the shareholders better off because of the sale of stock and the resultant investment? What other financing strategy could the company have tried to increase earnings per share? 15-18. Solution: Midland Corporation a. $21,120,000 net amount to be raised. Determine net price to the corporation $44.00 Public Price –1.76 4% Spread $42.24 Net Price Determine number of shares to be sold $21,120,000/$42.24 = 500,000 Shares 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 banker is attempting to attract investors into this temporarily dilutive situation. The investment banking firm is also reducing its own underwriting risk by pricing the issue at the lower value. 15-18. (Continued) c. EPS = $19,000,000/4,000,000 = $4.75 P/E Ratio = Price/EPS = $48/$4.75 = 10.11x EPS after Offering = $19,000,000/4,500,000 = $4.22 Price = P/E EPS = 10.11 $4.22 = $42.66 d. Net income = $19,000,000 + 13% ($21,120,000) = $19,000,000 + $2,745,600 = $21,745,600 EPS after Contribution = $21,745,600/4,500,000 =$4.83 Price = P/E EPS = 10.11 $4.83 = $48.83 e. In the long run, it appears that the company is better off because of the additional investment. Earnings per share are $.27 higher and the stock price also increased. If the firm had used debt financing or a combination of debt and stock, they would have increased earnings per share even more, but would have created additional financial obligations in the process. 19. Dilution and rates of return (LO15-3) The Presley Corporation is about to go public. It currently has aftertax earnings of $7,200,000, and 2,100,000 shares are owned by the present stockholders (the Presley family). The new public issue will represent 800,000 new shares. The new shares will be priced to the public at $25 per share, with a 5 percent spread on the offering price. There will also be $260,000 in out-of-pocket costs to the corporation. a. Compute the net proceeds to the Presley Corporation. b. Compute the earnings per share immediately before the stock issue. c. Compute the earnings per share immediately after the stock issue. d. Determine what rate of return must be earned on the net proceeds to the corporation so there will not be a dilution in earnings per share during the year of going public. e. Determine what rate of return must be earned on the proceeds to the corporation so there will be a 5 percent increase in earnings per share during the year of going public. 15-19. Solution: Presley Corporation a. $25 Price 95% = $23.75 Net Price $23.75 Net Price 800,000 New Shares $19,000,000 Proceeds before Out-of-Pocket Costs – 260,000 Out-of-Pocket Costs $18,740,000 Net Proceeds b. Earnings per Share before Stock Issue = $7,200,000/2,100,000 = $3.43 c. Earnings per Share after Stock Issue = $7,200,000/2,900,000 = $2.48 d. There are now 2,900,000 shares outstanding. To maintain earnings of $3.43 per share, total earnings must be $9,947,000. This would imply an increase in earnings of $2,747,000 ($9,947,000 – $7,200,000). Incremental Earnings / Net Proceeds = $2,747,000/$18,740,000 = 14.66% 14.66 percent must be earned on the net proceeds to produce EPS of $3.43. e. $3.43 (1.05) = $3.60 (5.00% increase in EPS) Total Earnings = $3.60 × 2,900,000 Shares = $10,440,000 Incremental Earnings = $10,440,000 – $7,200,000 = $3,240,000 Incremental Earnings / Net Proceeds = $3,240,000 / $18,740,000 = 17.29% 17.29 percent would have to be earned to produce EPS of $3.60 and the 5 percent growth in EPS. 20. Dilution and rates of return (LO15-3) Tyson Iron Works is about to go public. It currently has after tax earnings of $4,400,000, and 4,200,000 shares are owned by the present stockholders. The new public issue will represent 500,000 new shares. The new shares will be priced to the public at $25 per share with a 3 percent spread on the offering price. There will also be $280,000 in out-of-pocket costs to the corporation. a. Compute the net proceeds to Tyson Iron Works. b. Compute the earnings per share immediately before the stock issue. c. Compute the earnings per share immediately after the stock issue. d. Determine what rate of return must be earned on the net proceeds to the corporation so there will not be a dilution in earnings per share during the year of going public. e. Determine what rate of return must be earned on the proceeds to the corporation so there will be a 10 percent increase in earnings per share during the year of going public. 15-20. Solution: Tyson Iron Works $25 97% = $24.25 Net Price $24.25 Net Price 500,000 New Shares $12,125,000 Proceeds before Out-of-Pocket Costs 280,000 Out-of-Pocket Costs $11,845,000 Net Proceeds b. Earnings per Share before Stock Issue = $4,400,000/4,200,000 = $1.05 c. Earnings per Share after Stock Issue = $4,400,000/4,700,000 = $.94 d. There are now 4,700,000 shares outstanding. To maintain earnings per share of $1.05, total earnings must be $4,935,000 ($1.05 4,700,000 shares). This would imply an increase in earnings of $535,000 ($4,935,000 – $4,400,000) Incremental Earnings / Net Proceeds = $535,000/$11,845,000 = 4.52% 5 percent must be earned on the net proceeds to produce EPS of $1.05. e. $1.05 (1.10) = $1.16 (10% increase in EPS) Total Earnings = $1.16 4,700,000 = $5,452,000 Incremental Earnings = $5,452,000 – 4,400,000 = $1,052,000 Incremental Earnings / Net Proceeds = $1,052,000/$11,845,000 = 8.88% 8.88 percent would have to be earned to produce EPS of $1.16. 21. Aftermarket for new public issue (LO15-4) I. B. Michaels has a chance to participate in a new public offering by Hi-Tech Micro Computers. His broker informs him that demand for the 700,000 shares to be issued is very strong. His broker’s firm is assigned 25,000 shares in the distribution and will allow Michaels, a relatively good customer, 1.3 percent of its 25,000 share allocation. The initial offering price is $30 per share. There is a strong aftermarket, and the stock goes to $32 one week after issue. The first full month after issue, Mr. Michaels is pleased to observe his shares are selling for $33.5. He is content to place his shares in a lockbox and eventually use their anticipated increased value to help send his son to college many years in the future. However, one year after the distribution, he looks up the shares in The Wall Street Journal and finds they are trading at $28.5. a. Compute the total dollar profit or loss on Mr. Michaels’ shares one week, one month, and one year after the purchase. In each case, compute the profit or loss against the initial purchase price. b. Also compute the percentage gain or loss from the initial $30 price. c. Why might a new public issue be expected to have a strong aftermarket? 15-21. Solution: I. B. Michaels a. Mr. Michaels’ Purchase = 1.3% 25,000 shares = 325 shares Dollar profit or loss 1 week 325 Shares ($32 – $30) = $650.00 Profit 1 month 325 Shares ($33.5 – $30) = $1,137.5 Profit 1 year 325 Shares ($28.5 – $30) = $487.5 Loss b. Percentage profit or loss 1 week $2.00/$30 = +6.67% 1 month $3.5/$30 = +11.67% 1 year –$1.5/$30 = –5% c. A new public issue may be expected to have a strong after-market because investment bankers often underprice the issue to insure the success of the distribution. 22. Leveraged buyout (LO15-5) The management of Mitchell Labs decided to go private in 2002 by buying all 2.80 million of its outstanding shares at $24.80 per share. By 2006, management had restructured the company by selling off the petroleum research division for $10.75 million, the fiber technology division for $8.45 million, and the synthetic products division for $20 million. Because these divisions had been only marginally profitable, Mitchell Labs is a stronger company after the restructuring. Mitchell is now able to concentrate exclusively on contract research and will generate earnings per share of $1.10 this year. Investment bankers have contacted the firm and indicated that if it reentered the public market, the 2.80 million shares it purchased to go private could now be reissued to the public at a P/E ratio of 15 times earnings per share. a. What was the initial cost to Mitchell Labs to go private? b. What is the total value to the company from (1) the proceeds of the divisions that were sold, as well as (2) the current value of the 2.80 million shares (based on current earnings and an anticipated P/E of 15)? c. What is the percentage return to the management of Mitchell Labs from the restructuring? Use answers from parts a and b to determine this value. 15-22. Solution: Mitchell Labs a. 2.80 million Shares $24.80 = $69.44 million (cost to go private) b. Proceeds from sale of the divisions Petroleum Research Division $10.75 million Fiber Technology Division 8.45 million Synthetic Products Division 20.0 million $39.20 million Current value of the 2.80 million shares 2.80 million shares (P/E EPS) 2.80 million (15 $1.10) 2.80 million $16.50 $46.2 million Total Value to the Company $85.4 million 15-22. (Continued) c. Total Value to the Company $85.4 million – Cost to Go Private 69.44 million Profit from Restructuring $ 15.96 million Profit from Restructuring / Cost to Go Private = $15.96 million / $69.44 million = 22.98% COMPREHENSIVE PROBLEM Bailey Corporation (impact of new public offering) (LO15-4) The Bailey Corporation, a manufacturer of medical supplies and equipment, is planning to sell its shares to the general public for the first time. The firm’s investment banker, Robert Merrill and Company, is working with Bailey Corporation in determining a number of items. Information on the Bailey Corporation follows: BAILEY CORPORATION Income Statement For the Year 201X Sales (all on credit) $42,680,000 Cost of goods sold 32,240,000 Gross profit 10,440,000 Selling and administrative expenses 4,558,000 Operating profit 5,882,000 Interest expense 600,000 Net income before taxes 5,282,000 Taxes 2,120,000 Net income $ 3,162,000 CP 15-1. (Continued) BAILEY CORPORATION Balance Sheet As of December 31, 201X Assets Current assets Cash $ 250,000 Marketable securities 130,000 Accounts receivable 6,000,000 Inventory 8,300,000 Total current assets $14,680,000 Net plant and equipment 13,970,000 Total assets $28,650,000 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 3,800,000 Notes payable 3,550,000 Total current liabilities 7,350,000 Long-term liabilities 5,620,000 Total liabilities $12,970,000 Stockholders’ equity: Common stock (1,800,000 shares at $1 par) $ 1,800,000 Capital in excess of par 6,300,000 Retained earnings 7,580,000 Total stockholders’ equity 15,680,000 Total liabilities and stockholders’ equity $28,650,000 a. Assume that 800,000 new corporate shares will be issued to the general public. What will earnings per share be immediately after the public offering? (Round to two places to the right of the decimal point.) Based on the price-earnings ratio of 12, what will the initial price of the stock be? Use earnings per share after the distribution in the calculation. b. Assuming an underwriting spread of 5 percent and out-of-pocket costs of $300,000, what will net proceeds to the corporation be? c. What return must the corporation earn on the net proceeds to equal the earnings per share before the offering? How does this compare with current return on the total assets on the balance sheet? d. Now assume that, of the initial 800,000-share distribution, 400,000 belong to current stockholders and 400,000 are new shares, and the latter will be added to the 1,800,000 shares currently outstanding. What will earnings per share be immediately after the public offering? What will the initial market price of the stock be? Assume a price-earnings ratio of 12 and use earnings per share after the distribution in the calculation. e. Assuming an underwriting spread of 5 percent and out-of-pocket costs of $300,000, what will net proceeds to the corporation be? What return must the corporation now earn on the net proceeds to equal earnings per share before the offering? How does this compare with the current return on the total assets on the balance sheet? CP 15-1. Solution: New Public Offering Bailey Corporation In order to earn $1.76 after the offering, the return on $10,826,400 must produce new earnings equal to X. The firm must earn 13.06 percent on net proceeds to equal earnings per share before the offering. This is greater than the current return on assets of 11.04 percent. CP 15-1. (Continued) Initial market price = P/E EPS 12 $1.44 = $17.28 e. 400,000 $17.28 = $6,912,000 Gross Proceeds – 345,600 5% Spread – 300,000 Out-of-Pocket Costs $6,266,400 Net Proceeds f. $3,162,000 + X = $1.76 (2,200,000) X = $3,872,000 – $3,162,000 X = $710,000 Proof: CP 15-1. (Continued) thus: This is greater than the current return on assets of 11.04 percent. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160
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