Chapter 18 Initial Public Offerings, Investment Banking, and Financial Restructuring

A !"#R! $O B#%I I %&OF&C'AP$#R ()#!$IO !

18-1

Reasons for going public include the following. Note that, generally, several of these reasons will be important at the time of the IP . !o raise additional capital. riginal investors may be tapped out, or they may not want to put additional funds into the business for diversification reasons. !hus, the company needs to bring in outside funds, and an IP is the most efficient way of doing so. "ounding stoc#holders want li$uidity, which a public mar#et would provide. "ounding stoc#holders want to diversify. !hey can sell some shares during or after an IP . %any companies use stoc# options as part of their compensation plans. &mployees with options, li#e founding stoc#holders, want li$uidity and the opportunity to diversify their holdings. !o establish a mar#et price, which is useful for incentive employee option programs, for mergers, for estate ta' purposes, and in divorce situations. Public ownership may help the company ma#e sales, because public ownership may provide credibility with regard to (staying power)*no one wants to be dependent on a supplier that goes under because it was unable to raise needed capital. +lso, public ownership may provide some beneficial advertising effects.

,ome downsides to public ownership include- .osts, disclosure re$uirements, harder to engage in self-dealings that benefit the controlling stoc#holders. +lso, analysts do not follow very small stoc#s where trading volume is necessarily small. !herefore, if a firm is so small that an active mar#et for its stoc# cannot be developed, then public ownership won/t really ma#e it li$uid, and the price will fluctuate widely and not necessarily reflect the firm/s true value. In addition, if the firm goes public, it might be easier for a raider to gain control and oust the managers. !his is something that managers consider, especially if the management team will not have over 012 of the stoc# after the public offering. "inally, it is interesting to note that some very large companies with tens of thousands of employees li#e Publi', .%34ill, and .argill have been able to get most of the advantages listed above without actually going public. !hese companies have developed internal mar#ets that wor# as follows- 516 !he company hires an investment ban#ing firm to operate the plan, which is set up much li#e a mutual fund, with each participating employee having an account. 536 !he ban#er develops a formula for pricing the stoc#, Answers and Solutions: 18 & 1

ta#ing account of boo# value and earnings per share, the state of the stoc# mar#et as measured by an inde' of comparable companies/ stoc# plus an inde' such as the ,7P 011, the level of interest rates, and so forth. !he formula will be ad8usted over time to ensure that there is a fairly good balance between buyers and sellers. 596 ,everal times a year, employees will be given the opportunity to buy or sell shares at the announced formula price. If more buy orders than sell orders come in, the company may create and sell new shares. If sell orders e'ceed buy orders, the company will buy the e'cess and thus offset the imbalance. !he company can also offer new shares to its employees if it wants to raise additional e$uity capital, or it can repurchase shares if it wants to reduce e$uity. If the company is large enough, such an internal mar#et will provide li$uidity and also serve most of the other functions of a public mar#et, with the additional advantage that all of its stoc#holders will be in a position 5as employees6 to help the company perform well operationally. 18-3 In the late 1::1s it was common for IP stoc#s to rise far above the offering price on the first day of trading. !his situation indicated that companies were (leaving money on the table,) i.e., that they could have gotten more for the shares they sold than they actually received. !his under-pricing was rationali;ed on several grounds, including 516 that it reduced ris# to the underwriter and thus lowered costs to the issuer, 536 that it helped enhance the reputation of the underwriter, which benefited the issuer, and 596 that it helped insure a successful offering and thus made follow-on offerings easier to complete. In addition, if the issuing firm sold only a small percentage of its shares, the underpricing did not cause too much of a problem on a percentage basis. Note too that today it is clear that the analysts who wor#ed for some investment ban#ers rated some stoc#s higher than the fundamentals would 8ustify, ma#ing the offering price closer to the underlying value than appeared from the post-issue run-up. +lso, and very importantly, under-pricing enabled investment ban#ers to reward their good customers and give what amounted to bribes to e'ecutives of companies that were potential underwriting clients. ,everal investment ban#ing firms have been sued in connection with this practice. !he situation changed after 3111, when stoc#s, and especially the #inds of Nasda$ stoc#s that had been leading the IP mar#et, crashed. !hen, it became difficult for a company to have an IP , and the few that came out rarely had big run-ups and often actually declined. ,ee te't !able 1<-3 for data on this issue, and note that the corresponding table in the last edition of the te't 5two years earlier6 showed far higher run-ups. !he subse$uent crash in stoc# prices suggests that the valuations put on many IP s, and on tech stoc#s in general, was also too high, which could be another sign of an inefficient mar#et. !hat would not necessarily relate to inefficiency in the IP mar#et per se, but in the late 1::1s the IP mar#et and the general stoc# mar#et, especially the Nasda$ mar#et, were closely related. +ll of this does suggest that the IP mar#et was not very efficient, at least in the late 1::1s, in the sense of giving the seller the highest price buyers were willing to pay. !he ,&. and the N+,= are currently 5%arch 31106 investigating the IP mar#et, and the end result may be a more efficient IP mar#et in the future.

Answers and Solutions: 18 & *

#+ample ,f IPO Pricing +n e'ample of how an IP would be priced is shown in the > . model. !he valuation is, of course, a critical issue. !heoretically, the proper pricing basis is the =." model as discussed in .hapters 0 and 11. =ata on publicly-owned companies that are comparable to the company that is going public would be obtained and used to develop a discount rate, which would then applied to the company/s pro8ected cash flows. +lthough the =." model should be given the most weight in the valuation, investment ban#ers also loo# at selected multiples, especially the P?& and %?> ratios. "or e'ample, if a set of comparable companies has an average P?& of 31 and an average %?> of 9.1, and if the company in $uestion has total earnings of @11 million and total boo# e$uity of @<1 million, then it/s valuation would be @11,111,1115316 A @311 million by the P?& multiple method and @<1,111,11159.16 A @311 million by the %?> multiple method. !hen, if the =." analysis had also produced a valuation of about @310 million, the final corporate valuation would be set at @310 million. f course, the three methods would rarely if ever produce e'actly the same results, so in practice the final valuation would be some sort of 8udgmentally determined weighted average of the three separate valuations. Biven the total valuation, the ban#ers would need to find a price per share. >an#ers generally li#e to offer new stoc# at about @10 per share, though a higher price may be used for IP s of large, established companies li#e Craft, which came out at @91 per share. +ssuming the target price is @10, then the company will divide the total value by @10 to determine the total number of shares, so in our e'ample the company should have @310,111,111 ? @10 A 19,DDD,DD< shares outstanding when it goes public. If the actual number of shares currently outstanding is different from this target, then a split or reverse split would be used to get to the target number. IP s can consist entirely of currently outstanding shares to be sold by current stoc#holders, or entirely of new shares sold by the company to raise new capital, or a combination of the two. ,uppose the company wants to raise @11 million of new money to fund its business plan. If it needs 11 million but flotation costs would amount to <2, then it will have to raise a gross amount of @11 million ? 51.1 E 1.1<6 A @11,<03,D88. In that case, it would issue @11,<03,D88 ? @10 A <1D,8FD shares. 18-9 + rights offering is when a company sells shares and offers those shares to its current shareholders on a pro rata basis. &ach shareholder is given an option called a (right) to buy a stated number of shares at a specified price within a stated period. !he stoc#holder can e'ercise the right and buy new shares or sell the right to some other party who wants to buy the new shares. !ypically, companies use rights offerings in order to allow e'isting stoc#holders to maintain their relative position in the company, if they so desire. %ost private companies have the preemptive right, but most public companies do not, because stoc#holders can increase or decrease their holding in public companies easily. +n e'ample of a rights offering is provided in the &'cel model. It illustrates how rights are valued. It also shows that the lower the e'ercise price, the greater the (stoc# split effect,) and it shows that stoc#holders will come out with the same wealth regardless of whether they sell their rights or e'ercise them. Answers and Solutions: 18 & -

18-F

+n original issue discount 5 I=6 bond is a bond that, when issued, provides a coupon rate that is below the current mar#et interest rate, i.e., rcoupon G rd. ,ince the coupon rate is low, the bond will sell at a discount, but the discount must be such that the e'pected return on the bond is e$ual to rd. f course, many bonds, when they are sold, have rcoupon A rd , but rising rates in the mar#etplace cause the bond to sell at a discount. !hose bonds are not original issue discount bonds*they are 8ust plain bonds that sell at a discount due to changing mar#et conditions. ne important class of I= bonds is the ;ero coupon bond, which pays no interest, sells at a substantial discount, and they pays off at face value when it matures. !he value of ;eros and other discount bond tends to rise over time, and their value must be close to their face value 5@1,1116 8ust before maturity unless they are li#ely to default. !he pro8ected annual increase in value is called (accretion,) and for an original issue discount bond, it is treated for ta' purposes as ordinary income, not capital gains. If a bond is issued at par and then falls to a discount due to interest rate changes, then someone who purchases this discount bond can earn a capital gain if interest rates later fall and the bond rises in value. I= bonds are typically callable at the accreted value plus a specified call premium, such as 32 over the accreted value. +n e'ample that shows how ;eros are evaluated, and how returns on such bonds are calculated, is provided in the &'cel model. !he bond refunding decision is, in essence, a capital budgeting decision. + bond will be called if interest rates decline after the bond was issued by an amount sufficient to cause the annual interest saving from getting rid of the old-high interest bond and replacing it with a new low-interest bond to offset the costs associated with the refunding, mainly a call premium and flotation costs for the new issue. If the PH of the interest savings is greater than the costs associated with the refunding, then the refunding will be profitable. !a'es must be ta#en into account, and the flotation costs associated with the new and old issues must be dealt with properly. +n e'ample of refunding analysis is provided in the &'cel model. &ven though the NPH found in a refunding analysis is positive, it might be better to wait rather than call the bond immediately. If interest rates continue to decline, the NPH of the refunding might be much greater if the company delays the call. !he ability to call the bond is an option that the issuing company holds, and when they issue the call, they are e'ercising the option. Ii#e any option, it may or may not be advantageous to e'ercise it when it first gets (in the money.) ,o, a critical element in the refunding analysis is a pro8ection of future interest rates, and if rates are li#ely to decline in the future it may be best to delay the call. +gain, this is illustrated in the model.

18-0

Answers and Solutions: 18 & .

A !"#R! $O # /&OF&C'AP$#R ()#!$IO !

18-1

a. + closely held corporation goes public when it sells stoc# to the general public. Boing public increases the li$uidity of the stoc#, establishes a mar#et value, facilitates raising new e$uity, and allows the original owners to diversify. 4owever, going public increases business costs, re$uires disclosure of operating data, and reduces the control of the original owners. !he new issue mar#et is the mar#et for stoc# of companies that go public, and the issue is called an initial public offering 5IP 6. b. + public offering is an offer of new common stoc# to the general publicJ in other words, an offer in which the e'isting shareholders are not given any preemptive right to purchase the new shares. + private placement is the sale of stoc# to only one or a few investors, usually institutional investors. !he advantages of private placements are lower flotation costs and greater speed, since the shares issued are not sub8ect to ,&. registration. c. + venture capitalist is the manager of a venture capital fund. !he fund raises most of its capital from institutional investors and invests in start-up companies in e'change for e$uity. !he venture capitalist gets a seat on the companies/ boards of directors. >efore an IP , the senior management team and the investment ban#er ma#e presentations to potential investors. !hey ma#e presentations in tent to twenty cities, with three to five presentations per day, over a two wee# period. !he spread is the difference between the price at which an underwriter sells the stoc# in an IP and the proceeds that the underwriter passes on to the issuing firm. In other words, it is the fee collected by the underwriter, and it usually is seven percent of the offering price. d. !he ,ecurities and &'change .ommission 5,&.6 is a government agency which regulates the sales of new securities and the operations of securities e'changes. !he ,&., along with other government agencies and self-regulation, helps ensure stable mar#ets, sound bro#erage firms, and the absence of stoc# manipulation. Registration of securities is re$uired of companies by the ,&. before the securities can be offered to the public. !he registration statement is used to summari;e various financial and legal information about the company. "re$uently, companies will file a master registration statement and then update it with a short-form statement 8ust before an offering. !his procedure is termed shelf registration because companies put new securities (on the shelf) and then later sell them when the mar#et is right. >lue s#y laws are laws that prevent the sale of securities that have little or no asset bac#ing. !he margin is the percentage of a stoc#/s price that an investor has borrowed in order to purchase the stoc#. !he ,&. sets margin re$uirements, which is the ma'imum percentage of debt that can be used to purchase a stoc#. !he ,&. also controls Answers and Solutions: 18 & 0

trading by corporate insiders, who are the officers, directors, and ma8or stoc#holders of the firm. e. + prospectus summari;es information about a new security issue and the issuing company. + (red herring,) or preliminary prospectus, may be distributed to potential buyers prior to approval of the registration statement by the ,&.. +fter the registration has become effective, the securities, accompanied by the prospectus, may be offered for sale. f. !he National +ssociation of ,ecurities =ealers 5N+,=6 is an industry group primarily concerned with the operation of the over-the-counter 5 !.6 mar#et. g. + best efforts arrangement versus an underwritten sale refers to two methods of selling new stoc# issues. In a best efforts sale, the investment ban#er is only committed to ma#ing every effort to sell the stoc# at the offering price. In this case, the issuing firm bears the ris# that the new issue will not be fully subscribed. If the issue is underwritten, the investment ban#er agrees to buy the entire issue at a set price, and then resells the stoc# at the offering price. !hus, the ris# of selling the issue rests with the investment ban#er. h. Refunding occurs when a company issues debt at current low rates and uses the proceeds to repurchase one of its e'isting high coupon rate debt issues. ften these are callable issues, which means the company can purchase the debt at a lower-thanmar#et price. Pro8ect financings are arrangements used to finance mainly large capital pro8ects such as energy e'plorations, oil tan#ers, refineries, utility power plants, and so on. Ksually, one or more firms 5sponsors6 will provide the e$uity capital re$uired by the pro8ect, while the rest of the pro8ect/s capital is supplied by lenders and lessors. !he most important aspect of pro8ect financing is that the lenders and lessors do not have recourse against the sponsorsJ they must be repaid from the pro8ect/s cash flows and the e$uity cushion provided by the sponsors. ,ecuriti;ation is the process whereby financial instruments that were previously thinly traded are converted to a form that creates greater li$uidity. ,ecuriti;ation also applies to the situation where specific assets are pledged as collateral for securities, and hence asset-bac#ed securities are created. ne e'ample of the former is 8un# bondsJ an e'ample of the latter is mortgage-bac#ed securities. %aturity matching refers to matching the maturities of debt used to finance assets with the lives of the assets themselves. !he debt would be amorti;ed such that the outstanding amount declined as the asset lost value due to depreciation. 18-3 No. !he role of the investment ban#er is more important if the stoc# demand curve has a steep slope and the negative signaling effect is substantial. Knder such conditions, the investment ban#er will have a harder time holding up the stoc# price.

Answers and Solutions: 18 & 1

18-9

No. !he real value of a security is determined by the e$uilibrium forces of an efficient mar#et. +ssuming that the information provided on newly issued securities is accurate, the mar#et will establish the value of a security regardless of the opinions rendered by the ,&., or, for that matter, opinions offered by any advisory service or analyst. a. Boing public would tend to ma#e attracting capital easier and to decrease flotation costs. b. !he increasing institutionali;ation of the (buy side) of the stoc# and bond mar#ets should increase a firm/s ability to attract capital and should reduce flotation costs. c. "inancial conglomerates can offer a variety of financial services and types of investments, thus it seems a company/s ability to attract capital would increase and flotation costs would decrease. d. &limination of the preemptive right would li#ely not affect a large company where percentage ownership is not as important. Indeed, the trend today seems to be for companies to eliminate the preemptive right. f. !he introduction of shelf registration tended to speed up ,&. review time and lower the costs of floating each new issue. !hus, the company/s ability to attract new capital was increased.

18-F

18-0

Investment ban#ers must investigate the firms whose securities they sell, simply because, if an issue is overvalued and suffers mar#ed price declines after the issue, the ban#er will find it increasingly difficult to dispose of the new issue. In other words, reputation is highly important in the investment ban#ing industry.

Answers and Solutions: 18 & 2

!O3)$IO ! $O # /&OF&C'AP$#R PROB3#4!

18-1

a. @0 per share Bross proceeds A 59,111,11165@06 A @10,111,111. Net profit A @10,111,111 - @1F,111,111 - @911,111 A @<11,111. b. @D per share Bross proceeds A 59,111,11165@D6 A @18,111,111. Net profit A @18,111,111 - @1F,111,111 - @911,111 A @9,<11,111. c. @F per share Bross proceeds A 59,111,11165@F6 A @13,111,111. Net profit A @13,111,111 - @1F,111,111 - @911,111 A -@3,911,111.

18-3

Net proceeds per share A @3351 - 1.106 A @31.:1. Number of shares to be sold A 5@31,111,111 L 101,1116?@31.:1 A :DF,110 shares. a. If 111 shares are outstanding, then we have the following for &delman&arnings per share =ividends per share >oo# value per share 3111 311D @8,1D1 @13,111 F,311 D,111 :1,111

18-9

b. Ksing the following two e$uations, the growth rate for &P, and =P, can be determined. 51 L g&P,60 &P,11 A &P,1D. 51 L g=P,60 =P,11 A =P,1D. Cennedy ,trasburg &delman g&P, 8.F2 D.F 8.1 g=P, 8.F2 D.F <.F

c. >ased on the figures in Part a, it is obvious that &delman/s stoc# would not sell in the range of @30 to @111 per share. !he small number of shares outstanding has greatly inflated &P,, =P,, and boo# value per share. ,hould &delman attempt to sell its stoc# based on the &P, and =P, above, it would have difficulty finding investors at the economically 8ustified price. Answers and Solutions: 18 & 8

d. &delman/s management would probably be wise to split the stoc# so that &P,, =P,, and boo# value were closer to those of Cennedy and ,trasburg. !his would bring the price of the stoc# into a more reasonable range. e. + F,111-for-1 split would result in F11,111 shares outstanding. If &delman has F11,111 shares outstanding, then we would have the following&arnings per share =ividends per share >oo# value per share f. Cennedy ,trasburg &delman g. Cennedy ,trasburg &delman R & 10.112 19.DF 19.99 Payout Ratio 3111 311D 012 012 01 01 01 01 3111 @3.1F 1.10 311D @ 9.11 1.01 33.01

+ll three companies seem to be following similar dividend policies, paying out about 01 percent of their earnings. h. =?+ is F9 percent for Cennedy, 9< percent for ,trasburg, and 00 percent for &delman. !his suggests that &delman is more ris#y, hence should sell at relatively low multiples. i. Cennedy ,trasburg P?& @9D?@F.01 A 8.11 @D0?@<.01 A 8.D<

!hese ratios are not consistent with g and R &J based on gs and R &s, Cennedy should have the higher P?&. Probably si;e, listing status, and debt ratios are offsetting g and R &. 8. !he mar#et prices of Cennedy and ,trasburg yield the following multiples%ultiple of &P,, 311D 8.11 8.D< %ultiple of %ultiple of >oo# =P,, 311D Halue per ,hare, 311D 1D.11 1.31 1<.99 1.18 Answers and Solutions: 18 & 5

Cennedy ,trasburg

+pplying these multiples to the data in Part e, we obtain the following mar#et pricesIndicated %ar#et Price for &delman ,toc# >ased on =ata ofCennedy ,trasburg @3F.11 @3D.11 3F.11 3D.11 3<.11 3D.00

>ased on earnings, 3110 >ased on dividends, 3110 >ased on boo# value per share #.

= 1 51 + g 6 L g. P1

Kennedy Strasburg Edelman Based on Kennedy: Based on Strasburg:

@3.3051.18F6 L 8.F2 A 10.18. @9D

@9.<051.1DF6 L D.F2 A 13.0F2. @D0

M1 P

=1 . r g

P1 A P1 A

1.0151.1<<6 A @31.0F. 1.103 1.1<< 1.0151.1<<6 A @99.DD. 1.130 1.1<<

l. !he potential range, based on these data, is between @31.0F and @99.DD a share. !he data suggest that the price would be set toward the low end of the range- 516 &delman has a high debt ratio, 536 &delman is relatively small, and 596 &delman is new and will not be traded on an e'change. !he actual price would be based on negotiations between the underwriter and &delmanJ we cannot say what the e'act price would be, but the price would probably be set below @31.0F, with @31 being a reasonable guess. 18-F a. ,ince the call premium is 11 percent, the total premium is 1.115@F1,111,1116 A @F,F11,111. 4owever, this is a ta' deductible e'pense, so the relevant after-ta' cost is @F,F11,11151 - !6 A @F,F11,11151.D16 A @3,DF1,111. b. !he dollar flotation cost on the new issue is 1.1F5@F1,111,1116 A @1,D11,111. !his cost is not immediately ta' deductible, and hence the after-ta' cost is also @1,D11,111. 5Note that the flotation cost can be amorti;ed and e'pensed over the life of the issue. !he value of this ta' savings will be calculated in Part e.6

Answers and Solutions: 18 & 16

c. !he flotation costs on the old issue were 1.1D5@F1,111,1116 A @3,F11,111. !hese costs were deferred and are being amorti;ed over the 30-year life of the issue, and hence @3,F11,111?30 A @:D,111 are being e'pensed each year, or @F8,111 each D months. ,ince the bonds were issued 0 years ago, 50?3065@3,F11,1116 A @F81,111 of the flotation costs have already been e'pensed, and 531?3065@3,F11,1116 A @1,:31,111 remain une'pensed. If the issue is refunded, the une'pensed portion of the flotation costs can be immediately e'pensed, and this would result in a ta' savings of !5@1,:31,1116 A 1.F15@1,:31,1116 A @<D8,111. d. !he net after-ta' cash outlay is @9,F<3,111, as shown belowld issue call premium New issue flotation cost !a' savings on old issue flotation costs Net cash outlay @3,DF1,111 1,D11,111 5<D8,1116 @9,F<3,111

e. !he new issue flotation costs of @1,D11,111 would be amorti;ed over the 31-year life of the issue. !hus, @1,D11,111?31 A @81,111 would be e'pensed each year, or @F1,111 each D months. !he ta' savings from this ta' deduction is 51.F16@F1,111 A @1D,111 per semiannual period. >y refunding the old issue and immediately e'pensing the remaining old issue flotation costs, the firm forgoes the opportunity to continue to e'pense the old flotation costs over time. ,pecifically, @3,F11,111?30 A @:D,111 each year, or @F8,111 semiannually. !he value of each @F8,111 deduction forgone is 1.F15@F8,1116 A @1:,311. f. !he interest on the old issue is 1.115@F1,111,1116 A @F,F11,111 annually, or @3,311,111 semiannually. ,ince interest payments are ta' deductible, the after-ta' semiannual amount is 1.D5@3,311,1116 A @1,931,111. !he new issue carries an 8 percent coupon rate. !herefore, the annual interest would be 1.185@F1,111,1116 A @9,311,111, or @1,D11,111 semiannually. !he after-ta' cost is thus 1.D5@1,D11,1116 A @:D1,111. !hus, the after-ta' net interest savings if refunding ta#es place would be @1,931,111 N @:D1,111 A @9D1,111 semiannually.

Answers and Solutions: 18 & 11

g. !he net amorti;ation ta' effects are N@9,311 per year for 31 years, while the net interest savings are @9D1,111 per year for 31 years. !hus, the net semiannual cash flow is @90D,811, as shown below. ,emiannual "lotation .ost !a' &ffects,emiannual ta' savings on new flotation!a' benefits lost on old flotationNet amorti;ation ta' effects @1D,111 51:,3116 5@ 9,3116

,emiannual Interest ,avings =ue !o Refunding,emiannual interest on old bond,emiannual interest on new bondNet interest savings ,emiannual cash flow@1,931,111 5:D1,1116 @ 9D1,111 @ 90D,811

!he cash flows are based on contractual obligations, and hence have about the same amount of ris# as the firmOs debt. "urther, the cash flows are already net of ta'es. !hus, the appropriate interest rate is B,!Os after-ta' cost of debt. 5!he source of the cash to fund the net investment outlay also influences the discount rate, but most firms use debt to finance this outlay, and, in this case, the discount rate should be the after-ta' cost of debt.6 "inally, since we are valuing future flows, the appropriate debt cost is todayOs cost, or the cost of the new issue, and not the cost of debt floated 0 years ago. !hus, the appropriate discount rate is 1.D5826 A F.82 annually, or 3.F percent per semiannual period. +t this discount rate, the present value of the semiannual net cash flows is @:,11:,F30PH A @90D,8115PHI"+3.F2,F16 A @:,11:,F30. +lternatively, using a financial calculator, input N A F1, I A 3.F, P%! A -90D811, "H A 1, PH A P PH A @:,11:,F19. h. !he bond refunding would re$uire a @9,F<3,111 net cash outlay, but it would produce @:,11:,F19 in net savings on a present value basis. !hus, the NPH of refunding is @0,D9<,F19PH of net benefits .ost Refunding NPH @:,11:,F19 59,F<3,1116 @0,D9<,F19

!he decision to refund now rather than wait till later is much more difficult than finding the NPH of refunding now. If interest rates were e'pected to fall, and hence B,! would be able to issue debt in the future below todayOs 8 percent Answers and Solutions: 18 & 1*

rate, then it might pay to wait. 4owever, interest rate movements are very difficult, if not impossible, to forecast, and hence most financial managers would probably ta#e the Qbird-in-the-handQ and refund now with such a large NPH. Note, though, that if the NPH had been $uite small, say @1,111, management would have undoubtedly waited, hoping that interest rates would fall further, and the cost of waiting 5@1,1116 would not have been high enough to worry about. 18-0 a. Investment outlay re$uired to refund the issue.all premium on old issueNew flotation cost!a' savings on old flotation+dditional interest on old issueInterest earned on investment!otal investment outlay+nnual "lotation .ost !a' &ffects+nnual ta' savings on new flotation!a' benefits lost on old flotation+morti;ation ta' effects @ 81,111 5DD,DD<6 @ 19,999 @0,F11,111 0,111,111 51,DDD,DD<6 F01,111 5330,1116 @8,:08,999

+nnual Interest ,avings =ue to Refunding+nnual interest on old bond+nnual interest on new bondNet interest savings +nnual cash flowsNPH of refunding decision@0,F11,111 5F,011,1116 @ :11,111 @ :19,999 @3,<1<,138

Ksing a financial calculator, enter the cash flows into the cash flow register, I A D, NPH A P NPH A @3,<1<,138. b. !he company should consider what interest rates might be ne't year. If there is a high probability that rates will drop below the current rate, it may be more advantageous to refund later versus now. If there is a high probability that rates will increase, the firm should act now to refund the old issue. +lso, the company should consider how much ill will is created with investors if the issue is called. If !arpon is highly dependent on a small group of investors, it would want to avoid future difficulty in obtaining financing. 4owever, bond issues are callable after a certain time and investors e'pect them to be called if rates drop considerably. Answers and Solutions: 18 & 1-

!O3)$IO $O !PR#A/!'##$ PROB3#4

18-D

!he detailed solution for the problem is available both on the instructor/s resource .=R % 5in the file Solution for IFM9 Ch 18 P6 Build a Model.xls6 and on the instructor/s side of the web site, http788n,9:s9learning:c,m.

Answers and Solutions: 18 & 1.

4I I CA!#
Note to Instructors,ome instructors choose to assign the %ini .ase as homewor#. !herefore, the PowerPoint slides for the mini case, IFM9 Ch 18 Show.ppt, and the accompanying &'cel file, IFM9 Ch 18 Mini Case.xls, are not included for the students on !homsonNow. 4owever, many instructors, including us, want students to have copies of class notes. !herefore, we ma#e the PowerPoint slides and &'cel wor#sheets available to our students by posting them to our password-protected Reb site. Re encourage you to do the same if you would li#e for your students to have these files.

Rand;<s, a famil;&,9ned restaurant chain ,perating in Alabama, has gr,9n t, the p,int 9here e+pansi,n thr,ugh,ut the entire s,utheast is feasible: $he pr,p,sed e+pansi,n 9,uld re=uire the firm t, raise ab,ut >10 milli,n in ne9 capital: Because Rand;<s currentl; has a debt rati, ,f 06 percent, and als, because the famil; members alread; have all their pers,nal 9ealth invested in the c,mpan;, the famil; 9,uld like t, sell c,mm,n st,ck t, the public t, raise the >10 milli,n: ',9ever, the famil; d,es 9ant t, retain v,ting c,ntr,l: ?,u have been asked t, brief the famil; members ,n the issues inv,lved b; ans9ering the f,ll,9ing =uesti,ns7

a:

"hat agencies regulate securities markets@

Ans9er7 !he main agency that regulates the securities mar#et is the ,ecurities +nd &'change .ommission. ,ome of the responsibilities of the ,&. include- regulation of all national stoc# e'changes--companies whose securities are listed on an e'change must file annual reports with the ,&.J prohibiting manipulation by pools or wash salesJ controls over trading by corporate insidersJ and control over the pro'y statement and how it is used to solicit votes. !he "ederal Reserve >oard controls flow of credit into security transactions through margin re$uirements. ,tates also have some control over the issuance of new securities within their boundaries. !he securities industry itself reali;es the importance of stable mar#ets, therefore, the various e'changes wor# closely with the sec to police transactions and to maintain the integrity and credibility of the system.

Mini Case: 18 & 10

b:

',9 are start&up firms usuall; financed@

Ans9er7 !he first financing comes from the founders. !he first e'ternal financing comes from angels, who are wealthy individuals. !he ne't e'ternal financing comes from a venture capital fund. !he fund raises capital from institutional investors, usually around @<1 to @81 million. !he managers of the fund are called venture capitalists. !he fund invests in ten to twelve companies, and the venture capitalist sits on their boards. c: /ifferentiate bet9een a private placement and a public ,ffering:

Ans9er7 In a private placement stoc# is sold directly to one or a small group of investors rather than being distributed to the public at large. + private placement has the advantage of lower flotation costsJ however, since the stoc# would be bought by a small number of outsiders, it would not be actively traded, and a li$uid mar#et would not e'ist. "urther, since it would not have gone through the ,&. registration process, the holders would be unable to sell it e'cept to a restricted set of (sophisticated) investors. "urther, it might be difficult to find investors willing to invest large sums in the company and yet be minority stoc#holders. !hus, many of the advantages listed above would not be obtained. "or these reasons, a public placement ma#es more sense in Randy/s situation. d: "h; 9,uld a c,mpan; c,nsider g,ing public@ "hat are s,me advantages and disadvantages@

Ans9er7 + firm is said to be (going public) when it sells stoc# to the public for the first time. + company/s first stoc# offering to the public is called an (initial public offering 5IP 6.) !hus, Randy/s will go public if it goes through with its planned IP . !here are several advantages and disadvantages to going public+dvantages to going public Boing public will allow the family members to diversify their assets and reduce the ris#iness of their personal portfolios. It will increase the li$uidity of the firm/s stoc#, allowing the family stoc#holders to sell some stoc# if they need to raise cash. It will ma#e it easier for the firm to raise funds. !he firm would have a difficult time trying to sell stoc# privately to an investor who was not a family member. utside investors would be more willing to purchase the stoc# of a publicly held corporation which must file financial reports with the sec.

Mini Case: 18 & 11

Boing public will establish a value for the firm.

=isadvantages to going public !he firm will have to file financial reports with the ,&. and perhaps with state officials. !here is a cost involved in preparing these reports. !he firm will have to disclose operating data to the public. %any small firms do not li#e having to do this, because such information is available to competitors. +lso, some of the firm/s officers, directors, and ma8or stoc#holders will have to disclose their stoc# holdings, ma#ing it easy for others to estimate their net worth. %anagers of publicly-owned corporations have a more difficult time engaging in deals which benefit them personally, such as paying themselves high salaries, hiring family members, and en8oying not-strictly-necessary, but ta'-deductible, fringe benefits. If the company is very small, its stoc# may not be traded actively and the mar#et price may not reflect the stoc#/s true value.

!he advantages of public ownership would be recogni;ed by #ey employees, who would most li#ely be granted stoc# options, which would certainly be more valuable if the stoc# were publicly traded. e: "hat are the steps ,f an initial public ,ffering@

Ans9er7 ,elect an investment ban#er, file the ,-1 registration document with the ,&., choose a price range for the preliminary, or (red herring,) prospectus, go on a roadshow, set final price on final prospectus. f: "hat criteria are imp,rtant in ch,,sing an investment banker@

Ans9er7 516 reputation and e'perience in the industry. 536 e'isting mi' of institutional and retail 5i.e., individual6 clients. 596 support in the post-IP secondary mar#et, especially the reputation of the analyst who will cover the stoc#.

Mini Case: 18 & 12

g:

",uld c,mpanies g,ing public use a neg,tiated deal ,r a c,mpetitive bid@

Ans9er7 !he firm would almost certainly use a negotiated deal. !he competitive bid process for setting investment ban#ers/ fees is feasible only for large, well-established firms on large issues, and even here the use of bids is rare for e$uity issues. !his is because the process of ma#ing a bid is costly 5mainly for the research necessary to establish the price, but also because of the need for sec registration6, and investment ban#ers simply would not incur these costs unless they were assured of getting the deal or the issue was so large that a huge fee awaited the winner. h: ",uld the sale be ,n an under9ritten ,r best eff,rts basis@

Ans9er7 %ost stoc# offerings are done on an underwritten basis, but the price is not set until the investment ban#er has chec#ed investors for interest in the stoc#, and has received oral assurances of commitments at a price that will virtually guarantee the success of the offering barring a ma8or stoc# mar#et collapse. ,o, there is little effective difference between a best efforts and an underwritten deal. i: "ith,ut actuall; d,ing an; calculati,ns, describe h,9 the preliminar; ,ffering range f,r the price ,f an IPO 9,uld be determined@

Ans9er7 ,ince the firm is going public for the first time, there is no established price for its stoc#. !he firm and its investment ban#er would pro8ect future earnings and free cash flows. !he ban#er would then compare the firm with other restaurant firms of similar si;e. !he ban#er would try to determine a price range for the firm/s stoc# by applying the price?earnings ratios, price?dividends ratios, and price?boo# value ratios of similar firms to the firm/s earnings, dividends, and boo# value data. !he ban#er would also determine the price at which the firm/s stoc# would have to sell to earn the same rate of return as other firms in its industry. n the basis of all these factors, the investment ban#ers would determine a ballpar# price. !hey would then specify a range 5i.e., @11 to @136 in the preliminary prospectus.

Mini Case: 18 & 18

A:

"hat is a r,adsh,9@ "hat is b,,kbuilding@

Ans9er7 !he senior management team, the investment ban#er, and the lawyer ma#e presentations to potential institutional investors. !hey usually visit ten to twenty cities, and ma#e three to five presentations in each city. %anagement can/t say anything that is not in the registration statement, because the ,&. imposes a ($uiet period) from the time it ma#es the registration effective until 30 days after the stoc# begins trading. !he purpose is to prevent select investors from getting information that is not available to other investors. =uring the roadshow, the investment ban#ers as#s the investors to indicate how many shares they plan on buying. !he ban#er records this in his boo#. !he ban#er hopes for oversubscription. >ased on demand, the ban#er sets the final offer price on the evening before the stoc# is issued. k: /escribe the t;pical first&da; returns ,f an IPO and the l,ng&term returns t, IPO invest,rs:

Ans9er7 "irst-day returns average 1F.12, with many stoc#s having much higher returns. !he investment ban#er has an incentive to set a low price, both to ma#e its bro#erage customers happy and to ma#e it easy to sell the issue, whereas the firm would li#e to set as high a price as possible. Returns over the two-year period following the IP are generally lower than for comparable firms, indicating that the offering price is too low, but that the first-day run-up is too high. l: "hat are the direct and indirect c,sts ,f an IPO@

Ans9er7 !he underwriter usually charges a <2 fee, based on the offer price. In addition, there are direct costs to lawyers, accountants, printers, etc. !hat can easily total @F11,111. Indirect costs include the money left on the table, which is e$ual to the difference between the offer price and end-of-first-day price, multiplied by the number of shares. +lso, much of management/s time and attention is consumed by the IP in the months preceding the IP . m: "hat are e=uit; carve&,uts@

Ans9er7 &$uity carve-outs are a special type of IP in which a public company creates a new public company from one of its subsidiaries by issuing public stoc# in the subsidiary. !he parent usually retains a controlling interest.

Mini Case: 18 & 15

n:

In 9hat ,ther 9a;s are investment banks inv,lved in issuing securities@

Ans9er7 Investment ban#ers help companies with shelf registration 5,&. rule F016 in which securities are registered but not all of the issue is sold at once. Instead, the company sells a percentage of the issue each time it needs to raise capital. Investment ban#ers also help place private and public debt issues. !hey also help in seasoned e$uity offers, in which a public firms issues additional shares of stoc#. ,: "hat is meant b; g,ing private@ "hat are s,me advantages and disadvantages@

Ans9er7 Boing private is the reverse of going public. !ypically, the managers of a firm team up with a small group of outside investors, who furnish most of the e$uity capital, and purchase all of the publicly held shares of the company. !he new e$uity holders usually use a large amount of debt financing, up to :1 percent, to complete the purchase. ,uch a transaction is called a (leveraged buyout 5I> 6.) Boing private gives the managers greater incentives and more fle'ibility in running the company. It also removes the burden of sec filings, stoc#holder relations, annual reports, analyst meetings, and so on. !he ma8or disadvantage of going private is that it limits significantly the availability of new capital. ,ince the stoc# is not publicly traded, a new stoc# issue would not be practical, and, since such firms are normally leveraged to the hilt, it is tough to find additional debt financing. "or this reason, it is common for firms that have recently gone private to sell off some assets to $uic#ly reduce the debt burden to more conventional levels to give added financial fle'ibility. +fter several years of operating the business as a private firm, the owners typically go public again. +t this time, the firm is presumably operating at its pea#, and it will command top dollar compared to when it went private. In this way, the e$uity investors of the private firm are able to recover their investment and, hopefully, ma#e a tidy profit. ,o far I> s have, on average, been e'tremely profitable--since the 1:<1s, when I> firms such as Cohlberg Cravis Roberts 5CCR6 began operating, their annual rates of return are reported to have averaged over 01 percent annually. 4owever, Rall ,treet is becoming increasingly concerned about the use of debt, and in the beginning of the nineties the number of new I> s has fallen dramatically and some old ones have had ma8or financial difficulties.

Mini Case: 18 & *6

p:

',9 d, c,mpanies manage the maturit; structure ,f their debt@

Ans9er7 In discussing this $uestion, we emphasi;e that, if mar#ets are truly efficient and conditions are stable, the type of debt instrument will be immaterial, as the cost of each will be commensurate with its ris#. 4owever, if mar#ets are not totally efficient 5perhaps because management has information which investors do not have6, if the company/s ta' position changes, if some new security innovation is developed, or the li#e, then some types of securities might truly be less e'pensive, on a ris#-ad8usted basis, than others. "actors that influence the decision to issue long-term bonds rather than short-term debt %aturity matching 5assets to be financed6 Information asymmetries. If managers #now that the firm has strong prospects, they will issue short-term debt and refinance later when the mar#et recogni;es their prospects.

=:

)nder 9hat c,nditi,ns 9,uld a firm e+ercise a b,nd<s call pr,visi,n@

Ans9er7 Refunding decisions involve two separate $uestions- 516 is it profitable to call an outstanding issue in the current period and replace it with a new issueJ and 536 if refunding is currently profitable, would the value of the firm be increased even more if the refunding were postponed to a later dateP If these two conditions are true, a company would e'ercise their bond/s call provision. r: #+plain h,9 firms manage the risk structure ,f their debt 9ith7 financing, and B*C securitiDati,n: B1C pr,Aect

Ans9er7 1. Pro8ect financings are arrangements used to finance mainly large capital pro8ects such as energy e'plorations, oil tan#ers, refineries, utility power plants, and so on. Ksually, one or more firms 5sponsors6 will provide the e$uity capital re$uired by the pro8ect, while the rest of the pro8ect/s capital is supplied by lenders and lessors. !he most important aspect of pro8ect financing is that the lenders and lessors do not have recourse against the sponsorsJ they must be repaid from the pro8ect/s cash flows and the e$uity cushion provided by the sponsors. 3. ,ecuriti;ation is the process whereby financial instruments that were previously thinly traded are converted to a form that creates greater li$uidity. ,ecuriti;ation also applies to the situation where specific assets are pledged as collateral for securities, and hence asset-bac#ed securities are created. ne e'ample of the former is 8un# bondsJ an e'ample of the latter is mortgage-bac#ed securities.

Mini Case: 18 & *1