54 Y Chapter 11/Raising Long-Term Financing
time it wishes to issue securities, and its makes the process of issuing new debt and equity
6. What patterns have been observed in the types of firms going public in the United States?
Why do you think that certain industries become popular with investors at different
IPO financing is cyclical. There are "hot" and "cold" markets when IPO activity peaks
and then wanes. Industries may for a time be the "hot" industry, for example, tech firms
in the late 1990s. Previously, there were clusters of IPO activity in energy,
biotechnology, and communications. Industries become popular at certain times
because of their high growth rates and high returns. High tech companies had very high
returns (but also high risk) in the late 1990s.
7. What are the principal benefits of going public? What are the key drawbacks?
The benefits of going public include: raising new capital for the company, providing
publicly traded stocks that can be used in acquiring other companies, having listed stock
that can be used to compensate and retain key employees and providing personal wealth
and liquidity for entrepreneurs. Key drawbacks include the high financial cost of an IPO
(transactions fees for doing the deal), high managerial costs (management time taken up
in managing the deal rather than the core business), external pressures to maximize stock
price once the firm has gone public, and required, continuing information disclosures.
8. Distinguish between an equity carve-out and a spin-off. How might a spin-off create
value for shareholders?
In an equity carve-out only part of the company's equity is sold. This is sometimes called
a partial IPO. The parent company maintains control of the company, typically, but gets
the benefit of new capital raised in the external markets. In a spin-off, a part of the
company becomes a new, stand-alone company. Wealth may be created because it is
easier to value a spun off company, which will have its own set of financial statements. It
may also be possible to structure management compensation contracts to more correctly
reward managing the spun off business. The spun off business may be better focused
than when it was a division of a larger company.
9. What does the term "underpricing" refer to? If the average IPO is underpriced by about
15 percent, how might an unsophisticated investor who regularly invests in IPOs earn an
average return less than 15 percent?
Underpricing refers to the fact that IPO shares typically rise on the first day of trading,
indicating that they could have been priced higher to begin with. An unsophisticated
investor who invests in IPOs is likely to earn lower than average returns. Some IPOs are
underpriced, some very underpriced and some just slightly underpriced, while others are
overpriced. Sophisticated investors with more information about the IPO will choose to
invest only in the best, most underpriced deals. If an unsophisticated investor is able to
invest in an IPO, it is probably because there is low demand for that IPO because it is
not priced favorably priced for the investor. In other words, if an average investor can
buy into the deal, it is probably a below average deal.
10. How does underpricing add to the cost of going public?
Underpricing adds to the cost of going public because the company must issue more
shares at a lower price, and ultimately raises less money with the IPO. If issues were
Chapter 11/Raising Long-Term Financing Y 55
correctly valued, the company could either raise more money or it would have less
dilution from issuing fewer shares.
11. What happens to a firm's stock price when the firm announces plans for a seasoned
equity offering? What are the long-term returns to investors following an SEO?
A firm's stock price goes down when it announces a seasoned equity offering. The
market knows that the company knows more about the firm than average investors do,
and will only issue new equity when the stock is overvalued. The issuance of new equity
sends a sell signal to investors. There is some evidence that SEOs are bad news for
shareholders over the one to five year period following the SEO negative risk-adjusted
returns have been observed in this time period.
12. Why do you think that rights offerings have largely disappeared in the United States?
Companies--and their shareholders--found that restricting share sales to existing
shareholders severely restricted the potential market for new share sales. By voluntarily
allowing public firms to make general cash offers to all investors, shareholders allowed
companies to sell equity capital at a much higher price than would be possible if these
were restricted to existing investors only.
13. What is a qualified institutional buyer? How does this differ from an accredited investor?
An accredited investor is one who meets certain income and wealth requirements.
Accredited investors presumably don't need the protection afforded by the registration
process. Qualified institutional buyers are institutions with assets greater than $100
14. What are the relative advantages and disadvantages of private placements compared to
those of public offerings of stock and bond issues?
Private placements are less costly in terms of time and money than registering with the
SEC. Issuers do not have to reveal confidential information. Since there are fewer
investors, terms may be easier to negotiate. The disadvantages are that the issues don't
have a readily available market price, are illiquid and there is a smaller group of
potential investors than in the public market.
15. In what ways are non-U.S. (private-sector) initial public offerings similar to U.S. IPOs,
and in what ways are they different?
Less IPO money is raised in non-U.S. countries, and international IPOs are generally
smaller than U.S. company IPOs. Like U.S. IPOs, there is often significant first day
underpricing, sometimes even larger than U.S. IPO underpricing. U.S. and international
IPO companies also earn below average returns in the period following the IPO.
Popular non-U.S. IPOs are also oversubscribed, with allocation rules mandated by
national law or exchange regulations. Hot issue markets occur internationally as well as
in the U.S. Taxation issues, in particular capital gains tax issues, significantly impact
how issues are priced. Many international governments impose rules on firms going
public, such as requiring them to allocate minimum fractions of the issue to their
employees or other targeted groups.
16. What are American Depositary Receipts (ADRs), and how are these created? Why do you
think ADRs have proven so popular with U.S. investors?
56 Y Chapter 11/Raising Long-Term Financing
American Depository Receipts are dollar denominated claims issued by U.S. banks which
represent ownership of shares in a foreign company's stock held on deposit by the U.S.
bank in the issuing firm's home country. U.S. banks create them. They are popular
because they allow U.S. investors to easily diversify internationally. ADRs allow U.S.
investors to eliminate foreign exchange risk, which would exist without the creation of
ADRs. The shares are covered by U.S. securities laws and pay dividends in dollars.
17. In what key ways do share issue privatizations (SIPs) differ from private-sector share
offerings? Why do you think governments deliberately underprice SIPs?
In a share issue privatization a government sells all or part of its ownership in a state-
owned enterprise to private investors via a public share offering. These have done a
great deal to develop many national stock markets. SIPs tend to be very large and often
dramatically increase the national market's volume and liquidity. SIPs are almost
always secondary offerings the proceeds go to the government rather than the firm
being privatized. Governments underprice SIPs to create excess demand. The issuing
government then allocates shares to ensure maximum political benefit. Governments
typically favor employees and small domestic investors, with domestic institutions and
foreign investors allocated fewer shares than desired.
Answers to Self-Test Problems
ST11-1. Last year Guaraldi Instruments Inc. conducted an IPO, issuing 2 million common shares
with a par value of $0.25 to investors at a price of $15 per share. During its first year of
operation, Guaraldi earned net income of $0.07 per share and paid a dividend of $0.005
per share. At the end of the year, the company's stock was selling for $20 per share.
Construct the equity account for Guaraldi at the end of its first year in business, and
calculate the firm's market capitalization.
Immediately after the IPO, during which Guaraldi Instruments sold 2 million shares with
a par value of $0.25 each at a price of $15 each, the company's equity account would
have the following entries:
Common stock, at par value ($0.25 x 2 million) $500,000
Paid-in capital surplus (($15.00 $0.25) x 2 million) 29,500,000
Retained earnings 0
Total stockholders' equity $30,000,000
After the first year's net income (after dividend payments) are credited to Guaraldi's
balance sheet, the equity accounts will have the following entries:
Common stock, at par value ($0.25 x 2 million) $500,000
Paid-in capital surplus (($15.00 $0.25) x 2 million) 29,500,000
Retained earnings (($0.07 $0.005) x 2 million) 130,000
Total stockholders' equity $30,130,000
Guaraldi's market capitalization at the end of the first year would be $40 million
($20/share x 2 million shares).
ST11-2. The Bloomington Company needs to raise $20 million of new equity capital. Its common
stock is currently selling for $42 per share. The investment bankers require an
underwriting spread of 7 percent of the offering price, and the company's legal,
Chapter 11/Raising Long-Term Financing Y 57
accounting, and printing expenses associated with the seasoned offering are estimated to
be $450,000. How many new shares must the company sell to net $20 million?
The Bloomington Company needs to raise $20,000,000 + $450,000 = $20,450,000
7% x 42 = $2.94
The shares will net $39.06 a share
20,450,000/39.06 = 523,554 shares
ST11-3. Assume that Zurich Semiconductor Company (ZSC) wishes to create a sponsored ADR
program worth $75 million to trade its shares on the NASDAQ stock market. Assume
that ZSC is currently selling on the SWX Swiss Exchange for SF25.00 per share, and the
current dollar/Swiss franc exchange rate is $0.8000/SF. American Bank and Trust (ABT)
is handling the ADR issue for ZSC and has advised the company that the ideal trading
price for high-technology shares on the NASDAQ is about $60 per share (or per ADR).
a. Describe the precise steps ABT must take to create an ADR issue meeting ZSC's
b. Assume that ZSC's stock price declines from SF25.00 to SF22.50 per share. If the
exchange rate does not also change, what will happen to ZSC's ADR price?
c. If the Swiss franc depreciates from $0.8000/SF to $0.7500/SF, but the price of ZSC's
shares remains unchanged in Swiss francs, how will ZSC's ADR price change?
a. ZSC wants to start an ADR program equivalent to about $75 million.
Current ZSC stock price = SF25.00
Exchange rate: $0.8000/SF
Current ZSC stock price in dollars = SF25.00 x $0.8000 = $20.00/share.
Since the preferred ADR price is about $60/share, bundle three ZSC shares into each
ADR price in dollars = 3 x $20/share = $60
To raise roughly $75 million, PSC must sell about 1,250,000 ADRs at $60 each.
To begin ADR creation process, ABT would purchase 3,750,000 shares of ZSC (1.25
ADR x shs/ADR).
Step 1: Purchase 3,750,000 ZSC shares = 3,750,000 x SF25.00/share =
Step 2: Package stock into 1,250,000 ADRS and sell to US buyers for $60/ADR,
raising 1,250,000 ADRs x $60/ADR = $75,000,000.
Step 3: Convert dollar proceeds from selling ADRs into Swiss francs to cover cost of
purchasing stock $75,000,000 $0.8000/ SF = SF93,750,000; this covers ABT's
b. If ZSC's stock price declines to SF25.00/share from SF22.50/share, what happens to
ADR $ price?
New ADR price in dollars: SF22.50/share x 3 shares/ADR x $0.8000/SF = $54/
c. If ZSC stock price remains unchanged, but SF depreciates, what happens to ADR $
New ADR price in dollars: SF25.00/share x 3 shares/ADR x $0.7500/SF = $56.25/
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