Deck 20: Initial Public Offerings, Investment Banking, and Financial Restructuring

Question 1

Europa Corporation is financing an ongoing construction project. The firm will need $5,000,000 of new capital during each of the next 3 years. The firm has a choice of issuing new debt or equity each year as the funds are needed, or issue only debt now and equity later. Its target capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years, when the project has been completed. Debt flotation costs for a single debt issue would be 1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be 3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising all of the debt now, in a single issue, rather than in 3 separate issues?

A) $79,425
B) $83,606
C) $88,006
D) $92,406
E) $97,027

Answer 1

C

Question 2

If its managers make a tender offer and buy all shares that were not held by the management team, this is called a private placement.

Answer 2

False

Question 3

Which of the following statements is most CORRECT?

A) In a private placement, securities are sold to private (individual) investors rather than to institutions.
B) Private placements occur most frequently with stocks, but bonds can also be sold in a private placement.
C) Private placements are convenient for issuers, but the convenience is offset by higher flotation costs.
D) The SEC requires that all private placements be handled by a registered investment banker.
E) Private placements can generally bring in funds faster than is the case with public offerings.

Answer 3

E

Question 4

The cost of meeting SEC and possibly additional state reporting requirements regarding disclosure of financial information, the danger of losing control, and the possibility of an inactive market and an attendant low stock price are potential disadvantages of going public.

Question 5

Thompson Enterprises has $5,000,000 of bonds outstanding. Each bond has a maturity value of $1,000, an annual coupon of 12.0%, and 15 years left to maturity. The bonds can be called at any time with a premium of $50 per bond. If the bonds are called, the company must pay flotation costs of $10 per new refunding bond. Ignore tax considerations--assume that the firm's tax rate is zero.
The company's decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds. What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds?

A) 9.57%
B) 10.07%
C) 10.60%
D) 11.16%
E) 11.72%

Question 6

Whereas commercial banks take deposits from some customers and make loans to other customers, the principal activities of investment banks are (1) to help firms issue new stock and bonds and (2) to give firms advice with regard to mergers and other financial matters. However, financial corporations often own and operate subsidiaries that operate as commercial banks and others that are investment banks. This was not true some years ago, when the two types of banks were required by law to be completely independent of one another.

Question 7

If the firm uses the after-tax cost of new debt as the discount rate when analyzing a refunding decision, and if the NPV of refunding is positive, then the value of the firm will be maximized if it immediately calls the outstanding debt and replaces it with an issue that has a lower coupon rate.

A) ?$53.40 million
B) $61.96 million
C) $64.64 million
D) $76.96 million

Question 8

Which of the following is generally NOT true and an advantage of going public?

A) Facilitates stockholder diversification.
B) Increases the liquidity of the firm's stock.
C) Makes it easier to obtain new equity capital.
D) Establishes a market value for the firm.
E) Makes it easier for owner-managers to engage in profitable self- dealings.

Question 9

Suppose a company issued 30-year bonds 4 years ago, when the yield curve was inverted. Since then long-term rates (10 years or longer) have remained constant, but the yield curve has resumed its normal upward slope. Under such conditions, a bond refunding would almost certainly be profitable.

Question 10

Which of the following factors would increase the likelihood that a company would call its outstanding bonds at this time?
A) The preemptive right gives each existing common stockholder the right to purchase his or her proportionate share of a new stock issue.
A) The yield to maturity on the company's outstanding bonds increases due to a weakening of the firm's financial situation.

A) When a corporation's shares are owned by a few individuals who own most of the stock or are part of the firm's management, we say that the firm is "closely, or privately, held."
B) A provision in the bond indenture lowers the call price on specific dates, and yesterday was one of those dates.

Question 11

Tuttle Buildings Inc. has decided to go public by selling $5,000,000 of new common stock. Its investment bankers agreed to take a smaller fee now (6% of gross proceeds versus their normal 10%) in exchange for a
1-year option to purchase an additional 200,000 shares at $5.00 per share. The investment bankers expect to exercise the option and purchase the 200,000 shares in exactly one year, when the stock price is forecasted to be $6.50 per share. However, there is a chance that the stock price will actually be $12.00 per share one year from now. If the $12 price occurs, what would the present value of the entire underwriting compensation be? Assume that the investment banker's required return on such arrangements is 15%, and ignore taxes.

A) $1,235,925
B) $1,300,973
C) $1,369,446
D) $1,441,522
E) $1,517,391

Question 12

Going public establishes a market value for the firm's stock, and it also ensures that a liquid market will continue to exist for the firm's shares. This is especially true for small firms that are not widely followed by security analysts.

Question 13

(The following data apply to following Problems. The problems MUST be kept together.)
New York Waste (NYW) is considering refunding a $50,000,000, annual payment, 14% coupon, 30-year bond issue that was issued 5 years ago. It has been amortizing $3 million of flotation costs on these bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest rate of 11.67% in today's market. A call premium of 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. NYW's marginal tax rate is 40%. The new bonds would be issued when the old bonds are called.
What is the required after-tax refunding investment outlay, i.e., the cash outlay at the time of the refunding?

A) $5,049,939
B) $5,315,725
C) $5,595,500
D) $5,890,000
E) $6,200,000

Question 14

The term "equity carve-out" refers to the situation where a firm's managers give themselves the right to purchase new stock at a price far below the going market price. Since this dilutes the value of the public stockholders, it "carves out" some of their value.

Question 15

The appropriate discount rate to use when analyzing a refunding decision is the after-tax cost of new debt, in part because there is relatively little risk of not realizing the interest savings.

Question 16

Which of the following statements about listing on a stock exchange is most CORRECT?

A) Listing is a decision of more significance to a firm than going public.
B) Any firm can be listed on the NYSE as long as it pays the listing fee.
C) Listing provides a company with some "free" advertising, and it may enhance the firm's prestige and help it do more business.
D) Listing reduces the reporting requirements for firms, because listed firms file reports with the exchange rather than with the SEC.

Question 17

The term "leaving money on the table" refers to the situation where an investment banking house makes a very low bid for the right to underwrite a firm's new stock offering. The banker is, in effect, "buying the job" with the low bid and thus not getting all the money his firm would normally earn on the job.

Question 18

Which of the following statements is most CORRECT?

A) If new debt is used to refund old debt, the correct discount rate to use in the refunding analysis is the before-tax cost of new debt.
B) The key benefits associated with refunding debt are the reduction in the firm's debt ratio and the creation of more reserve borrowing capacity.
C) The mechanics of finding the NPV of a refunding decision are fairly straightforward. However, the decision of when to refund is not always clear because it requires a forecast of future interest rates.
D) If a firm with a positive NPV refunding project delays refunding and interest rates rise, the firm can still obtain the entire NPV by locking in a low coupon rate when the rates are low, even though it actually refunds the debt after rates have risen.
E) Suppose a firm is considering refunding and interest rates rise during time when the analysis is being done. The rise in rates would tend to lower the expected price of the new bonds, which would make them cheaper to the firm and thus increase the expected interest savings.

Question 19

Rainier Bros. has 12.0% semiannual coupon bonds outstanding that mature in 10 years. Each bond is now eligible to be called at a call price of
$1,060. If the bonds are called, the company must replace them with new 10-year bonds. The flotation cost of issuing new bonds is estimated to be $45 per bond. How low would the yield to maturity on the new bonds have to be in order for it to be profitable to call the bonds today, i.e., what is the nominal annual "breakeven rate"?

A) 9.29%
B) 9.78%
C) 10.29%
D) 10.81%
E) 11.35%

Question 20

When a firm refunds a debt issue, the firm's stockholders gain and its bondholders lose. This points out the risk of a call provision to bondholders and explains why a non-callable bond will typically command a higher price than an otherwise similar callable bond.

Question 21

(The following data apply to following Problems. The problems MUST be kept together.)
New York Waste (NYW) is considering refunding a $50,000,000, annual payment, 14% coupon, 30-year bond issue that was issued 5 years ago. It has been amortizing $3 million of flotation costs on these bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest rate of 11.67% in today's market. A call premium of 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. NYW's marginal tax rate is 40%. The new bonds would be issued when the old bonds are called.
The amortization of flotation costs reduces taxes and thus provides an annual cash flow. What will the net increase or decrease in the annual flotation cost tax savings be if refunding takes place?

A) $6,480
B) $7,200
C) $8,000
D) $8,800
E) $9,680

Question 22

(The following data apply to following Problems. The problems MUST be kept together.)
New York Waste (NYW) is considering refunding a $50,000,000, annual payment, 14% coupon, 30-year bond issue that was issued 5 years ago. It has been amortizing $3 million of flotation costs on these bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest rate of 11.67% in today's market. A call premium of 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. NYW's marginal tax rate is 40%. The new bonds would be issued when the old bonds are called.
What will the after-tax annual interest savings for NYW be if the refunding takes place?

A) $664,050
B) $699,000
C) $768,900
D) $845,790
E) $930,369