Solutions Manual

11. Competitive offer and negotiated offer are two methods to select investment bankers for
underwriting. Under the competitive offers, the issuing firm can award its securities to the
underwriter with the highest bid, which in turn implies the lowest cost. On the other hand, in
negotiated deals, the underwriter gains much information about the issuing firm through negotiation,
which helps increase the possibility of a successful offering.

12. There are two possible reasons for stock price drops on the announcement of a new equity issue: 1)
Management may attempt to issue new shares of stock when the stock is over-valued, that is, the
intrinsic value is lower than the market price. The price drop is the result of the downward
adjustment of the overvaluation. 2) When there is an increase in the possibility of financial distress, a
firm is more likely to raise capital through equity than debt. The market price drops because the
market interprets the equity issue announcement as bad news.

13. If the interest of management is to increase the wealth of the current shareholders, a rights offering
may be preferable because issuing costs as a percentage of capital raised are lower for rights
offerings. Management does not have to worry about underpricing because shareholders get the
rights, which are worth something. Rights offerings also prevent existing shareholders from losing
proportionate ownership control. Finally, whether the shareholders exercise or sell their rights, they
are the only beneficiaries.

14. Reasons for shelf registration include: 1) Flexibility in raising money only when necessary without
incurring additional issuance costs. 2) As Bhagat, Marr and Thompson showed, shelf registration is
less costly than conventional underwritten issues. 3) Issuance of securities is greatly simplified.

15. Basic empirical regularities in IPOs include: 1) underpricing of the offer price, 2) best-efforts
offerings are generally used for small IPOs and firm-commitment offerings are generally used for
large IPOs, 3) the underwriter price stabilization of the aftermarket and, 4) that issuing costs are
higher in negotiated deals than in competitive ones.

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.

Basic

1. a. The new market value will be the current shares outstanding times the stock price plus the
rights offered times the rights price, so:

New market value = 550,000($87) + 85,000($81) = $54,735,000

b. The number of rights associated with the old shares is the number of shares outstanding divided
by the rights offered, so:

Number of rights needed = 550,000 old shares/85,000 new shares = 6.47 rights per new share

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Solutions Manual

c. The new price of the stock will be the new market value of the company divided by the total
number of shares outstanding after the rights offer, which will be:

PX = $54,735,000/(550,000 + 85,000) = $86.20

d. The value of the right

Value of a right = $87.00 – 86.20 = $.80

e. A rights offering usually costs less, it protects the proportionate interests of existing share-
holders and also protects against underpricing.

2. a. The maximum subscription price is the current stock price, or $27. The minimum price is
anything greater than $0.

b. The number of new shares will be the amount raised divided by the subscription price, so:

Number of new shares = $28,000,000/$25 = 1,120,000 shares

And the number of rights needed to buy one share will be the current shares outstanding
divided by the number of new shares offered, so:

Number of rights needed = 2,900,000 shares outstanding/1,120,000 new shares = 2.59

c. A shareholder can buy 2.59 rights on shares for:

2.59($27) = $69.91

The shareholder can exercise these rights for $25, at a total cost of:

$69.91 + 25 = $94.91

The investor will then have:

Ex-rights shares = 1 + 2.59

The ex-rights price per share is:

PX = [2.59($27) + $25]/3.595 = $26.44

So, the value of a right is:

Value of a right = $27 –26.44 = $.56

d. Before the offer, a shareholder will have the shares owned at the current market price, or:

Portfolio value = (1,000 shares)($27) = $27,000

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Solutions Manual

After the rights offer, the share price will fall, but the shareholder will also hold the rights, so:

Portfolio value = (1,000 shares)($26.44) + (1,000 rights)($.56) = $27,000

3. Using the equation we derived in Problem 2, part c to calculate the price of the stock ex-rights, we
can find the number of shares a shareholder will have ex-rights, which is:

PX = $63.18 = [N($65) + $50]/(N + 1)

The number of new shares is the amount raised divided by the per-share subscription price, so:

Number of new shares = $15,000,000/$50 = 300,000

And the number of old shares is the number of new shares times the number of shares ex-rights, so:

Number of old shares = 7.242(300,000) = 2,172,527

4. If you receive 1,000 shares of each, the profit is:

Profit = 1,000($9) – 1,000($4) = $5,000

Since you will only receive one-half of the shares of the oversubscribed issue, your profit will be:

Expected profit = 500($9) – 1,000($4) = $500

This is an example of the winner’s curse.

5. Using X to stand for the required sale proceeds, the equation to calculate the total sale proceeds,
including flotation costs is:

X(1 – .07) = $45,000,000

So the number of shares offered is the total amount raised divided by the offer price, which is:

Number of shares offered = $48,387,097/$31 = 1,560,874

6. This is basically the same as the previous problem, except we need to include the $1,900,000 of
expenses in the amount the company needs to raise, so:

X(1 – .07) = $46,900,000

Number of shares offered = $50,430,108/$31 = 1,626,778

7. We need to calculate the net amount raised and the costs associated with the offer. The net amount
raised is the number of shares offered times the price received by the company, minus the costs
associated with the offer, so:

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Solutions Manual

Net amount raised = (7,000,000 shares)($26.04) – 1,850,000 – 370,000 = $180,060,000

The company received $180,060,000 from the stock offering. Now we can calculate the direct costs.
Part of the direct costs are given in the problem, but the company also had to pay the underwriters.
The stock was offered at $28 per share, and the company received $26.04 per share. The difference,
which is the underwriters spread, is also a direct cost. The total direct costs were:

Total direct costs = $1,850,000 + ($28 – 26.04)(7,000,000 shares) = $15,570,000

We are given part of the indirect costs in the problem. Another indirect cost is the immediate price
appreciation. The total indirect costs were:

Total indirect costs = $370,000 + ($32.30 – 28)(7,000,000 shares) = $30,470,000

This makes the total costs:

Total costs = $15,570,000 + 30,470,000 = $46,040,000

The flotation costs as a percentage of the amount raised is the total cost divided by the amount raised,
so:

Flotation cost percentage = $46,040,000/$180,060,000 = .2557, or 25.57%

8. The number of rights needed per new share is:

Number of rights needed = 135,000 old shares/30,000 new shares = 4.5 rights per new share.

Using PRO as the rights-on price, and PS as the subscription price, we can express the price per share
of the stock ex-rights as:

PX = [NPRO + PS]/(N + 1)

a. PX = [4.5($75) + $75]/5.5 = $75.00; No change

b. PX = [4.5($75) + $70]/5.5 = $74.09; Price drops by $.91 per share

c. PX = [4.5($75) + $65]/5.5 = $73.18; Price drops by $1.82 per share

9. In general, the new price per share after the offering will be:

Current market value  Proceeds from offer

The current market value of the company is the number of shares outstanding times the share price,
or:

Market value of company = 50,000($40)

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.