Chapter 15
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.
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 level 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.
Explain how the price of a new security issue is determined.
The price is determined by the firm's industry,its financial characteristics,and the firm's anticipated earnings and divided-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.
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.
15-7.
Comment on the market performance of companies going public,both immediately after the offering has been made and some time later,Relate this to research that has been done in this area.
Due to underpricing by the investment banker,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.
15-8.
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.
15-9.
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.
15-10.
If a company were 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.
15-11.
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.
15-12.
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.
15-13.
What is privatization?
In the international markets,investment bankers take companies private that were previously owned by the government.
Problems
15-1.
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?
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 x $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.
15-2.
In problem 1,if the 1 million additional shares can only be issued at $32 per share and the company can earn 5 percent on the proceeds,should the new issue be undertaken based on earnings per share?
Solution:
Louisiana Timber Company (Continued)
Net income = $ 9,000,000 +,05 ($1,000,000 x $32)
= $ 9,000,000 +,05 ($32,000,000)
= $ 9,000,000 + $1,600,000
= $10,600,000
Earnings per share after additional income
EPS = $10,600,000/$6,000,000 = $1.77
No,E.P.S,would decline by 3 cents from $1.80 to $1.77.
15-3.
Micromanagement,Inc,has 8 million shares of stock outstanding and will report earnings of $20 million in the current year,The company is considering the issuance of 2 million 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 Micromanagement can earn 12.5 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?
Solution:
Micromanagement,Inc.
a. Earnings per share before stock issue
$20,000,000/8,000,000 = $2.50
Earnings per share after stock issue
$20,000,000/10,000,000 = $2.00
dilution $2.50
2.00
$,50 per share
b. Net income = $20,000,000 +,125 (2,000,000 x $30)
= $20,000,000 +,125 ($60,000,000)
= $20,000,000 + $7,500,000
= $27,500,000
Earnings per share after additional income
EPS = $27,500,000/10,000,000
= $2.75
Yes,the EPS of $2.75 is higher than $2.50.
15-4.
In problem 3,if the 2 million additional shares can be issued at $27 per share and the company can earn 10.8 percent on the proceeds,should the new issue be undertaken based on earnings per share?
Solution:
Micromanagement,Inc,(Continued)
Net income = $20,000,000 +,108 (2,000,000 x $27)
= $20,000,000 +,108 ($54,000,000)
= $20,000,000 + $5,832,000
= $25,832,000
Earnings per share after additional income
EPS = $25,832,000/10,000,000
= $2.58
Yes,the EPS of $2.58 is still higher than $2.50.
15-5.
Assume Safeguard Detective Company is thinking about three different size offerings for the issuance of additional shares.
Size of Offer Public Price Net to Corporation
a. $1.5 million $50 $46.10
b. $5.5 million $50 $46.80
c. $20.0 million $50 $48.15
What is the percentage underwriting spread for each size offer? What principle does this demonstrate?
Solution:
Safeguard Detective Company
a. Spread = $50 – $46.10 = $3.90 (on $1.5 million)
% underwriting spread = $3.90/$50 = 7.80%
b. Spread = $50 – $46.80 = $3.20 (on $5.5 million)
% underwriting spread = $3.20/$50 = 6.40%
c. Spread = $50 – $48.15 = $1.85 (on $20 million)
% underwriting spread = $1.85/$50 = 3.70%
The principle demonstrated is the larger the offer size,the lower the percentage spread.
15-6.
Blaine and Company is the managing investment banker for a major new underwriting,The price of the stock to the investment banker is $24 per share,Other syndicate members may buy the stock for $24.30,The price to the selected dealers group is $24.90,with a price to brokers of $25.32,The price to the public is $25.60.
a. If Blaine and Company sells its shares to the dealer group,what will be the percentage return?
b. If Blaine and Company performs the dealer's function also and sells to brokers,what will be the percentage return?
c. If Blaine and Company fully integrates its operation and sells directly to the public,what will be the percentage return?
Solution:
Blaine and Company
a. $24.90 Selected dealer group's price
24.00 Managing investing banker's price
$,90 Differential
$,90 = 3.75% Return
$24.00
b. $25.32 Broker’s price
24.00 Managing investment banker's price
$ 1.32 Differential
$ 1.32 = 5.5% Return
$24.00
c. $25.60 Public price
24.00 Managing investment banker's price
$ 1.60 Differential
$ 1.60 = 6.67% Return
$24.00
15-7.
The Detroit Slugger Bat Company needs to raise $30 million,The investment banking firm of Kaline,Horton,& Greenberg will handle the transaction.
a. If stock is utilized,1.8 million shares will be sold to the public at $16.75 per share,The corporation will receive a net price of $16 per share,What is the percentage of underwriting spread per share?
b. If bonds are utilized,slightly over 30,000 bonds will be sold to the public at $1,001 per bond,The corporation will receive a net price of $993 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?
Solution:
Detroit Slugger Bat Company
a. Spread = $16.75 – $16.00 = $0.75
% Underwriting spread = $0.75/$16.75 = 4.48%
b. Spread = $1,001 – $993 = $8
% Underwriting spread = $8/$1,001 =,799% or
,80% (rounded)
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.
15-8.
Womenpower Temporaries,Inc.,has earnings of $4.5 million with 1.8 million shares outstanding before a public distribution,Four hundred thousand shares will be included in the sale,of which 250,000 are new corporate shares,and 150,000 are shares currently owned by Julie Lipner,the founder and CEO,The 150,000 shares that Julie is selling are referred to as a secondary offering and all proceeds will go to her.
The net price from the offering will be $22.50 and the corporate proceeds are expected to produce $2 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?
Solution:
Womenpower Temporaries,Inc.
a. Earnings per share before the stock issue
$4,500,000/$1,800,000 = $2.50
b. Earnings per share after the stock issue
Total Earnings
Before offering $4,500,000
Incremental Earnings 2,000,000
Earnings after offering $6,500,000
Corporate shares outstanding
Before offering 1,800,000
Incremental Shares 250,000*
Shares after offering 2,050,000
* The 150,000 secondary shares are not included as new corporate shares.
15-9.
Lynch Brothers is the managing underwriter for a 1-million share issue by Overcharge Healthcare,Inc,Lynch Brothers is "handling" 10 percent of the issue,Its price is $30 per share and the price to the public is $31.50.
Lynch also provides the market stabilization function,During the issuance,the market for the stock turned soft,and Lynch was forced to repurchase 45,000 shares in the open market at an average price of $29.90,It later sold the shares at an average value of $26.
Compute Lynch Brothers’ overall gain or loss from managing the issue.
Solution:
Lynch Brothers
Original Distribution
10% x 1,000,000 = 100,000 shares for Lynch
$ 1.50 profit per share
$150,000 profit on original distribution
Market Stabilization
45,000 shares for Lynch
$ 3.90 loss per share (29.90 – 26.00)
$175,500 loss on market stabilization
Gain on original distribution $150,000
Loss on market stabilization 175,500
Net loss ($ 25,500)
15-10.
Skyway Airlines will issue stock at a retail (public) price of $15,The company will receive $13.80 per share.
a. What is the spread on the issue in percentage terms?
b. If Skyway Airlines demands receiving a net price only $.75 below the public price suggested in part a,what will the spread be in percentage terms?
c. To hold the spread down to 3 percent based on the public price in part a,what net amount should Skyway Airlines receive?
Solution:
Skyway Airlines
a.
b.
c. Public Price $15.00
3% Spread ,45
Net Amount Received $14.55
15-11.
Winston Sporting Goods is considering a public offering of common stock,Its investment banker has informed the company that the retail price will be $18 per share for 600,000 shares,The company will receive $16.50 per share and will incur $150,000 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 $18 million from this issue,how many shares must be sold?
Solution:
Winston Sporting Goods
a. $18 – $16.50 = $1.50 spread $1.50/$18.00 = 8.33% spread
Total value = 600,000 shares x $18 = $10,800,000
Out-of-picket/total value $150,000/$10,800,000 = 1.39%
8.33% Spread
1.39% Out-of-pocket
9.72% Total %
b. Amount needed = $18,000,000
Total shares to be sold to net $18,000,000
= ($18,000,000 + issue costs)/net price per share
= $18,150,000/$16.50 per share = 1,100,000 shares
15-12.
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:
Growth rate in earnings per share
Consistency of performance
Debt to total assets
Turnover of product
Quality of management
Richmond
15%
Increased earnings
4 out of 5 years
52%
Slightly below
average
High
Car Rental
Industry
10%
Increased earnings
3 out of 5 years
39%
Average
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?
Solution:
Richmond Rent-A-Car
80% of the S&P 500 Stock Index = 80% x 25 = 20
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 +?
Quality of management-superior +?
Initial P/E ratio = 20 +? = 20?
15-13.
The investment banking firm of Luther King,Inc.,will use a dividend valuation model to appraise the shares of the Pyramid Corporation,Dividends (D1) at the end of the current year will be $1.20,The growth rate (g) is 9 percent and the discount rate (Ke) is 13 percent.
a. Using Formula 10-9 from Chapter 10,what should be the price of the stock to the public?
b. If there is a 6 percent total underwriting spread on the stock,how much will the issuing corporation receive?
c. If the issuing corporation requires a net price of $29 (proceeds to the corporation) and there is a 6 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.)
Solution:
Luther King,Inc.
b. Public Price $30.00
Underwriting spread (6%) 1.80
Net price to the corporation $28.20
15-14.
The Alston Corporation needs to raise $1 million of debt on a 20-year issue,If it places the bonds privately,the interest rate will be 11 percent,and $25,000 in out-of-pocket costs will be incurred,For a public issue,the interest rate will be 10 percent,and the underwriting spread will be 5 percent,There will be $75,000 in out-of-pocket costs.
Assume interest on the debt is paid semiannually,and the debt will be outstanding for the full 20 years,at which time it will be repaid.
Which plan offers the higher net present value? 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,but use 6 percent semiannually throughout the analysis,(Disregard taxes.)
Solution:
Alston Corporation
Private Placement
$1,000,000 debt
– 25,000 out-of-pocket costs
$ 975,000 net amount to Alston
Present value of future interest payments
interest payments (semiannually) = 11%/2 = 5.5%
interest payments = 5.5% x $1,000,000 = $55,000
PVA = A x PVIF (n = 40,i = 6%) (Appendix D)
PVA = $55,000 x 15.046
PVA = $827,530
Present value of lump-sum payment at maturity
PV = FV x PVIF (n = 40,i = 6%) (Appendix B)
PV = $1,000,000 x,097
PV = $97,000
15-14,Continued
$827,530
+ 97,000
$924,530 total present value
The net present value equals the net amount to Alston minus the present value of future payments.
$975,000 net amount to Alston
–924,530 present value of future payments
$ 50,470 net present value (private offering)
Public Issue
$1,000,000 debt
– 50,000 spread
– 75,000 out-of-pocket costs
$ 875,000 net amount to Alston
Present value of future interest payments
interest payments (semiannually) = 10%/2 = 5%
interest payments = 5% x $1,000,000 = $50,000
PVA = A x PVIF (n = 40,i = 6%) (Appendix D)
PVA = $50,000 x 15.046
PVA = $752,300
Present value of lump-sum payment at maturity
PV = FV x PVIF (n = 40,i = 6%)
PV = $1,000,000 x,097
PV = $97,000
15-14,Continued
$752,300
+ 97,000
$849,300 total present value
Net present value equals the net amount to Alston minus the present value of future payments.
$875,000 net amount to Alston
–849,300 present value of future payments
$ 25,700 net amount to Alston
The private placement has the higher net present value ($50,470 vs,$25,700)
15-15.
Warner Drug Co,has a net income of $18 million and 9 million shares outstanding,Its common stock is currently selling for $30 per share,Warner plans to sell common stock to set up a major new production facility with a net cost of $21,280,000,The production facility will not produce a profit for one year,and then it is expected to earn a 16 percent return on the investment,Roth and Stern,an investment banking firm,plans to sell the issue to the public for $28 per share with a spread of 5 percent.
a. How many shares of stock must be sold to net $21,280,000? (Note,No out-of-pocket costs should 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 $30)? What will be the price per share immediately after the sale of stock if the P/E stays constant (based on including the additional shares computed in part a)?
d. Compute the EPS and the price (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?
15-15,Continued
Solution:
Warner Drug Company
a. $21,280,000 net amount to be raised.
Determine net price to the corporation
$28.00 public price
– 1.40 5% spread
$26.60 net price
Determine number of shares to be sold
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.
c. EPS = $18,000,000/9,000,000 = $2.00
P/E ratio = Price/EPS = $30/$2 = 15x
EPS after offering = $18,000,000/9,800,000 = $1.84
Price = P/E x EPS = 15 x $1.84 = $27.60
15-15,Continued
d. Net income = $18,000,000 + 16% ($21,280,000)
= $18,000,000 + $3,404,800
= $21,404,800
EPS after contribution = $21,404,800/9,800,000 = $2.18
Price = P/E x EPS = 15 x $2.18 = $32.70
e. In the long run,it appears that the company is better off because of the additional investment,Earnings per share are $.18 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.
15-16.
The Presley Corporation is about to go public,It currently has aftertax earnings of $7.5 million and 2.5 million shares are owned by the present stockholders (the Presley family),The new public issue will represent 600,000 new shares,The new shares will be priced to the public at $20 per share,with a 5 percent spread on the offering price,There will also be $200,000 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.
15-16,Continued
Solution:
Presley Corporation
a. $20 price x 95% = $19 net price
$19 net price
x 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. Earnings per share before stock issue
= $7,500,000/2,500,000 = $3.00
c. Earnings per share after stock issue
= $7,500,000/3,100,000 = $2.42
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).
16.07% must be earned on the net proceeds to produce EPS of $3.00.
15-16,Continued
e. $3.00 (1.05) = $3.15 (5% increase in EPS)
Total earnings = $3.15 x 3,100,000 shares = $9,765,000
incremental earnings = $9,765,000 – $7,500,000
= $2,265,000
20.22% would have to be earned to produce EPS of $3.15.
15-17.
B,P,Hart has a chance to participate in a new public offering by Cardiovascular Systems,Inc,His broker informs him that demand for the 800,000 shares to be issued is very strong,His broker's firm is assigned 20,000 shares in the distribution and will allow Hart,a relatively good customer,1.5 percent of its 20,000 share allocation.
The initial offering price is $40 per share,There is a strong aftermarket,and the stock goes to $44 one week after issue,After the first full month after issue,Mr,Hart is pleased to observe his shares are selling for $46.25,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 $38.50.
a. Compute the total dollar profit or loss on Mr,Hart’s 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 this percentage gain or loss from the initial $40 price and compare this to the results that might be expected in an investment of this nature based on prior research,Assume the overall stock market was basically unchanged during the period of observation.
c. Why might a new public issue be expected to have a strong aftermarket?
15-17,Continued
Solution:
B,P,Hart—Cardiovascular Systems,Inc.
a. Mr,Hart’s purchase = 1.5% x 20,000 shares = 300 shares
Dollar profit or loss
1 week 300 shares x ($44 – $40) = $1,200 profit
1 month 300 shares x ($46.25 – $40) = $1,875 profit
1 year 300 shares x ($38.50 – $40) = $ 450 loss
b. Percentage profit or loss
1 week $4.00/$40 = 10.00%
1 month $6.25/$40 = 15.63%
1 year –$1.50/$40 = –3.75%
The results are in line with prior research,The stock 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 stock was 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 after-market because investment bankers often underprice the issue to insure the success of the distribution.
15-18.
The management of Rowe Boat Co,decided to go private in 1999 by buying all 2 million of its outstanding shares at $16.50 per share,By 2004,management had restructured the company by selling off the scuba diving division for $7.5 million,the pleasure cruise division for $9 million,and the military contract aqua division for $11 million,
Because these divisions had been only marginally profitable,Rowe Boat is a stronger company after the restructuring,Rowe is now able to concentrate exclusively on the construction of new boats and will generate earnings per share of $1.20 this year,Investment bankers have contacted the firm and indicated that,if it reentered the public market,the 2 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 Rowe Boat Co,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 million shares (based on current earnings and an anticipated P/E of 15)?
c. What is the percentage return to the management of Rowe Boat Co,from the restructuring? Use answers from parts a and b to determine this value.
Solution:
Rowe Boat Company
a. 2 million shares x $16.50 = $33.0 million (cost to go private)
b. Proceeds from sale of the divisions
Scuba Diving division $ 7.5 million
Pleasure Cruise division 9.0 million
Military Contract Aqua division 11.0 million
$27.5 million
Current value of the 2 million shares
2 million shares x (P/E x EPS)
2 million x (15 x $1.20)
2 million x $18 $36.0 million
Total value to the company $63.5 million
15-18,Continued
c. Total value to the company $63.5 million
– Cost to go private 33.0 million
Profit from restructuring $30.5 million
Comprehensive Problem
CP 15-1.
The Anton Corporation,a manufacturer of radar control equipment,is planning to sell its shares to the general public for the first time,The firm's investment banker is working with the Anton Corporation in determining a number of items,Information on the Anton Corporation follows:
Anton Corporation
Income Statement
For the Year 200X
Sales (all on credit) $22,428,000
Cost of goods sold 16,228,000
Gross profit 6,200,000
Selling and administrative expenses 2,659,400
Operating profit 3,540,600
Interest expense 370,600
Net income before taxes 3,170,000
Taxes 1,442,000
Net income $ 1,728,000
Balance Sheet
As of December 31,200X
Assets
Cash $ 150,000
Marketable securities 100,000
Accounts receivable 2,000,000
Inventory 3,800,000
Total current assets $ 6,050,000
Net plant and equipment 6,750,000
Total assets $12,800,000
CP 15-1,Continued
Liabilities and Stockholders' Equity
Accounts payable $ 1,000,000
Notes payable 1,200,000
Total current liabilities 2,200,000
Long-term liabilities 2,380,000
Total liabilities $ 4,580,000
Common stock (1,200,000 shares at $1 par) $ 1,200,000
Capital in excess of par 2,800,000
Retained earnings 4,220,000
Total stockholders' equity 8,220,000
Total liabilities and stockholders' equity $12,800,000
The new public offering will be at 10 times the earnings per share.
a. Assume that 500,000 new corporate shares will be issued to the general public,What will earnings per share immediately after the public offering be? (Round to two places to the right of the decimal point.) Based on the price-earnings ratio of 10,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 7 percent and out-of-pocket costs of $150,000,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 500,000-share distribution,250,000 shares belong to current stockholders and 250,000 are new corporate shares,and these will be added to the 1,200,000 corporate 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 10 and use earnings per share after the distribution in the calculation.
e. Assuming an underwriter spread of 7 percent and out-of-pocket costs of $150,000,what will net proceeds to the corporation be?
f. What return must the corporation now earn on the net proceeds to equal earnings per share before the offering? How does this compare with current return on the total assets on the balance sheet?
CP 15-1,Continued
Solution:
New Public Offering
Anton Corporation
Initial market price = P/E x EPS
= 10 x $1.02 = $10.20
b. 500,000 shares x $10.20 = $5,100,000 gross proceeds
– 357,000 7% spread
– 150,000 out-of-pocket costs
$4,593,000 net proceeds
In order to earn $1.44 after the offering,the return on $4,593,000 must produce new earnings equal to X.
CP 15-1,Continued
$1,728,000 + X = $1.44 (1,700,000)
X = $2,448,000 – $1,728,000
X = $720,000
Proof:
The firm must earn 15.68% on net proceeds to equal earnings per share before the offering,This is greater than current return on assets of 13.50%.
CP 15-1,Continued
Initial market price = P/E x EPS
10 x $1.19 = $11.90
e. 250,000 x $11.90 = $2,975,000 gross proceeds
– 208,250 7% spread
– 150,000 out-of-pocket costs
$2,616,750 net proceeds
f. $1.44 represents earnings per share before the offering,In order to earn $1.44 after the offering,the return on $2,616,750 must produce new earnings equal to X.
X = $2,088,000 – $1,728,000
X = $360,000
CP 15-1,Continued
Proof:
Thus:
This is greater than the current return on assets of 13.50%.
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.
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 level 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.
Explain how the price of a new security issue is determined.
The price is determined by the firm's industry,its financial characteristics,and the firm's anticipated earnings and divided-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.
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.
15-7.
Comment on the market performance of companies going public,both immediately after the offering has been made and some time later,Relate this to research that has been done in this area.
Due to underpricing by the investment banker,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.
15-8.
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.
15-9.
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.
15-10.
If a company were 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.
15-11.
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.
15-12.
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.
15-13.
What is privatization?
In the international markets,investment bankers take companies private that were previously owned by the government.
Problems
15-1.
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?
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 x $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.
15-2.
In problem 1,if the 1 million additional shares can only be issued at $32 per share and the company can earn 5 percent on the proceeds,should the new issue be undertaken based on earnings per share?
Solution:
Louisiana Timber Company (Continued)
Net income = $ 9,000,000 +,05 ($1,000,000 x $32)
= $ 9,000,000 +,05 ($32,000,000)
= $ 9,000,000 + $1,600,000
= $10,600,000
Earnings per share after additional income
EPS = $10,600,000/$6,000,000 = $1.77
No,E.P.S,would decline by 3 cents from $1.80 to $1.77.
15-3.
Micromanagement,Inc,has 8 million shares of stock outstanding and will report earnings of $20 million in the current year,The company is considering the issuance of 2 million 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 Micromanagement can earn 12.5 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?
Solution:
Micromanagement,Inc.
a. Earnings per share before stock issue
$20,000,000/8,000,000 = $2.50
Earnings per share after stock issue
$20,000,000/10,000,000 = $2.00
dilution $2.50
2.00
$,50 per share
b. Net income = $20,000,000 +,125 (2,000,000 x $30)
= $20,000,000 +,125 ($60,000,000)
= $20,000,000 + $7,500,000
= $27,500,000
Earnings per share after additional income
EPS = $27,500,000/10,000,000
= $2.75
Yes,the EPS of $2.75 is higher than $2.50.
15-4.
In problem 3,if the 2 million additional shares can be issued at $27 per share and the company can earn 10.8 percent on the proceeds,should the new issue be undertaken based on earnings per share?
Solution:
Micromanagement,Inc,(Continued)
Net income = $20,000,000 +,108 (2,000,000 x $27)
= $20,000,000 +,108 ($54,000,000)
= $20,000,000 + $5,832,000
= $25,832,000
Earnings per share after additional income
EPS = $25,832,000/10,000,000
= $2.58
Yes,the EPS of $2.58 is still higher than $2.50.
15-5.
Assume Safeguard Detective Company is thinking about three different size offerings for the issuance of additional shares.
Size of Offer Public Price Net to Corporation
a. $1.5 million $50 $46.10
b. $5.5 million $50 $46.80
c. $20.0 million $50 $48.15
What is the percentage underwriting spread for each size offer? What principle does this demonstrate?
Solution:
Safeguard Detective Company
a. Spread = $50 – $46.10 = $3.90 (on $1.5 million)
% underwriting spread = $3.90/$50 = 7.80%
b. Spread = $50 – $46.80 = $3.20 (on $5.5 million)
% underwriting spread = $3.20/$50 = 6.40%
c. Spread = $50 – $48.15 = $1.85 (on $20 million)
% underwriting spread = $1.85/$50 = 3.70%
The principle demonstrated is the larger the offer size,the lower the percentage spread.
15-6.
Blaine and Company is the managing investment banker for a major new underwriting,The price of the stock to the investment banker is $24 per share,Other syndicate members may buy the stock for $24.30,The price to the selected dealers group is $24.90,with a price to brokers of $25.32,The price to the public is $25.60.
a. If Blaine and Company sells its shares to the dealer group,what will be the percentage return?
b. If Blaine and Company performs the dealer's function also and sells to brokers,what will be the percentage return?
c. If Blaine and Company fully integrates its operation and sells directly to the public,what will be the percentage return?
Solution:
Blaine and Company
a. $24.90 Selected dealer group's price
24.00 Managing investing banker's price
$,90 Differential
$,90 = 3.75% Return
$24.00
b. $25.32 Broker’s price
24.00 Managing investment banker's price
$ 1.32 Differential
$ 1.32 = 5.5% Return
$24.00
c. $25.60 Public price
24.00 Managing investment banker's price
$ 1.60 Differential
$ 1.60 = 6.67% Return
$24.00
15-7.
The Detroit Slugger Bat Company needs to raise $30 million,The investment banking firm of Kaline,Horton,& Greenberg will handle the transaction.
a. If stock is utilized,1.8 million shares will be sold to the public at $16.75 per share,The corporation will receive a net price of $16 per share,What is the percentage of underwriting spread per share?
b. If bonds are utilized,slightly over 30,000 bonds will be sold to the public at $1,001 per bond,The corporation will receive a net price of $993 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?
Solution:
Detroit Slugger Bat Company
a. Spread = $16.75 – $16.00 = $0.75
% Underwriting spread = $0.75/$16.75 = 4.48%
b. Spread = $1,001 – $993 = $8
% Underwriting spread = $8/$1,001 =,799% or
,80% (rounded)
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.
15-8.
Womenpower Temporaries,Inc.,has earnings of $4.5 million with 1.8 million shares outstanding before a public distribution,Four hundred thousand shares will be included in the sale,of which 250,000 are new corporate shares,and 150,000 are shares currently owned by Julie Lipner,the founder and CEO,The 150,000 shares that Julie is selling are referred to as a secondary offering and all proceeds will go to her.
The net price from the offering will be $22.50 and the corporate proceeds are expected to produce $2 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?
Solution:
Womenpower Temporaries,Inc.
a. Earnings per share before the stock issue
$4,500,000/$1,800,000 = $2.50
b. Earnings per share after the stock issue
Total Earnings
Before offering $4,500,000
Incremental Earnings 2,000,000
Earnings after offering $6,500,000
Corporate shares outstanding
Before offering 1,800,000
Incremental Shares 250,000*
Shares after offering 2,050,000
* The 150,000 secondary shares are not included as new corporate shares.
15-9.
Lynch Brothers is the managing underwriter for a 1-million share issue by Overcharge Healthcare,Inc,Lynch Brothers is "handling" 10 percent of the issue,Its price is $30 per share and the price to the public is $31.50.
Lynch also provides the market stabilization function,During the issuance,the market for the stock turned soft,and Lynch was forced to repurchase 45,000 shares in the open market at an average price of $29.90,It later sold the shares at an average value of $26.
Compute Lynch Brothers’ overall gain or loss from managing the issue.
Solution:
Lynch Brothers
Original Distribution
10% x 1,000,000 = 100,000 shares for Lynch
$ 1.50 profit per share
$150,000 profit on original distribution
Market Stabilization
45,000 shares for Lynch
$ 3.90 loss per share (29.90 – 26.00)
$175,500 loss on market stabilization
Gain on original distribution $150,000
Loss on market stabilization 175,500
Net loss ($ 25,500)
15-10.
Skyway Airlines will issue stock at a retail (public) price of $15,The company will receive $13.80 per share.
a. What is the spread on the issue in percentage terms?
b. If Skyway Airlines demands receiving a net price only $.75 below the public price suggested in part a,what will the spread be in percentage terms?
c. To hold the spread down to 3 percent based on the public price in part a,what net amount should Skyway Airlines receive?
Solution:
Skyway Airlines
a.
b.
c. Public Price $15.00
3% Spread ,45
Net Amount Received $14.55
15-11.
Winston Sporting Goods is considering a public offering of common stock,Its investment banker has informed the company that the retail price will be $18 per share for 600,000 shares,The company will receive $16.50 per share and will incur $150,000 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 $18 million from this issue,how many shares must be sold?
Solution:
Winston Sporting Goods
a. $18 – $16.50 = $1.50 spread $1.50/$18.00 = 8.33% spread
Total value = 600,000 shares x $18 = $10,800,000
Out-of-picket/total value $150,000/$10,800,000 = 1.39%
8.33% Spread
1.39% Out-of-pocket
9.72% Total %
b. Amount needed = $18,000,000
Total shares to be sold to net $18,000,000
= ($18,000,000 + issue costs)/net price per share
= $18,150,000/$16.50 per share = 1,100,000 shares
15-12.
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:
Growth rate in earnings per share
Consistency of performance
Debt to total assets
Turnover of product
Quality of management
Richmond
15%
Increased earnings
4 out of 5 years
52%
Slightly below
average
High
Car Rental
Industry
10%
Increased earnings
3 out of 5 years
39%
Average
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?
Solution:
Richmond Rent-A-Car
80% of the S&P 500 Stock Index = 80% x 25 = 20
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 +?
Quality of management-superior +?
Initial P/E ratio = 20 +? = 20?
15-13.
The investment banking firm of Luther King,Inc.,will use a dividend valuation model to appraise the shares of the Pyramid Corporation,Dividends (D1) at the end of the current year will be $1.20,The growth rate (g) is 9 percent and the discount rate (Ke) is 13 percent.
a. Using Formula 10-9 from Chapter 10,what should be the price of the stock to the public?
b. If there is a 6 percent total underwriting spread on the stock,how much will the issuing corporation receive?
c. If the issuing corporation requires a net price of $29 (proceeds to the corporation) and there is a 6 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.)
Solution:
Luther King,Inc.
b. Public Price $30.00
Underwriting spread (6%) 1.80
Net price to the corporation $28.20
15-14.
The Alston Corporation needs to raise $1 million of debt on a 20-year issue,If it places the bonds privately,the interest rate will be 11 percent,and $25,000 in out-of-pocket costs will be incurred,For a public issue,the interest rate will be 10 percent,and the underwriting spread will be 5 percent,There will be $75,000 in out-of-pocket costs.
Assume interest on the debt is paid semiannually,and the debt will be outstanding for the full 20 years,at which time it will be repaid.
Which plan offers the higher net present value? 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,but use 6 percent semiannually throughout the analysis,(Disregard taxes.)
Solution:
Alston Corporation
Private Placement
$1,000,000 debt
– 25,000 out-of-pocket costs
$ 975,000 net amount to Alston
Present value of future interest payments
interest payments (semiannually) = 11%/2 = 5.5%
interest payments = 5.5% x $1,000,000 = $55,000
PVA = A x PVIF (n = 40,i = 6%) (Appendix D)
PVA = $55,000 x 15.046
PVA = $827,530
Present value of lump-sum payment at maturity
PV = FV x PVIF (n = 40,i = 6%) (Appendix B)
PV = $1,000,000 x,097
PV = $97,000
15-14,Continued
$827,530
+ 97,000
$924,530 total present value
The net present value equals the net amount to Alston minus the present value of future payments.
$975,000 net amount to Alston
–924,530 present value of future payments
$ 50,470 net present value (private offering)
Public Issue
$1,000,000 debt
– 50,000 spread
– 75,000 out-of-pocket costs
$ 875,000 net amount to Alston
Present value of future interest payments
interest payments (semiannually) = 10%/2 = 5%
interest payments = 5% x $1,000,000 = $50,000
PVA = A x PVIF (n = 40,i = 6%) (Appendix D)
PVA = $50,000 x 15.046
PVA = $752,300
Present value of lump-sum payment at maturity
PV = FV x PVIF (n = 40,i = 6%)
PV = $1,000,000 x,097
PV = $97,000
15-14,Continued
$752,300
+ 97,000
$849,300 total present value
Net present value equals the net amount to Alston minus the present value of future payments.
$875,000 net amount to Alston
–849,300 present value of future payments
$ 25,700 net amount to Alston
The private placement has the higher net present value ($50,470 vs,$25,700)
15-15.
Warner Drug Co,has a net income of $18 million and 9 million shares outstanding,Its common stock is currently selling for $30 per share,Warner plans to sell common stock to set up a major new production facility with a net cost of $21,280,000,The production facility will not produce a profit for one year,and then it is expected to earn a 16 percent return on the investment,Roth and Stern,an investment banking firm,plans to sell the issue to the public for $28 per share with a spread of 5 percent.
a. How many shares of stock must be sold to net $21,280,000? (Note,No out-of-pocket costs should 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 $30)? What will be the price per share immediately after the sale of stock if the P/E stays constant (based on including the additional shares computed in part a)?
d. Compute the EPS and the price (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?
15-15,Continued
Solution:
Warner Drug Company
a. $21,280,000 net amount to be raised.
Determine net price to the corporation
$28.00 public price
– 1.40 5% spread
$26.60 net price
Determine number of shares to be sold
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.
c. EPS = $18,000,000/9,000,000 = $2.00
P/E ratio = Price/EPS = $30/$2 = 15x
EPS after offering = $18,000,000/9,800,000 = $1.84
Price = P/E x EPS = 15 x $1.84 = $27.60
15-15,Continued
d. Net income = $18,000,000 + 16% ($21,280,000)
= $18,000,000 + $3,404,800
= $21,404,800
EPS after contribution = $21,404,800/9,800,000 = $2.18
Price = P/E x EPS = 15 x $2.18 = $32.70
e. In the long run,it appears that the company is better off because of the additional investment,Earnings per share are $.18 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.
15-16.
The Presley Corporation is about to go public,It currently has aftertax earnings of $7.5 million and 2.5 million shares are owned by the present stockholders (the Presley family),The new public issue will represent 600,000 new shares,The new shares will be priced to the public at $20 per share,with a 5 percent spread on the offering price,There will also be $200,000 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.
15-16,Continued
Solution:
Presley Corporation
a. $20 price x 95% = $19 net price
$19 net price
x 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. Earnings per share before stock issue
= $7,500,000/2,500,000 = $3.00
c. Earnings per share after stock issue
= $7,500,000/3,100,000 = $2.42
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).
16.07% must be earned on the net proceeds to produce EPS of $3.00.
15-16,Continued
e. $3.00 (1.05) = $3.15 (5% increase in EPS)
Total earnings = $3.15 x 3,100,000 shares = $9,765,000
incremental earnings = $9,765,000 – $7,500,000
= $2,265,000
20.22% would have to be earned to produce EPS of $3.15.
15-17.
B,P,Hart has a chance to participate in a new public offering by Cardiovascular Systems,Inc,His broker informs him that demand for the 800,000 shares to be issued is very strong,His broker's firm is assigned 20,000 shares in the distribution and will allow Hart,a relatively good customer,1.5 percent of its 20,000 share allocation.
The initial offering price is $40 per share,There is a strong aftermarket,and the stock goes to $44 one week after issue,After the first full month after issue,Mr,Hart is pleased to observe his shares are selling for $46.25,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 $38.50.
a. Compute the total dollar profit or loss on Mr,Hart’s 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 this percentage gain or loss from the initial $40 price and compare this to the results that might be expected in an investment of this nature based on prior research,Assume the overall stock market was basically unchanged during the period of observation.
c. Why might a new public issue be expected to have a strong aftermarket?
15-17,Continued
Solution:
B,P,Hart—Cardiovascular Systems,Inc.
a. Mr,Hart’s purchase = 1.5% x 20,000 shares = 300 shares
Dollar profit or loss
1 week 300 shares x ($44 – $40) = $1,200 profit
1 month 300 shares x ($46.25 – $40) = $1,875 profit
1 year 300 shares x ($38.50 – $40) = $ 450 loss
b. Percentage profit or loss
1 week $4.00/$40 = 10.00%
1 month $6.25/$40 = 15.63%
1 year –$1.50/$40 = –3.75%
The results are in line with prior research,The stock 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 stock was 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 after-market because investment bankers often underprice the issue to insure the success of the distribution.
15-18.
The management of Rowe Boat Co,decided to go private in 1999 by buying all 2 million of its outstanding shares at $16.50 per share,By 2004,management had restructured the company by selling off the scuba diving division for $7.5 million,the pleasure cruise division for $9 million,and the military contract aqua division for $11 million,
Because these divisions had been only marginally profitable,Rowe Boat is a stronger company after the restructuring,Rowe is now able to concentrate exclusively on the construction of new boats and will generate earnings per share of $1.20 this year,Investment bankers have contacted the firm and indicated that,if it reentered the public market,the 2 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 Rowe Boat Co,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 million shares (based on current earnings and an anticipated P/E of 15)?
c. What is the percentage return to the management of Rowe Boat Co,from the restructuring? Use answers from parts a and b to determine this value.
Solution:
Rowe Boat Company
a. 2 million shares x $16.50 = $33.0 million (cost to go private)
b. Proceeds from sale of the divisions
Scuba Diving division $ 7.5 million
Pleasure Cruise division 9.0 million
Military Contract Aqua division 11.0 million
$27.5 million
Current value of the 2 million shares
2 million shares x (P/E x EPS)
2 million x (15 x $1.20)
2 million x $18 $36.0 million
Total value to the company $63.5 million
15-18,Continued
c. Total value to the company $63.5 million
– Cost to go private 33.0 million
Profit from restructuring $30.5 million
Comprehensive Problem
CP 15-1.
The Anton Corporation,a manufacturer of radar control equipment,is planning to sell its shares to the general public for the first time,The firm's investment banker is working with the Anton Corporation in determining a number of items,Information on the Anton Corporation follows:
Anton Corporation
Income Statement
For the Year 200X
Sales (all on credit) $22,428,000
Cost of goods sold 16,228,000
Gross profit 6,200,000
Selling and administrative expenses 2,659,400
Operating profit 3,540,600
Interest expense 370,600
Net income before taxes 3,170,000
Taxes 1,442,000
Net income $ 1,728,000
Balance Sheet
As of December 31,200X
Assets
Cash $ 150,000
Marketable securities 100,000
Accounts receivable 2,000,000
Inventory 3,800,000
Total current assets $ 6,050,000
Net plant and equipment 6,750,000
Total assets $12,800,000
CP 15-1,Continued
Liabilities and Stockholders' Equity
Accounts payable $ 1,000,000
Notes payable 1,200,000
Total current liabilities 2,200,000
Long-term liabilities 2,380,000
Total liabilities $ 4,580,000
Common stock (1,200,000 shares at $1 par) $ 1,200,000
Capital in excess of par 2,800,000
Retained earnings 4,220,000
Total stockholders' equity 8,220,000
Total liabilities and stockholders' equity $12,800,000
The new public offering will be at 10 times the earnings per share.
a. Assume that 500,000 new corporate shares will be issued to the general public,What will earnings per share immediately after the public offering be? (Round to two places to the right of the decimal point.) Based on the price-earnings ratio of 10,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 7 percent and out-of-pocket costs of $150,000,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 500,000-share distribution,250,000 shares belong to current stockholders and 250,000 are new corporate shares,and these will be added to the 1,200,000 corporate 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 10 and use earnings per share after the distribution in the calculation.
e. Assuming an underwriter spread of 7 percent and out-of-pocket costs of $150,000,what will net proceeds to the corporation be?
f. What return must the corporation now earn on the net proceeds to equal earnings per share before the offering? How does this compare with current return on the total assets on the balance sheet?
CP 15-1,Continued
Solution:
New Public Offering
Anton Corporation
Initial market price = P/E x EPS
= 10 x $1.02 = $10.20
b. 500,000 shares x $10.20 = $5,100,000 gross proceeds
– 357,000 7% spread
– 150,000 out-of-pocket costs
$4,593,000 net proceeds
In order to earn $1.44 after the offering,the return on $4,593,000 must produce new earnings equal to X.
CP 15-1,Continued
$1,728,000 + X = $1.44 (1,700,000)
X = $2,448,000 – $1,728,000
X = $720,000
Proof:
The firm must earn 15.68% on net proceeds to equal earnings per share before the offering,This is greater than current return on assets of 13.50%.
CP 15-1,Continued
Initial market price = P/E x EPS
10 x $1.19 = $11.90
e. 250,000 x $11.90 = $2,975,000 gross proceeds
– 208,250 7% spread
– 150,000 out-of-pocket costs
$2,616,750 net proceeds
f. $1.44 represents earnings per share before the offering,In order to earn $1.44 after the offering,the return on $2,616,750 must produce new earnings equal to X.
X = $2,088,000 – $1,728,000
X = $360,000
CP 15-1,Continued
Proof:
Thus:
This is greater than the current return on assets of 13.50%.
