Investment Banking
15
Investment Banking
Public and Private Placement
LEARNING OBJECTIVES
| LO 15-1 | Investment bankers are intermediaries between corporations in need of funds and the investing public. They also provide important advice. |
| LO 15-2 | Investment bankers, rather than corporations, normally take the risk of successfully distributing corporate securities and for this there are costs involved. |
| LO 15-3 | Distribution of new securities may involve dilution in earnings per share. |
| LO 15-4 | Corporations turn to investment bankers when making the critical decision about whether to go public (distribute their securities in the public markets) or stay private. |
| LO 15-5 | Leveraged buyouts rely heavily on debt in the restructuring of a corporation. |
In 2014 the IPO (initial public offering) market made a comeback. Alibaba, a Chinese Internet company, set a new record with a $25 billion offering, and other companies you may recognize, like Spotify, Dropbox, and J. Crew, also had initial public offerings of their common stock. Two hundred seventy-five companies came to market in 2014, the most since 2000. They raised a total of $85 billion, with Alibaba accounting for 29 percent of that amount. Table 15-1 lists the 10 largest equity IPOs of 2014.
Table 15-1 Top equity IPOs in 2014
Source: Dealogic, www.dealogic.com .
Page 474
In 2012 Facebook was the IPO poster child and on its way to over a billion users when it went public. The issue price of $38 per share valued the company at $104 billion, the largest valuation ever for a newly listed public company. The company’s share of the proceeds was $16 billion, and the rest went to existing shareholders. Facebook’s initial public offering (IPO) was one of 94 that occurred in 2012, but this followed the worst environment in modern times for companies wishing to go public. As a worldwide financial crisis took hold in 2008, companies were forced to shelve plans for raising new capital through IPOs. By one count, only 21 companies went public in 2008. Even the revived IPO market of 2012 looks weak when compared to the hot IPO market of the 1990s. Between 1993 and 1999, on average more than 460 companies went public every year. In particular, during the late 1990s investors seemed to go wild over companies that had anything to do with the Internet. It seemed that if a company ended its name with “.com” or was connected to the Internet because of its business model, it could easily raise capital without having any cash flow or earnings. Investors were willing to pay high prices for stocks based on expectations that one day the companies would make large profits. Sometimes things worked out well.
Amazon.com , the Internet book company, became a public company in 1998, as did eBay, the Internet auction company. Actually, eBay was one of those rare Internet companies that made money, and the demand for shares of its initial public offering was 10 times greater than the shares available for sale. Goldman Sachs, its managing investment banker, priced the shares at $18 per share for the 3.5 million shares available for sale on the day of the offering. The opening price for eBay common stock was $53.50 per share. It never traded at its anticipated offering price of $18.
Amazon and eBay are examples of two winners. Amazon’s stock price soared to new highs and split (2:1) three times, so an initial investor would have multiple shares for each share purchased. When Amazon peaked out at $113 in late 1999, an original investor had earned a 7,533 percent return in less than two years. Then, as the Internet stock bubble collapsed, the price of Amazon’s stock fell by more than 95 percent to $5.50 per share in late 2001. By July 2015, Amazon’s stock traded for over $435.00. It had recovered all of the earlier decline almost four times over.
eBay was another highly successful Internet business, and because of stock splits an original investor would have 24 shares of eBay today for each original share purchased. After accounting for splits, the stock traded as high as $765 per original share ($18) by March 2000. Then the stock’s price fell by 79 percent before the end of that year. However, eBay continued to be a successful business, and its price eventually recovered to rise to new highs. Both Amazon and eBay had business strategies that worked. Although they were overpriced in 1999, their business met real market needs, and the companies continued to grow. Eventually their stock prices recovered. In contrast, many other Internet-based “new economy” companies failed or were acquired at low prices by other firms.
Sometimes investors think that all they have to do is buy IPOs and they will get rich. Unfortunately it doesn’t always work out that way. Many companies that went public during the Internet bubble of the late 1990s and 2000 crashed and burned, losing investors their total investment. So while we marvel at the success of companies like Alibaba, we never seem to hear about the failures of 2014 such as MOL Global, Sysorex Global Holdings, Viggle, or Eclipse Resources, companies that all lost close to 80 percent of their issue price within 12 months of their public offerings. So did the investment banker misprice these issues, or did their projections turn out to be wrong? What does an investment banker actually do for a company in an initial public offering? Keep reading.
The Role of Investment Banking
Page 475
The investment banker is the link between the corporation in need of funds and the investor. As a middleman, the investment banker is responsible for designing a security offering and selling the securities to the public. The investment banking fraternity has long been thought of as an elite group—with appropriate memberships in the country club, the yacht club, and other such venerable institutions. However, several changes have occurred in the investment banking industry over the last decade.
Investment Banking Competition Competition has become the new way of doing business, in which the fittest survive and prosper, while others drop out of the game. Raising capital has become an international proposition, and firms need to be very large to compete. This concentration of capital allows large firms to take additional risks and satisfy the needs of an increasingly hungry capital market. There have been international consolidations under way for some time, with foreign banks buying U.S. firms and U.S. banks buying foreign firms. The high level of global concentration is shown in Table 15-2 with the top 10 global investment bankers listed by revenue generated. The top 10 investment bankers accounted for 51.9 percent of the total revenue generated.
Table 15-2 Global ranking of investment bankers, 2014
Source: Dealogic, www.dealogic.com .
Enumeration of Functions
As a middleman in the distribution of securities, the investment banker has a number of key roles. These functions are described next.
Underwriter In most cases, the investment banker is a risk taker. The investment banker will contract to buy securities from the corporation and resell them to other security dealers and the public. By giving a “firm commitment” to purchase the securities from the corporation, the investment banker is said to underwrite any risks that might be associated with a new issue. While the risk may be fairly low in handling a bond offering for ExxonMobil or General Electric in a stable market, such may not be the case in selling the shares of a lesser-known firm in a volatile market environment.
Page 476
Though most large, well-established investment bankers would not consider managing a public offering without assuming the risk of distribution, smaller investment houses may handle distributions for relatively unknown corporations on a “best-efforts,” or commission, basis. Some issuing companies even choose to sell their own securities directly. Both the “best-efforts” and “direct” methods account for a relatively small portion of total offerings.
Market Maker During distribution and for a limited time afterward, the investment banker may make a market in a given security—that is, engage in the buying and selling of the security to ensure a liquid market. The investment banker may also provide research on the firm to encourage active investor interest.
Advisor The investment banker may advise clients on a continuing basis about the types of securities to be sold, the number of shares or units for distribution, and the timing of the sale. A company considering a stock issuance to the public may be persuaded, in counsel with an investment banker, to borrow the funds from an insurance company or, if stock is to be sold, to wait for two more quarters of earnings before going to the market. The investment banker also provides important advisory services in the area of mergers and acquisitions, leveraged buyouts, and corporate restructuring.
Agency Functions The investment banker may act as an agent for a corporation that wishes to place its securities privately with an insurance company, a pension fund, or a wealthy individual. In this instance, the investment banker will shop around among potential investors and negotiate the best possible deal for the corporation.
Page 477
Table 15-3 illustrates the revenue generated for each product serviced by investment bankers. So we can see that the revenues generated by the equity markets, the debt markets, and the merger and acquisition markets for 2014 were all in the $21 billion range and that syndicated lending accounted for more than $17 billion. Each category has a subheading with the respective amounts listed. We can see that follow-on offerings in the secondary equity markets generated more revenue than equity IPOs. Under the debt heading, investment-grade bonds generated more revenue than high-yield bonds, but notice that high-yield bonds (junk bonds) are quite a significant slice of the debt pie. Investment bankers love to advise on mergers and acquisitions because they are profitable and don’t entail as much risk as initial public offerings. An interesting fact is that even though the investment banking markets are global, three U.S. firms dominate the revenue generated, with Morgan Stanley leading in three categories, Goldman Sachs in one, and JPMorgan in six.
Table 15-3 Top IB earners by product, 2014
Dealogic Revenue analytics are employed where fees are not disclosed.
Source: Dealogic, www.dealogic.com .
The Distribution Process
The actual distribution process requires the active participation of a number of parties. The principal or managing investment banker, often referred to as the bookrunner, will call on other investment banking houses to share the burden of risk and to aid in the distribution. To this end, they will form an underwriting syndicate comprising as few as 2 or as many as 100 investment banking houses. In Figure 15-1 we see a typical case in which a hypothetical firm, the Maxwell Corporation, wishes to issue 250,000 additional shares of stock with Bank of America Merrill Lynch as the managing underwriter and an underwriting syndicate of 15 firms.
Figure 15-1 Distribution process in investment banking
Page 478
The underwriting syndicate will purchase shares from the Maxwell Corporation and distribute them through the channels of distribution. Syndicate members will act as wholesalers in distributing the shares to brokers and dealers who will eventually sell the shares to the public. Large investment banking houses may be vertically integrated, acting as underwriter-dealer-brokers and capturing all fees and commissions.
The Spread The underwriting spread represents the total compensation for those who participate in the distribution process. If the public or retail price is $21.50 and the managing investment banker pays a price of $20.00 to the issuing company, we say there is a total spread of $1.50. The $1.50 may be divided among the participants, as indicated in Figure 15-2 .
Figure 15-2 Allocation of underwriting spread
Note that the lower a party falls in the distribution process, the higher the price for shares. The managing investment banker pays $20, while dealers pay $20.75. Also, the farther down the line the securities are resold, the higher is the potential profit. If the managing investment banker resells to dealers, he makes 75 cents per share; if he resells to the public, he makes $1.50.
The total spread of $1.50 in the present case represents approximately 7 percent of the offering price ($1.50/$21.50). Generally, the larger the dollar value of an issue, the smaller the spread is as a percentage of the offering price. Percentage figures on underwriting spreads for U.S. corporations are presented in Table 15-4 . This table illustrates that the smaller the issue, the higher the fees percentagewise, and also that equity capital is more expensive than debt capital. The higher equity spreads reflect the fact that there is more uncertainty with common stock than for other types of capital.
Since the Maxwell Corporation stock issue is for $5.375 million (250,000 shares × $21.50), the 7 percent spread is in line with SEC figures in Table 15-4 . It should be noted that the issuer bears not only the “give-up” expense of the spread in the underwriting process but also out-of-pocket costs related to legal and accounting fees, printing expenses, exchange listing fees, and so forth. As indicated in Table 15-5 , when the spread plus the out-of-pocket costs are considered, the total cost of a small issue is high but decreases as the issue size increases. Of course substantial benefits may still be received.
Page 479
Table 15-4 Underwriting compensation as a percentage of proceeds
| Spread | ||
| Size of Issue ($ millions) | Common Stock | Debt |
| Under 0.5 | 11.3% | 7.4% |
| 0.5–0.9 | 9.7 | 7.2 |
| 1.0–1.9 | 8.6 | 7.0 |
| 2.0–4.9 | 7.4 | 4.2 |
| 5.0–9.9 | 6.7 | 1.5 |
| 10.0–19.9 | 6.2 | 1.0 |
| 20.0–49.9 | 4.9 | 1.0 |
| 50.0 and over | 2.3 | 0.8 |
Source: Securities and Exchange Commission data.
Table 15-5 Total costs to issue stock (percentage of total proceeds)
*Out-of-pocket cost of debts is approximately the same.
Source: Securities and Exchange Commission data.
Pricing the Security
Because the syndicate members purchase the stock for redistribution in the marketing channels, they must be careful about the pricing of the stock. When a stock is sold to the public for the first time (i.e., the firm is going public), the managing investment banker will do an in-depth analysis of the company to determine its value. The study will include an analysis of the firm’s industry, financial characteristics, and anticipated earnings and dividend-paying capability. Based on valuation techniques that the underwriter deems to be appropriate, a price will be tentatively assigned and will be compared to that enjoyed by similar firms in a given industry. If the industry’s average price-earnings ratio is 20, the firm is likely to be priced near this norm. Anticipated public demand will also be a major factor in pricing a new issue.
Page 480
Finance in ACTION Managerial Warren Buffett’s Bailout of Goldman Sachs
At the peak of the recent financial crisis, Goldman Sachs turned to Warren Buffett’s Berkshire Hathaway Inc. to bail it out of trouble. After Bear Stearns and Lehman Brothers collapsed at the start of the global financial crisis, Goldman Sachs found itself short of capital. Fortunately, Warren Buffett stood ready with billions to invest. Warren Buffett’s Berkshire Hathaway bought $5 billion of Goldman Sachs Series G preferred stock yielding a 10 percent guaranteed annual return. Along with the preferred stock came warrants to buy an additional $5 billion of common stock, or more precisely, 43.5 million shares of Goldman Sachs at $115 per share.
Before Buffett closed the deal on September 23, 2008, Goldman Sachs (ticker symbol GS) traded for $113. After the announcement the stock rose to $129.95 and closed on the day at $125.05. Just by investing $5 billion, the value of Buffett’s warrants rose by $10 per share, or $435 million. Buffett’s investment didn’t end Goldman’s troubles completely. Over the next two months, financial markets kept getting worse, and Goldman Sachs stock fell as low as $54.54 per share. As the financial crisis bottomed out and the government stabilized the markets, bank and investment bank stock prices increased. The Goldman Sachs stock price hit a high of $193.60 towards the end of 2009, and by June of 2013, it traded at $165 per share.
Berkshire Hathaway had until October 1, 2013, to purchase the 43.5 million shares. By March of 2013, it was clear to Goldman Sachs that the company didn’t need another $5 billion from Buffett through the exercise of the 43.5 million shares of stock, so instead they agreed to a swap. Goldman would subtract the $115 strike price from the average market price 10 days prior to October 1 and give Buffett the value in shares. This was advantageous for Buffett because he didn’t have to come up with $5 billion in cash, and instead he received 13.06 million shares or 2.8 percent ownership in Goldman Sachs. As of July 2015 those shares were worth approximately $2.7 billion, not a bad return on top of a 10 percent annual dividend payment of $500 million over five years.
The great majority of the issues handled by investment bankers are, however, additional issues of stocks or bonds for companies already trading publicly. When additional shares are to be issued, the investment bankers will generally set the price at slightly below the current market value. This process, known as underpricing, will help ensure a receptive market for the securities.
At times, an investment banker also will underwrite the sale of large blocks of stock for existing stockholders, rather than for the company. When holders of these blocks wish to sell too many shares for normal channels to handle, the investment banker will manage the sale and underprice the stock below current market prices. This process is known as a secondary offering. Secondary offerings occur after an IPO, also known as a primary offering, in which securities are sold to the public for the first time. Secondary offerings often combine shareholder blocks with additional shares being issued directly by the company. Table 15-3 refers to secondary offerings in the category “Follow-on.”
A secondary offering can also occur without shareholder blocks being included. Three of the largest equity offerings ever were secondary offerings that occurred in December 2009. Several banking giants (Citigroup, Bank of America, and Wells Fargo) raised over $52 billion in new capital to pay back the U.S. government for bailout funding received the previous year. These banks wished to avoid restrictions on their activities that the government had imposed until repayments were made.
Page 481
Debt versus Equity Offerings
Students are often surprised that debt offerings outnumber equity offerings in number and dollar amounts. Perhaps it is because we are bombarded with daily Dow Jones updates in the financial press that stock seems to take preference over bonds. Table 15-6 however shows that for 2014 and 2013, debt offerings were more than three times equity offerings. In 2014 $6.325 trillion of debt was issued globally while $935 billion of equity was issued. There were 20,728 debt offerings and 5,464 equity offerings. But referring back to Table 15-3 , you can see that investment banking revenue from debt and equity was almost equal, which magnifies the point that equity is more profitable to the investment banker because there is more risk involved in an equity IPO than in a debt IPO.
Table 15-6 Global debt and equity capital markets bookrunner rankings
Source: Dealogic, www.dealogic.com .
Dilution
A problem a company faces when issuing additional securities is the actual or perceived dilution of earnings effect on shares currently outstanding. In the case of the Maxwell Corporation, the 250,000 new shares may represent a 10 percent increment to shares currently in existence. Perhaps the firm had earnings of $5 million on 2,500,000 shares before the offering, indicating earnings per share of $2. With 250,000 new shares to be issued, earnings per share will temporarily slip to $1.82 ($5,000,000 ÷ 2,750,000).
The proceeds from the sale of new shares may well be expected to provide the increased earnings necessary to bring earnings back to at least $2. While financial theory dictates that a new equity issue should not be undertaken if it diminishes the overall wealth of current stockholders, there may be a perceived time lag in the recovery of earnings per share as a result of the increased shares outstanding. For this reason, there may be a temporary weakness in a stock when an issue of additional shares is proposed. In most cases this is overcome with time.
Page 482
Market Stabilization
Another problem may set in when the actual public distribution begins—namely, unanticipated weakness in the stock or bond market. Since the sales group normally has made a firm commitment to purchase stock at a given price for redistribution, it is essential that the price of the stock remain relatively strong. Syndicate members, committed to purchasing the stock at $20 or better, could be in trouble if the sale price falls to $19 or $18. The managing investment banker is generally responsible for stabilizing the offering during the distribution period and may accomplish this by repurchasing securities as the market price moves below the initial public offering price.
The period of market stabilization usually lasts two or three days after the initial offering, but it may extend up to 30 days for difficult-to-distribute securities. In a very poor market environment, stabilization may be virtually impossible to achieve. Consider Facebook’s initial public offering on Friday, May 18, 2012. The initial IPO price was set at $38 by the lead underwriter, Morgan Stanley. The offering was a big news event, and many small investors rushed into the stock in the first minutes of trading. The stock was extremely volatile on the first day of trading, but the stock price never fell below the offering price because Morgan Stanley was actively buying shares when the price hit $38.
Figure 15-3 shows that the price fell to $38 during the morning when Morgan Stanley apparently intervened. The price fell back to $38 later in the day as price support activities held the price above $38 at the close.
Figure 15-3 Facebook share price on the first day of trading
Page 483
Facebook’s price quotes near the end of the first trading day show the magnitude of the price support. In Figure 15-4 , notice that there is a bid for almost 10 million shares of Facebook stock at exactly $38 per share. This is almost certainly a bid by Morgan Stanley attempting to support the price at that level. To put the size of this support into perspective, it was not unusual for the bid size to be less than 5,000 shares in later transactions.
Figure 15-4 Facebook closing quotes on May 18, 2012
On Monday, May 21, the price support was removed and the price fell to $34. By September, the price had collapsed to a low of $17.55. Investors who understood that the underwriter was only temporarily supporting the price were probably able to avoid these early losses.
Manipulation of prices in security markets is normally illegal. Market stabilization or underwriter price support is a rare exception to the general market manipulation prohibition. Temporary market stabilization is accepted by the Securities and Exchange Commission as necessary for smoothly functioning new-issue markets.
Aftermarket
The investment banker is also interested in how well the underwritten security behaves after the distribution period because the banker’s ultimate reputation rests on bringing strong securities to the market. This is particularly true of initial public offerings.
Page 484
Exhaustive research shows that initial public offerings tend to perform well in the immediate aftermarket. Between 1980 and 2012 there were more than 7,700 initial public offerings in the United States. The average first-day return for these stocks was 18 percent. In many countries, the initial aftermarket returns are even higher. In China, initial aftermarket returns have averaged more than 160 percent. Studies covering over 22,000 non-U.S. IPOs from 38 other countries show initial returns that average more than40 percent. In fact, IPOs are underpriced in every country where stocks are publicly traded.
After the issuance, initial public offerings appear to lose their luster. Over the first three years of trading, excluding the first-day price jump, IPO returns are approximately 7 percent lower than those of similar firms. The typical IPO is a good deal for investors who purchase shares from the underwriter at the offering price, but after the first day of trading most companies underperform the market for several years.
Shelf Registration
The Securities and Exchange Commission also allows a filing process called shelf registration under SEC Rule 415. Shelf registration permits large companies, such as IBM or Citigroup, to file one comprehensive registration statement that outlines the firm’s financing plans for up to the next two years. Then, when market conditions seem appropriate, the firm can issue the securities without further SEC approval. Future issues are thought to be sitting on the shelf, waiting for the appropriate time to appear.
Shelf registration is at variance with the traditional requirement that security issuers file a detailed registration statement for SEC review and approval every time they plan a sale. Whether investors are deprived of important “current” information as a result of shelf registration is difficult to judge. While shelf registration was started on an experimental basis by the SEC in 1982, it has now become a permanent part of the underwriting process. Shelf registration has been most frequently used with debt issues, with relatively less utilization in the equity markets (corporations do not wish to announce equity dilution in advance).
Shelf registration has contributed to the concentrated nature of the investment banking business, previously discussed. The strong firms are acquiring more and more business and, in some cases, are less dependent on large syndications to handle debt issues. Only investment banking firms with a big capital base and substantial expertise are in a position to benefit from this registration process.
The Gramm–Leach–Bliley Act Repeals the Glass–Steagall Act The Glass–Steagall Act, passed after the great crash of 1929 and bank runs of the early 1930s, required U.S. banks to separate their commercial banking operations and investment banking operations into two different entities. Banks like J.P. Morgan were forced to sell off Morgan Stanley. Congress took this position because they thought the risk of the securities business impaired bank capital and put the banking system at risk of default. As global financial markets grew, it became clear that U.S. commercial and investment banks were at a competitive disadvantage against large European and Japanese banks, who were not hobbled by these restrictions. Foreign banks were universal banks and could offer traditional banking services as well as insurance, securities brokerage, and investment banking.
Page 485
In 1999 the U.S. Congress passed the Gramm–Leach–Bliley Act, which repealed Depression-era laws that had separated banking, brokerage, insurance, and investment banking. Now banks may engage in all these activities. The Federal Reserve and the Treasury, however, still have the power to impose restrictions on the activities of banks. Recently the Fed and Treasury have been concerned that banks’ investments into risky venture capital companies may impair their capital. The Fed has effectively banned some banks from participating in this merchant banking activity unless they set aside reserves equal to 50 percent of their capital. This allows the strong banks to participate in the venture capital market but forces the weak ones to sit on the sidelines.
Economists (and politicians) currently argue over whether repeal of Glass–Steagall was a major cause of the banking crisis in 2008, but most agree that inadequate regulatory oversight was the main cause. The Dodd–Frank law enacted in 2010 included the Volcker Rule, named for a former Federal Reserve Chairman Paul Volcker. The rule is intended to restrict banks from making certain risky investments that the repeal of Glass–Steagall allowed. The Volcker Rule has been criticized as a watered-down version of the old Glass–Steagall restrictions.
Public versus Private Financing
Our discussion to this point has assumed the firm was distributing stocks or bonds in the public markets (as explained in Chapter 14 ). However, many companies, by choice or circumstance, prefer to remain private—restricting their financial activities to direct negotiations with bankers, insurance companies, and so forth. Let us evaluate the advantages and the disadvantages of public placement versus private financing and then explore the avenues open to a privately financed firm.
Advantages of Being Public
First of all, the corporation may tap the security markets for a greater amount of funds by selling securities to the public. With over 90 million individual stockholders in the country, combined with thousands of institutional investors, the greatest pool of funds is channeled toward publicly traded securities. Furthermore, the attendant prestige of a public security may be helpful in bank negotiations, executive recruitment, and the marketing of products. Some corporations listed on the New York Stock Exchange actually allow stockholders a discount on the purchase of their products.
Stockholders of a heretofore private corporation may also sell part of their holdings if the corporation decides to go public. A million-share offering may contain 500,000 authorized but unissued corporate shares and 500,000 existing stockholder shares. The stockholder is able to achieve a higher degree of liquidity and to diversify his or her portfolio. A publicly traded stock with an established price may also be helpful for estate planning.
Finally, going public allows the firm to play the merger game, using marketable securities for the purchase of other firms. A public company can purchase another firm using its own stock as currency, whereas a private firm might be forced to buy using cash. The high visibility of a public offering may even make the acquiring firm a potential recipient of attractive offers for its own securities. (This may not be viewed as an advantage by firms that do not wish to be acquired.)
Disadvantages of Being Public
The company must make all information available to the public through SEC and state filings. Not only is this tedious, time-consuming, and expensive, but also important corporate information on profit margins and product lines must be divulged. The CEO (chief executive officer) and the CFO (chief financial officer) must adapt to being public relations representatives to all interested members of the securities industry.
Page 486
Another disadvantage of being public is the tremendous pressure for short-term performance placed on the firm by security analysts and large institutional investors. Quarter-to-quarter earnings reports can become more important to top management than providing a long-run stewardship for the company. A capital budgeting decision calling for the selection of Alternative A—carrying a million dollars higher net present value than Alternative B—may be discarded in favor of the latter because Alternative B adds two cents more to next quarter’s earnings per share.
In a number of cases, the blessings of having a publicly quoted security may become quite the opposite. Although a security may have had an enthusiastic reception in a strong “new-issues” market, such as that of 1967–68, 1981–83, or 1998–99, a dramatic erosion in value may later occur, causing embarrassment and anxiety for stockholders and employees.
As was evidenced in Tables 15-4 and 15-5 , there can be a high cost to going public. For small firms, the underwriting spread and the out-of-pocket costs can run in the 15–18 percent range. Moreover, after going public the firm faces higher compliance costs because of various public disclosure requirements. In response to the collapse of Enron Corporation and its accounting firm, Arthur Andersen and Co., Congress passed the Sarbanes–Oxley Act of 2002 which created several costly new requirements.
Public Offerings
A Classic Example—Rosetta Stone Goes Public
A classic example of an IPO is that of Rosetta Stone Inc., which went public on April 16, 2009. The company offers self-study language software for over 30 languages. Prior to the offering, the company filed a registration statement with the SEC that included a prospectus that was distributed to potential investors. Every public offering must be preceded by a prospectus that offers details about the company and the offering. The front page of Rosetta Stone’s prospectus is shown in Figure 15-5 .
As shown in the figure, 6.25 million shares (top of page) were offered to the public at a price of $18 per share (middle of page). Underwriting commissions were $1.26 per share, exactly 7 percent of the offer price. Also, the company received only half of the remaining proceeds. The other half went to shareholders who sold part of their interest in the company. Table 15-7 on page 488 shows the out-of-pocket costs that Rosetta Stone incurred.
Members of the underwriting syndicate are shown along the bottom of Figure 15-5 . Morgan Stanley was the lead underwriter with William Blair & Company listed as a co-lead. The other members of the syndicate are listed below these underwriters. On the whole, the features shown in Figure 15-5 are all very standard for primary offerings.
The day of the offering, Rosetta Stone’s shares began trading on the NYSE at $23 and closed at $25.12, for a first-day gain of more than 39 percent ($25 – $18)/$18. This is a good example of the first-day underpricing that frequently accompanies IPOs. Over the next several months, the price of Rosetta Stone continued to climb, and the stock traded for almost $31 per share on August 10, 2009. After the stock market closed on that day, Rosetta Stone announced that it had filed another registration statement with the SEC for a secondary offering of its common stock. Most of the stock to be sold in the secondary offering would come from two shareholders who owned large stakes prior to the IPO, not from new stock issued by the company. Because very little of the stock would be newly issued, dilution would not be a problem. Nevertheless, the financial markets interpreted this news negatively. If two large insiders believed the stock should be sold at this price, then perhaps the market price was too high.
Page 487
Figure 15-5 Rosetta Stone’s prospectus
Source: The Wall Street Journal, Tuesday, December 21, 1999, C7, © 1999 Dow Jones & Co. Inc. All Rights Reserved Worldwide.
Page 488
Table 15-7 Out-of-pocket costs for Rosetta Stone IPO
| Amount Paid | |
| SEC registration fee | $ 6,819 |
| FINRA filing fee | 12,719 |
| Initial NYSE listing fee | 157,500 |
| Legal fees and expenses | 700,000 |
| Accounting fees and expenses | 2,000,000 |
| Printing expenses | 250,000 |
| Transfer agent and registrar fees and expenses | 10,000 |
| Miscellaneous expenses | 346,982 |
| Total | $3,484,020 |
Source: Rosetta Stone prospectus.
Over the next week, Rosetta Stone’s price fell to $20 per share, a 35 percent drop in one week. On August 17, the firm announced that the secondary offering was canceled. The stock price immediately stabilized, and the stock rose in value to over $22 per share by the end of the month. Figure 15-6 shows Rosetta Stone’s stock price performance and the S&P 500 Index return during all of 2009.
Figure 15-6 2009 stock returns for Rosetta Stone and S&P 500 Index
Source: Yahoo! Inc., http://finance.yahoo.com .
Page 489
This narrative offers several general observations about IPOs and secondary offerings. IPOs are typically underpriced and have high first-day returns. Consistent with Rosetta Stone’s original plan, secondary offerings frequently occur after a stock has risen significantly in value. Often the stockholders sell because they want to diversify their portfolio, but the market generally interprets secondary offerings as a sign that company managers or insiders view the stock as overvalued, and the share price declines when the offering is announced. However, Rosetta Stone’s decline was larger than most.
Private placement
Private placement refers to the selling of securities directly to insurance companies, pension funds, and wealthy individuals, rather than through the security markets. This financing device may be employed by a growing firm that wishes to avoid or defer an initial public stock offering or by a publicly traded company that wishes to incorporate private funds into its financing package. Private placements exceed 50 percent of all long-term corporate debt outstanding.
The advantages of private placement are worthy of note. First, there is no lengthy, expensive registration process with the SEC. Second, the firm has greater flexibility in negotiating with one or a handful of insurance companies, pension funds, or bankers than is possible in a public offering. Because there is no SEC registration or underwriting, the initial costs of a private placement may be considerably lower than those of a public issue. However, the interest rate on bonds is usually higher to compensate the investor for holding a less liquid obligation.
Going Private and Leveraged Buyouts
Throughout the years, there have always been some public firms going private. In the 1970s, a number of firms gave up their public listings to be private, but these were usually small firms. Management figured it could save several hundred thousand dollars a year in annual report expenses, legal and auditing fees, and security analysts meetings—a significant amount for a small company.
In the 1980s, 1990s, and mid-2000s, however, very large corporations began going private and not just to save several hundred thousand dollars. More likely they had a long-term strategy in mind.
There are basically two ways to accomplish going private. In the most frequent method, a publicly owned company is purchased by a private company or a private equity fund. Private equity funds typically are partnerships formed specifically to buy companies. An alternative avenue for going private is for a company to repurchase all publicly traded shares from stockholders. Both methods have been in vogue and are usually accomplished through the use of a leveraged buyout. In a leveraged buyout, either the management or some other investor group borrows the needed cash to repurchase all the shares of the company. After the repurchase, the company has substantial debt and heavy interest expense.
Usually management of the private company must sell assets to reduce the debt load, and a corporate restructuring occurs, wherein divisions and products are sold and assets redeployed into new, higher-return areas. As specialists in the valuation of assets, investment bankers try to determine the “breakup value” of a large company. This is its value if all its divisions were divided up and sold separately. Over the long run, these strategies can be rewarding, and these companies may again become publicly owned. For example, Beatrice Foods went private in 1986 for $6.2 billion. One year later, it sold various pieces of the company—Avis, Coke Bottling, International Playtex, and other assets worth $6 billion—and still had assets left valued at $4 billion for a public offering.
Page 490
Finance in ACTION Managerial Tulip Auctions and the Google IPO
While traditional investment banking relies on institutional relationships, there is a move afoot to do some initial public offerings on the Internet using auctions. Most individual investors (especially those with less than million-dollar accounts) find it very difficult to acquire shares in a traditional IPO. Shares are typically allocated to mutual funds, pension funds, and other institutional investors who have connections with the investment bankers. Often, these institutions are repeat customers who participate in most of an underwriter’s offerings. While this is obviously bad for small investors, firms that are going public also have concerns with the traditional distribution system. They wonder whose interest the underwriter is looking out for. Are they looking out for the issuer? Or is the banker looking out for the interests of the institutional investors who are the banker’s repeat customers?
In 1998, William Hambrecht founded WR Hambrecht & Co., which helped pioneer U.S. stock auctions. Hambrecht’s Open IPO® auctions are based on the method developed to auction Dutch tulip bulbs in the 17th century. In a “Dutch” auction, prices are determined after all prospective buyers have placed bids. Then one price is set for all buyers. That price is the highest price at which all the securities can be sold to the bidders. No investor pays more than his bid price, but many will receive securities at a price that is less than their bid. Dutch auctions are commonly used to sell U.S. Treasury securities, and about 150 auctions of Treasuries are held each year. One of the attractive features of Dutch auctions is that connections don’t matter. Mom-and-Pop investors can compete for shares alongside big institutional investors.
In August 2004, Google Inc. went public using a variation on the Dutch auction. Google’s IPO was, by far, the largest auction-based offering ever. The auction rules ensured that small investors could participate because orders as small as 5 shares were accepted. In traditional IPOs, allocations of less than 100 shares are rare, although most deals have no official minimum. Google’s IPO did not go off without a hitch. The company originally estimated a selling range between $108 and $135 per share, but the eventual issue price was only $85 per share. Noting this fact, many Wall Street bankers and professional investors declared the IPO auction a failure. Of course, there is no evidence that a traditional IPO would have yielded a higher initial selling price, and Google paid underwriting fees of only 2.8 percent, which is less than the norm. On the first day of trading, Google’s price rose in the aftermarket to $100.34, an 18 percent gain that is about average for IPOs. By January 2009, Google’s price had risen above $600 per share.
In 2005, Chicago investment research firm Morningstar Inc. chose to go public using Hambrecht’s OpenIPO system. However, traditional Wall Street underwriters strongly discouraged Morningstar from using the auction format. After all, the traditional underwriting method is extremely profitable for underwriters and institutional investors. Institutional investors clearly did not receive preferential treatment in the Morningstar IPO. Investment behemoth Fidelity Investments received no shares in the IPO. Its $17.50 bid for 2.2 million Morningstar shares was too low. The auction clearing price was set at $18.50. Morningstar paid underwriting fees of less than 2 percent of the offering proceeds, much less than would be expected in a traditional offering.
Internet-based auctions may eventually capture a significant share of the underwriting market, but that time is probably still far off.
However, not all leveraged buyouts have worked as planned. Because they are based on the heavy use of debt, any shortfall in a company’s performance after the buyout can prove disastrous.
Page 491
It should be further pointed out that the impetus to going private was once again stimulated in 2002 by the Sarbanes–Oxley Act, which greatly increased the reporting requirements and potential liability for publicly traded companies. This was especially true for smaller companies where the financial burden of reporting was a significant expense. Many of these decided to go private.
International Investment Banking Deals
Privatization
Beginning in the 1980s and continuing to date, governments around the world have privatized companies previously owned by the state. The word “privatization” can be confusing, because in the United States we refer to many companies as “publicly owned” when they are actually owned by private investors. So-called “public” companies like General Electric, Intel, and Boeing are not owned by the government. They are owned by private individuals, mutual funds, pension funds, and other investors. This has been a common practice in the United States for over 100 years. However, in many countries—especially socialist and communist countries—the auto industry, steel industry, aerospace industry, and virtually all other major industries have been owned by the state. The process of privatization involves investment bankers taking companies public, but instead of selling companies formerly owned by individuals, the companies sold had been previously owned by governments.
Although Britain privatized its state-owned steel industry in the 1950s, in many respects, the privatization of British Telecom in 1984 was the first significant effort to turn state-owned businesses into private companies. Subsequently, a wave of privatizations swept Western Europe, Latin America, and the more capitalist countries of Asia. With the collapse of the USSR, many of the former communist countries such as Poland, Hungary, and the Czech Republic began to privatize their industries with public offerings of common stock. In recent years, China and Russia have joined the push toward reducing government ownership of assets. In 2007, three of the world’s four largest public stock offerings involved the privatization of petroleum and coal companies in China and a government-owned bank in Russia.
Around the world, governments continue to own a wealth of assets. Consider the United States, a country with a tradition of private ownership. The federal and state governments still own 88 percent of Alaska’s land, over 320 million acres. Almost all of the roads in the United States are owned by state, local, and federal governments. There may be good reasons for state ownership of these assets, but as the public demands more services from the government, a huge source of potential cash could be tapped by the privatization of some of these assets. In 2006 Indiana effectively privatized the Indiana East-West Toll Road by leasing the road to a Spanish-Australian partnership, which now operates it. The road needed to be upgraded, and the Indiana government balked at spending taxpayer money on a toll road when other needs were deemed to be more pressing. In many other countries, the fraction of wealth owned by the state is much higher than in the United States. It can be expected that governments around the world will continue to privatize government businesses and assets.
SUMMARY
Page 492
The investment banker acts as an intermediary between corporations in need of funds and investors having funds, such as the investing public, pension funds, and mutual funds, to name a few. Of course the investment banker charges a fee to the corporation selling securities, and the fee is based on the size of the offering, the risk associated with the company, and whether the security is equity or debt.
The role of the investment banker is critical to the distribution of securities in the U.S. economy. The investment banker serves as an underwriter or the risk taker by purchasing securities from the issuing corporation and redistributing them to the public; he or she may continue to maintain a market in the distributed securities after they have been sold to the public. The investment banking firm can also help a company sell a new issue on a “best-efforts” basis. As corporations become larger and more global, they need larger investment banks, and this has caused consolidation in the investment banking industry. A few large investment banks that are able to take down large blocks of securities and compete in international markets now dominate the industry.
Investment bankers also serve as important advisors to corporations by providing advice on mergers, acquisitions, foreign capital markets, and leveraged buyouts, and also on resisting hostile takeover attempts. The fees earned for this advice can be substantial.
The advantages of selling securities in the public markets must be weighed against the disadvantages. While going public may give the corporation and major stockholders greater access to funds, as well as additional prestige, these advantages quickly disappear in a down market. Furthermore the corporation must open its books to the public and orient itself to the short-term emphasis of investors.
Companies may decide to go from public to private. This trend was evident in the late 1980s, 1990s, and mid-2000s with many large companies going private through leveraged buyouts. However, a number of these companies again publicly distributed their shares a year or two later, generating large profits for their owners in the process.
LIST OF TERMS
investment banker 474
underwrite 475
“best-efforts” basis 476
agent 476
managing investment banker 477
bookrunner 477
underwriting syndicate 477
underwriting spread 478
underpricing 480
dilution of earnings 481
market stabilization 482
aftermarket 483
shelf registration 484
public placement 485
private placement 489
going private 489
leveraged buyout 489
restructuring 489
privatization 491
Page 493
DISCUSSION QUESTIONS
1. In what way is an investment banker a risk taker? (LO15-2)
2. What is the purpose of market stabilization activities during the distribution process? (LO15-1)
3. Discuss how an underwriting syndicate decreases risk for each underwriter and at the same time facilitates the distribution process. (LO15-2)
4. Discuss the reason for the differences between underwriting spreads for stocks and bonds. (LO15-2)
5. What is shelf registration? How does it differ from the traditional requirements for security offerings? (LO15-1)
6. Discuss the benefits accruing to a company that is traded in the public securities markets. (LO15-4)
7. What are the disadvantages to being public? (LO15-4)
8. If a company were looking for capital by way of a private placement, where would it look for funds? (LO15-1)
9. How does a leveraged buyout work? What does the debt structure of the firm normally look like after a leveraged buyout? What might be done to reduce the debt? (LO15-5)
10. How might a leveraged buyout eventually lead to high returns for a company? (LO15-5)
11. What is privatization? (LO15-5)
PRACTICE PROBLEMS AND SOLUTIONS
Dilution effect of new issue
(LO15-3)
1. Dawson Motor Company has 6 million shares outstanding with total earnings of $12 million. The company is considering issuing 1.5 million new shares.
a. What will be the immediate dilution in earnings per share?
b. If the new shares can be sold at $25 per share and the proceeds will earn 12 percent, will there still be dilution? Based on the new EPS, should the new shares be issued?
Underwriting costs
(LO15-2)
2. Gallagher Corp. will issue 300,000 shares at a retail (public) price of $40. The company will receive $37.90 per share and incur $160,000 in out-of-pocket expenses.
a. What is the percentage spread?
b. What percentage of the total value of the issue (based on the retail price) are the out-of-pocket costs?
Solutions
1. a. Earnings per share before the stock issue:
Page 494
Earnings per share after the stock issue:
b. New income = 12% × (1.5 million shares × $25) = 12% × 37,500,000
= $4,500,000
Total income = $12,000,000 + $4,500,000 = $16,500,000
Earnings per share based on the additional income included in total income:
There is no longer dilution. Earnings per share will grow from the initial amount of $2.00 to $2.20. The new shares should be issued.
2. a.
b.
PROBLEMS
Selected problems are available with Connect. Please see the preface for more information.
Basic Problems
Dilution effect of stock issue
(LO15-3)
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?
Dilution effect of stock issue
(LO15-3)
Page 495
2. The Hamilton Corporation Company has 4 million shares of stock outstanding and will report earnings of $6,910,000 in the current year. The company is considering the issuance of 1 million additional shares that can only be issued at $30 per share.
a. Assume the Hamilton Corporation Company can earn 7.0 percent on the proceeds. Calculate the earnings per share.
b. Should the new issue be undertaken based on earnings per share?
Dilution effect of stock issue
(LO15-3)
3. American Health Systems currently has 6,400,000 shares of stock outstanding and will report earnings of $10 million in the current year. The company is considering the issuance of 1,700,000 additional shares that will net $30 per share to the corporation.
a. What is the immediate dilution potential for this new stock issue?
b. Assume that American Health Systems can earn 9 percent on the proceeds of the stock issue in time to include them in the current year’s results. Calculate earnings per share. Should the new issue be undertaken based on earnings per share?
Dilution effect of stock issue
(LO15-3)
4. Using the information in Problem 3, assume that American Health Systems’ 1,700,000 additional shares can only be issued at $18 per share.
a. Assume that American Health Systems can earn 6 percent on the proceeds. Calculate earnings per share.
b. Should the new issue be undertaken based on earnings per share?
Dilution and pricing effect of stock issue
(LO15-3)
5. Jordan Broadcasting Company is going public at $50 net per share to the company. There also are founding stockholders that are selling part of their shares at the same price. Prior to the offering, the firm had $26 million in earnings divided over 11 million shares. The public offering will be for 5 million shares; 3 million will be new corporate shares and 2 million will be shares currently owned by the founding stockholders.
a. What is the immediate dilution based on the new corporate shares that are being offered?
b. If the stock has a P/E of 30 immediately after the offering, what will the stock price be?
c. Should the founding stockholders be pleased with the $50 they received for their shares?
Underwriting spread
(LO15-2)
6. Solar Energy Corp. has $4 million in earnings with 4 million shares outstanding. Investment bankers think the stock can justify a P/E ratio of 21. Assume the underwriting spread is 5 percent. What should the price to the public be?
Underwriting spread
(LO15-2)
7. Tiger Golf Supplies has $25 million in earnings with 7 million shares outstanding. Its investment banker thinks the stock should trade at a P/E ratio of 31. Assume there is an underwriting spread of 7.8 percent. What should the price to the public be?
Underwriting spread
(LO15-2)
8. Assume Sybase Software is thinking about three different size offerings for issuance of additional shares.
Page 496
| Size of Offer | Public Price | Net to Corporation |
| a. 1.1 million | $30 | $27.50 |
| b. 7.0 million | $30 | 28.44 |
| c. 28.0 million | $30 | 29.15 |
What is the percentage underwriting spread for each size offer?
Underwriting spread
(LO15-2)
9. Walton and Company is the managing investment banker for a major new underwriting. The price of the stock to the investment banker is $23 per share. Other syndicate members may buy the stock for $24.25. The price to the selected dealers group is $24.80, with a price to brokers of $25.20. Finally, the price to the public is $29.50.
a. If Walton and Company sells its shares to the dealer group, what will the percentage return be?
b. If Walton and Company performs the dealer’s function also and sells to brokers, what will the percentage return be?
c. If Walton and Company fully integrates its operation and sells directly to the public, what will its percentage return be?
Underwriting spread
(LO15-2)
10. The Wrigley Corporation needs to raise $44 million. The investment banking firm of Tinkers, Evers & Chance will handle the transaction.
a. If stock is utilized, 2,300,000 shares will be sold to the public at $20.50 per share. The corporation will receive a net price of $19 per share. What is the percentage underwriting spread per share?
b. If bonds are utilized, slightly over 43,700 bonds will be sold to the public at $1,009 per bond. The corporation will receive a net price of $994 per bond. What is the percentage of underwriting spread per bond? (Relate the dollar spread to the public price.)
c. Which alternative has the larger percentage of spread? Is this the normal relationship between the two types of issues?
Secondary offering
(LO15-2)
11. Kevin’s Bacon Company Inc. has earnings of $9 million with 2,100,000 shares outstanding before a public distribution. Seven hundred thousand shares will be included in the sale, of which 400,000 are new corporate shares, and 300,000 are shares currently owned by Ann Fry, the founder and CEO. The 300,000 shares that Ann is selling are referred to as a secondary offering, and all proceeds will go to her.
The net price from the offering will be $16.50, and the corporate proceeds are expected to produce $1.8 million in corporate earnings.
a. What were the corporation’s earnings per share before the offering?
b. What are the corporation’s earnings per share expected to be after the offering?
Market stabilization and risk
(LO15-2)
12. Becker Brothers is the managing underwriter for a 1.45-million-share issue by Jay’s Hamburger Heaven. Becker Brothers is “handling” 10 percent of the issue. Its price is $27 per share, and the price to the public is $28.95.Page 497
Becker also provides the market stabilization function. During the issuance, the market for the stock turns soft, and Becker is forced to purchase 50,000 shares in the open market at an average price of $27.50. It later sells the shares at an average value of $27.20.
Compute Becker Brothers’ overall gain or loss from managing the issue.
Underwriting costs
(LO15-2)
13. Trump Card Co. will issue stock at a retail (public) price of $32. The company will receive $29.20 per share.
a. What is the spread on the issue in percentage terms?
b. If the firm demands receiving a new price only $2.20 below the public price suggested in part a, what will the spread be in percentage terms?
c. To hold the spread down to 2.5 percent based on the public price in part a, what net amount should Trump Card Co. receive?
Underwriting costs
(LO15-2)
14. Winston Sporting Goods is considering a public offering of common stock. Its investment banker has informed the company that the retail price will be $16.85 per share for 550,000 shares. The company will receive $15.40 per share and will incur $180,000 in registration, accounting, and printing fees.
a. What is the spread on this issue in percentage terms? What are the total expenses of the issue as a percentage of total value (at retail)?
b. If the firm wanted to net $15.99 million from this issue, how many shares must be sold?
Intermediate Problems
P/E ratio for new public issue
(LO15-2)
15. Richmond Rent-A-Car is about to go public. The investment banking firm of Tinkers, Evers & Chance is attempting to price the issue. The car rental industry generally trades at a 20 percent discount below the P/E ratio on the Standard & Poor’s 500 Stock Index. Assume that index currently has a P/E ratio of 25. The firm can be compared to the car rental industry as follows:
| Richmond | Car Rental Industry | |
| Growth rate in earnings per share | 15% | 10% |
| Consistency of performance | Increased earnings 4 out of 5 years | Increased earnings 3 out of 5 years |
| Debt to total assets | 52% | 39% |
| Turnover of product | Slightly below average | Average |
| Quality of management | High | Average |
Assume, in assessing the initial P/E ratio, the investment banker will first determine the appropriate industry P/E based on the Standard & Poor’s 500 Index. Then a half point will be added to the P/E ratio for each case in which Richmond Rent-A-Car is superior to the industry norm, and a half point will be deducted for an inferior comparison. On this basis, what should the initial P/E be for the firm?
Dividend valuation model for new public issue
(LO15-1)
Page 498
16. The investment banking firm of Einstein & Co. will use a dividend valuation model to appraise the shares of the Modern Physics Corporation. Dividends (D1) at the end of the current year will be $1.64. The growth rate (g) is 8 percent and the discount rate (Ke) is 13 percent.
a. What should be the price of the stock to the public?
b. If there is a 7 percent total underwriting spread on the stock, how much will the issuing corporation receive?
c. If the issuing corporation requires a net price of $31.30 (proceeds to the corporation) and there is a 7 percent underwriting spread, what should be the price of the stock to the public? (Round to two places to the right of the decimal point.)
Comparison of private and public debt offering
(LO15-1)
17. The Landers Corporation needs to raise $1.60 million of debt on a 20-year issue. If it places the bonds privately, the interest rate will be 10 percent. Twenty thousand dollars in out-of-pocket costs will be incurred. For a public issue, the interest rate will be 9 percent, and the underwriting spread will be 2 percent. There will be $120,000 in out-of-pocket costs. Assume interest on the debt is paid semiannually, and the debt will be outstanding for the full 20-year period, at which time it will be repaid.
For each plan, compare the net amount of funds initially available—inflow—to the present value of future payments of interest and principal to determine net present value. Assume the stated discount rate is 12 percent annually. Use 6 percent semiannually throughout the analysis. (Disregard taxes.)
Advanced Problems
Features associated with a stock distribution
(LO15-3)
18. Midland Corporation has a net income of $19 million and 4 million shares outstanding. Its common stock is currently selling for $48 per share. Midland plans to sell common stock to set up a major new production facility with a net cost of $21,120,000. The production facility will not produce a profit for one year, and then it is expected to earn a 13 percent return on the investment. Stanley Morgan and Co., an investment banking firm, plans to sell the issue to the public for $44 per share with a spread of 4 percent.
a. How many shares of stock must be sold to net $21,120,000? (Note: No out-of-pocket costs must be considered in this problem.)
b. Why is the investment banker selling the stock at less than its current market price?
c. What are the earnings per share (EPS) and the price-earnings ratio before the issue (based on a stock price of $48)? What will be the price per share immediately after the sale of stock if the P/E stays constant?
d. Compute the EPS and the price (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?
Dilution and rates of return
(LO15-3)
Page 499
19. The Presley Corporation is about to go public. It currently has aftertax earnings of $7,200,000, and 2,100,000 shares are owned by the present stockholders (the Presley family). The new public issue will represent 800,000 new shares. The new shares will be priced to the public at $25 per share, with a 5 percent spread on the offering price. There will also be $260,000 in out-of-pocket costs to the corporation.
a. Compute the net proceeds to the Presley Corporation.
b. Compute the earnings per share immediately before the stock issue.
c. Compute the earnings per share immediately after the stock issue.
d. Determine what rate of return must be earned on the net proceeds to the corporation so there will not be a dilution in earnings per share during the year of going public.
e. Determine what rate of return must be earned on the proceeds to the corporation so there will be a 5 percent increase in earnings per share during the year of going public.
Dilution and rates of return
(LO15-3)
20. Tyson Iron Works is about to go public. It currently has aftertax earnings of $4,400,000, and 4,200,000 shares are owned by the present stockholders. The new public issue will represent 500,000 new shares. The new shares will be priced to the public at $25 per share with a 3 percent spread on the offering price. There will also be $280,000 in out-of-pocket costs to the corporation.
a. Compute the net proceeds to Tyson Iron Works.
b. Compute the earnings per share immediately before the stock issue.
c. Compute the earnings per share immediately after the stock issue.
d. Determine what rate of return must be earned on the net proceeds to the corporation so there will not be a dilution in earnings per share during the year of going public.
e. Determine what rate of return must be earned on the proceeds to the corporation so there will be a 10 percent increase in earnings per share during the year of going public.
Aftermarket for new public issue
(LO15-4)
21. I. B. Michaels has a chance to participate in a new public offering by Hi-Tech Micro Computers. His broker informs him that demand for the 700,000 shares to be issued is very strong. His broker’s firm is assigned 25,000 shares in the distribution and will allow Michaels, a relatively good customer, 1.3 percent of its 25,000 share allocation.
The initial offering price is $30 per share. There is a strong aftermarket, and the stock goes to $32 one week after issue. The first full month after issue, Mr. Michaels is pleased to observe his shares are selling for $33.50. He is content to place his shares in a lockbox and eventually use their anticipated increased value to help send his son to college many years in the future. However, one year after the distribution, he looks up the shares in The Wall Street Journal and finds they are trading at $28.50.
a. Compute the total dollar profit or loss on Mr. Michaels’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 $30 price.
c. Why might a new public issue be expected to have a strong aftermarket?
Leveraged buyout
(LO15-5)
Page 500
22. The management of Mitchell Labs decided to go private in 2002 by buying in all 2.80 million of its outstanding shares at $24.80 per share. By 2006, management had restructured the company by selling off the petroleum research division for $10.75 million, the fiber technology division for $8.45 million, and the synthetic products division for $20 million. Because these divisions had been only marginally profitable, Mitchell Labs is a stronger company after the restructuring. Mitchell is now able to concentrate exclusively on contract research and will generate earnings per share of $1.10 this year. Investment bankers have contacted the firm and indicated that if it reentered the public market, the 2.80 million shares it purchased to go private could now be reissued to the public at a P/E ratio of 15 times earnings per share.
a. What was the initial cost to Mitchell Labs to go private?
b. What is the total value to the company from (1) the proceeds of the divisions that were sold, as well as (2) the current value of the 2.80 million shares (based on current earnings and an anticipated P/E of 15)?
c. What is the percentage return to the management of Mitchell Labs from the restructuring? Use answers from parts a and b to determine this value.
COMPREHENSIVE PROBLEM
Bailey Corporation
(Impact of new public offering)
(LO15-4)
The Bailey Corporation, a manufacturer of medical supplies and equipment, is planning to sell its shares to the general public for the first time. The firm’s investment banker, Robert Merrill and Company, is working with Bailey Corporation in determining a number of items. Information on the Bailey Corporation follows:
| BAILEY CORPORATION Income Statement For the Year 20X1 | |
| Sales (all on credit) | $42,680,000 |
| Cost of goods sold | 32,240,000 |
| Gross profit | $10,440,000 |
| Selling and administrative expenses | 4,558,000 |
| Operating profit | $ 5,882,000 |
| Interest expense | 600,000 |
| Net income before taxes | 5,282,000 |
| Taxes | 2,120,000 |
| Net income | $ 3,162,000 |
Page 501
| BAILEY CORPORATION Balance Sheet As of December 31, 20X1 | |
| Assets | |
| Current assets: | |
| Cash | $ 250,000 |
| Marketable securities | 130,000 |
| Accounts receivable | 6,000,000 |
| Inventory | 8,300,000 |
| Total current assets | $14,680,000 |
| Net plant and equipment | 13,970,000 |
| Total assets | $28,650,000 |
| Liabilities and Stockholders’ Equity | |
| Current liabilities: | |
| Accounts payable | $ 3,800,000 |
| Notes payable | 3,550,000 |
| Total current liabilities | $ 7,350,000 |
| Long-term liabilities | 5,620,000 |
| Total liabilities | $12,970,000 |
| Stockholders’ equity: | |
| Common stock (1,800,000 shares at $1 par) | $ 1,800,000 |
| Capital in excess of par | 6,300,000 |
| Retained earnings | 7,580,000 |
| Total stockholders’ equity | $15,680,000 |
| Total liabilities and stockholders’ equity | $28,650,000 |
a. Assume that 800,000 new corporate shares will be issued to the general public. What will earnings per share be immediately after the public offering? (Round to two places to the right of the decimal point.) Based on the price-earnings ratio of 12, what will the initial price of the stock be? Use earnings per share after the distribution in the calculation.
b. Assuming an underwriting spread of 5 percent and out-of-pocket costs of $300,000, what will net proceeds to the corporation be?
c. What return must the corporation earn on the net proceeds to equal the earnings per share before the offering? How does this compare with current return on the total assets on the balance sheet?
d. Now assume that, of the initial 800,000 share distribution, 400,000 belong to current stockholders and 400,000 are new shares, and the latter will be added to the 1,800,000 shares currently outstanding. What will earnings per share be immediately after the public offering? What will the initial market price of the stock be? Assume a price-earnings ratio of 12, and use earnings per share after the distribution in the calculation.
Page 502
e. Assuming an underwriting spread of 5 percent and out-of-pocket costs of $300,000, 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?
WEB EXERCISE
1. Initial public offerings (IPOs) were covered in the chapter. Let’s take a closer look at two actual issues. Go to www.hoovers.com/global/ipoc/index.xhtml . For the first two issues under “Latest Pricings,” do the following steps all the way through, one company at a time. Use the menu in the left margin to navigate the IPO.
2. a. Click on and write down the company name.
b. Write a short paragraph about what the company does or its products.
c. Scroll down and record the date the company went public.
d. Write down the actual offer price.
e. Write down the offering amount (mil.).
f. Record the name of the lead underwriter.
Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for.