ISSUING CAPITAL AND THE INVESTMENT BANKING PROCESS
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  • 1. Chapter 16, Solutions Cornett, Adair, and Nofsinger ISSUING CAPITAL AND THE INVESTMENT BANKING PROCESS Questions LG1 1. Describe the various sources of capital funding available to new and small firms. Most new and small firms finance their business assets by borrowing funds from private or public sources. Private capital fund suppliers fall into two basic categories: suppliers of debt financing and suppliers of equity financing. Debt financing includes capital funds borrowed from personal savings, friends or relatives, financial institutions such as commercial bank loans, or venture capitalists. Equity financing includes capital funds invested by venture capitalists. Public sources of capital include debt and equity financing provided by government agencies such as the U.S. Small Business Administration (SBA). LG1 2. What process do banks use to evaluate bank loans to small versus mid-market business firms? Low profitability has caused many banks to build small-business scoring models similar to, but more sophisticated than, those used for mortgage loans and consumer credit. Small business models often combine computer-based financial analysis of borrower financial statements with behavioral analysis of the owner of the new and/or small business. LG1 3. What is the difference between a spot loan and a loan commitment? Spot loans are loans in which the firm would receive the funds as soon as the bank approved the loan. These days, most business loans are made as firms “take down” (or borrow against) pre-negotiated lines of credit or loan commitments. Banks make loan commitment agreements--contractual commitments to loan the firm a certain maximum amount (say, $10 million)--at given interest rate terms (say, 12 percent). The loan commitment agreement also defines the length of time over which the borrower may take down this loan. LG1 4. Why do banks charge up-front fees and back-end fees on loan commitments? In return for making the loan commitment, the bank may charge an up-front fee (or facility fee) of, say 1/8th of 1 percent of the commitment size. The bank may also charge the borrower a back-end fee (or commitment fee) on any unused balances on the commitment line at the end of the period. LG1 5. What is the difference between a fixed rate and a floating rate loan? With fixed-rate loans, the firm makes fixed interest payments over the life of the loan. With variable-rate loans the loan’s interest rate (and thus the interest payments the firm must make) changes over the loan life. A floating rate is set at a fixed spread over a prevailing benchmark 1
  • 2. Chapter 16, Solutions Cornett, Adair, and Nofsinger rate, such as a Treasury-bill rate, the federal funds rate, or a prime rate. If the benchmark rate rises during the loan period, so does the firm’s loan cost. LG1 6. What types of programs does the Small Business Administration offer to new and small businesses? Under what conditions would a new or small firm use each program? For qualified new and small firms that cannot obtain long-term financing on reasonable terms from banks or other financial institutions, the SBA offers a basic loan guarantee program. Through this program, the SBA can guarantee up to $750,000 (representing 70 to 90 percent of the loan value) at an interest rate not to exceed 2.75 percent more than the prime lending rate. Maturities on these loans can extend up to 10 years for working capital loans and 25 years for fixed asset loans. While the SBA’s primary function is to guarantee loans made to new and small businesses by private financial institutions (such as banks), the SBA offers direct loan programs as well. The SBA’s Certified Development Company Loan Program provides long-term, fixed-rate capital funding to small businesses that use the funds to purchase real estate, machinery, or equipment for expansion or modernization. Private, nonprofit corporations called certified development companies offer these loans to contribute to communities’ or regions’ economic development. The SBA funds the loans via a 100 percent SBA-guaranteed debenture and a bank generally secures the loans. SBA loans require an investment of at least 10 percent owner equity. The SBA’s Microloan Loan Program provides up to $35,000 in short-term loans to small businesses to fund working capital purchases. Through this program the SBA makes or guarantees a loan to a bank, which then makes the microloan to the firm. The bank also provides the fledgling firm with management and technical assistance. LG2 7. What is venture capital? Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Venture capital is generally provided by investment institutions or private individuals willing to back an untried company and its managers in return for an equity investment in the firm. Venture capital firms do not make outright loans. Rather, they purchase equity interests in firms that give the venture capitalists the same rights and privileges associated with equity investments made by the firm’s other owners. As equityholders, venture capital firms are not generally passive investors. Rather, they provide valuable expertise to the firm’s managers and sometimes even help in recruiting senior mangers for the firm. They also generally expect to be kept fully informed about the firm’s operations, any problems, and whether all firm owners’ joint goals are being met. LG2 8. What are the different types of venture capital firms? How do institutional venture capital firms differ from angel venture capital firms? Institutional venture capital firms’ sole purpose is to find and fund the most promising new firms. Private-sector institutional venture capital firms include venture capital limited partnerships (that are established by professional venture capital firms, acting as general partners in the firm: organizing and managing the firm and eventually liquidating 2
  • 3. Chapter 16, Solutions Cornett, Adair, and Nofsinger their equity investment), financial venture capital firms (subsidiaries of banks), and corporate venture capital firms (subsidiaries of nonfinancial corporations that generally specialize in making start-up investments in high-tech firms). Limited partner venture capital firms dominate the industry. In addition to private sector institutional venture capital firms, the federal government, through the SBA, operates Small Business Investment Companies (SBICs). SBICs are privately organized venture capital firms licensed by the SBA to make equity investments (as well as loans) to entrepreneurs for start-up activities and expansions. As federally sponsored entities, SBICs rely upon their unique opportunity to obtain investment funds from the U.S. Treasury at very low rates relative to private-sector institutional venture capital firms. In contrast to institutional venture capital firms, angel venture capitalists (or angels) are wealthy individuals who make equity investments. Angel venture capitalists have invested much more in new and small firms than institutional venture capital firms have. LG2 9. What are the advantages and disadvantages to a new or small firm of getting capital funding from a venture capital firm? Venture capital firms receive many unsolicited proposals of funding from new and small firms. The venture capital firms reject the majority of these requests. Venture capital firms look for two things in making their decisions to invest in a firm. The first is a high return. Venture capital firms are willing to invest in high-risk new and small firms. However, they require high levels of returns (sometimes as high as 700 percent within five to seven years) to take on these risks. The second is an easy exit. Venture capital firms realize a profit on their investments by eventually selling their firm interests. They want a quick and easy exit opportunity when it comes time to sell. Basically, venture capital firms provide equity funds to new, unproven, and young firms. This willingness separates venture capital firms from commercial banks and investment firms, which prefer to invest in existing, financially secure businesses. LG1 10. As a new or small firm considers going public what must the owners consider? In making the decision to go from a private to a public firm, managers must consider the benefits versus the costs of doing so. As mentioned above, a major benefit of going public is that the firm will have to a new, larger pool of equity capital than is available from any previous source (bank or venture capitalist). This new equity allows a firm to undertake new and profitable investment opportunities that it could not undertake as a private firm. The market provides a market value for the firm’s common stock, which is really a readily available measure of firm performance (another advantage of going public). Such a transparent measure of firm performance can attract even more stockholders and can provide a tool that can be used to reward firm mangers (i.e., through stock or option payments as part of compensation packages). Finally, as private firms, managers generally must invest much of their personal wealth and human capital in the firm. From Chapters 9 and 10, we know that this results in a poorly diversified portfolio for the firm’s original owners. By going public, the original owners can reallocate their personal wealth away from the firm and into more diversified portfolios. 3
  • 4. Chapter 16, Solutions Cornett, Adair, and Nofsinger However, some significant costs are attached to the decision to become a public firm. First and foremost is the direct financial cost of an IPO. Cash expenses associated with an IPO (e.g., legal services, printing) can total $1 million. These expenses must be paid regardless of whether the IPO succeeds or not. Additionally, underwriters charge a discount (on average about 7 percent) to sell the stock and IPOs are typically underpriced (on average about 15 percent) to ensure a successful sale. Thus, a significant amount of the issue proceeds do not actually become available to the newly public firm. Add to these financial costs a substantial demand for time from the firm’s owners during the IPO process. That is, the firm’s owners and top managers must spend a significant amount of time with the investment bankers to discuss all aspects of the firm and with major potential stockholders before the IPO is completed. These time demands grow even more significantly as the offering date approaches. Finally, throughout the IPO process, managers must disclose firm details that may be valuable to competitors. Further, as a public firm, shareholders have the right to a great deal of information about the firm. The release of this information to stockholders also releases it to competitors. LG3 11. Describe the various sources of capital funding available to public firms. In contrast to small and new firms that can only get capital funding from mainly private sources, public firms raise the majority of their capital funds from public debt and equity markets. Public firms raise large amounts of short-term debt in the money market, primarily as commercial paper. Further, public firms raise long-term capital by issuing securities in the public debt and equity markets. LG3 12. What is the difference between a direct and an indirect placement of commercial paper? Commercial paper is sold to investors either directly (about 20 percent of all issues in 2008— see Figure 16.3), using the issuers’ own sales force (e.g., GMAC), or indirectly through brokers and dealers (about 80 percent of all issues in 2008), such as commercial banks and investment banks underwriting the issues (see below). Commercial paper underwritten and issued through brokers and dealers is more expensive to the issuer, usually increasing the cost of the issue by one-tenth to one-eighth of a percent, reflecting an underwriting cost. In return, the dealer guarantees the sale of the whole issue. LG3 13. Can a public firm with a lower than prime credit rating issue commercial paper? Commercial paper issuers with lower than prime credit ratings often back their commercial paper issues with lines of credit from commercial banks. In these cases, banks agree to make the promised payment on the commercial paper if the issuer cannot pay off the debt at maturity. Thus, a letter of credit backing commercial paper effectively substitutes the credit rating of the issuing firm with the credit rating of the bank. This reduces the paper purchasers’ risk and results in a lower interest rate (and higher credit rating) on the commercial paper. In other cases, the issuing firm arranges a line of credit with a bank (a loan commitment) and draws on this line if it has insufficient funds to repay the commercial paper issue at maturity. 4
  • 5. Chapter 16, Solutions Cornett, Adair, and Nofsinger LG4 14. How does a best efforts underwriting differ from a firm commitment underwriting? If you operated a company issuing stock for the first time, which type of underwriting would you prefer? Why might you still choose the alternative? Normally, the investment bank facilitates this transaction using a firm commitment underwriting. The investment bank guarantees the firm a price for newly issued bonds by buying the whole issue at a fixed price (the bid price) from the bond issuing firm at a discount from par. The investment bank then seeks to resell these securities to investors at a higher price (the offer price). As a result, the investment bank takes a risk that it may not be able to resell the securities to investors at a higher price. Some corporate securities are offered on a best efforts (underwriting) basis, in which the underwriter does not guarantee a firm price to the issuer (as with a firm commitment offering). Here, the underwriter acts more as a placing or distribution agent for a fee. LG4 15. How does a competitive sale of securities differ from a negotiated sale? Which type of underwriting would you prefer? Why might you still choose the alternative? The investment bank can purchase the bonds through competitive bidding against other investment bankers or by directly negotiating with the issuer. In a competitive sale, the bond issuing firm invites bids from a number of underwriters. The investment bank that submits the highest bid to the bond issuer wins the bid. The underwriter may use a syndicate of other underwriters and investment banks to distribute (sell) the issue to the public. With a negotiated sale, a single investment bank obtains the exclusive right to originate, underwrite, and distribute the new bonds through a one-on-one negotiation process. With a negotiated sale, the investment bank provides the origination and advising services to the issuers. LG4 16. How does a public offering of debt or equity securities issued by a public firm differ from a private placement? Most often, corporate bonds are offered publicly through investments banking firms as underwriters. In a public sale of stock, once the issuing firm and the investment bank have agreed on the stock issue details, the investment bank must get SEC approval in accordance with the Securities and Exchange Act of 1934. Stock registration can be a lengthy process. In a private placement, a public firm (sometimes with an investment bank’s help) seeks to find a large institutional buyer or group of buyers (usually less than 10) to purchase the whole issue. To protect smaller individual investors against a lack of disclosure, the Security and Exchange Act of 1934 requires publicly traded securities to be registered with the Securities and Exchange Commission (SEC). Private placements, on the other hand, can be unregistered and can only be resold to large, financially sophisticated investors. These large investors supposedly possess the resources and expertise to analyze a security’s risk. LG4 17. What are the net proceeds, gross proceeds and underwriter’s spread? How does each affect the funds received by a public firm when debt or equity securities are issued? 5
  • 6. Chapter 16, Solutions Cornett, Adair, and Nofsinger In a firm commitment underwriting, the investment bank purchases stock from the issuing firm for a guaranteed price (called the net proceeds) and resells them to investors at a higher price (called the gross proceeds). The difference between the gross proceeds and the net proceeds on an issue (called the underwriter’s spread) is compensation for the expenses and risks incurred by the investment bank. LG4 18. Why would an investment bank use a syndicate to assist in underwriting debt or equity securities? Once an issue is arranged and its terms set, each syndicate member is assigned a given number of shares in the issue for which it is responsible for selling. Shares of stock issued through a syndicate of investment banks spreads the risk associated with the stock sale among several investment banks. A syndicate also results in a larger pool of potential outside investors, widening the scope of the investor base and increasing the probability of a successful sale. LG4 19. What is the difference between a prospectus and a red herring prospectus? At the same time that the issuing firm and its investment bank prepare the registration statement to be filed with the SEC, they must also prepare a preliminary version of the public offering’s prospectus called the red herring prospectus. The red herring prospectus is similar to the registration statement, but is distributed to potential equity buyers. Once the SEC registers the issue, the red herring prospectus is replaced with the official or final prospectus. LG4 20. What is a shelf registration? Why would a public firm want to issue securities using a shelf registration? To reduce registration time and costs, yet still protect the public by requiring issuers to disclose information about the firm and the security to be issued, the SEC passed a rule in 1982 allowing for “shelf registration.” A shelf registration allows firms that plan to offer multiple issues of stock over a two-year period to submit one registration statement as described above (called a master registration statement). The registration statement summarizes the firm’s financing plans for the two-year period. Thus, the securities are shelved for up to two years until the firm is ready to issue them. Once the issuer and its investment bank decide to issue shares during the two-year shelf registration period, they prepare and file a short form statement with the SEC. Upon SEC approval, the shares can be priced and offered to the public usually within one or two days of deciding to take the shares “off the shelf.” Thus, shelf registration allows a firm to get stocks into the market quickly (e.g., in one or two days) if the firm feels conditions (especially the price they can get for the new stock) are right, without the time lag generally associated with full SEC registration. 6
  • 7. Chapter 16, Solutions Cornett, Adair, and Nofsinger Problems Basic 16-1 Calculating Fees on a Loan Commitment You have approached your local bank for a Problems start-up loan commitment for $250,000 needed to open a computer repair store. You have requested that the term of the loan be one-year. Your bank has offered you the following terms: size of loan commitment = $250,000, term = 1 year, up-front fee = 50 basis points, LG1 back-end fee = 75 basis points. If you take down 80 percent of the total loan commitment, calculate the total fees you have paid on this loan commitment. Up-front fee = $250,000 x 0.0050 = $1,250 Back-end fee = $250,000 x 0.0075 x 0.20 = 375 Total = $1,625 LG1 16-2 Calculating Fees on a Loan Commitment Calculate the total fees a firm would have to pay when its bank offers the firm the following loan commitment: A loan commitment of $2,500,000 with an up-front fee of 75 basis points and a back-end fee of 25 basis points. The take down on the loan is 50%. Up-front fee = $2,500,000 x 0.0075 = $18,750 Back-end fee = $2,500,000 x 0.0025 x 0.50 = 3,125 Total = $21,875 LG4 16-3 Calculating Costs of Issuing Stock Husker’s Tuxedo’s, Inc. needs to raise $250 million to finance its plan for nationwide expansion. In discussions with its investment bank, Husker’s learns that the bankers recommend an offer price (or gross price) of $35 per share and they will charge an underwriter’s spread of $1.75 per share. Calculate the net proceeds to Husker’s from the sale of stock. How many shares of stock will Husker’s need to sell in order to receive the $250 million they need? Net proceeds = Gross proceeds – Underwriter’s spread = $35 – $1.75 = $33.25 Funds needed = $250 million = $33.25 x Number of shares sold => Number of shares sold = $250 million/$33.25 = 7,518,797 shares LG4 16-4 Calculating Costs of Issuing Stock Don’s Captain Morgan, Inc. needs to raise $12.5 million to finance plant expansion. In discussions with its investment bank, Don’s learns that the bankers recommend an offer price (or gross proceeds) of $15 per share and Don’s will receive $14 per share. Calculate the underwriter’s spread on the issue. How many shares of stock will Don’s need to sell in order to receive the $250 million they need? Underwriter’s spread = Gross proceeds - Net proceeds = $15 – $14 = $1 Funds needed = $12.5 million = $14 x Number of shares sold => Number of shares sold = $12.5 million/$14 = 892,857 shares 7
  • 8. Chapter 16, Solutions Cornett, Adair, and Nofsinger LG4 16-5 Calculating Costs of Issuing Debt Kelly Girl’s Golf Games, Inc., with the help of its investment bank recently issued $43.125 million of new debt. The offer price (and face value) on the debt was $1,000 per bond and the underwriter’s spread was 7 percent of the gross proceeds. Calculate the amount of capital funding Kelly Girl’s Golf Games, Inc. raised through this debt offering. Underwriter’s fees = .07 x $43.125m = $3,018,750 => Funds received by Kelly Girl’s Golf Games = $43.125 million - $3,018,750 = $40,106,250 LG4 16-6 Calculating Costs of Issuing Debt Bailey’s Dog Pens, Inc., with the help of its investment bank recently issued $112,500,000 of new debt. The offer price on the debt was $1,000 per bond and the underwriter’s spread was 5 percent of the gross proceeds. Calculate the amount of capital funding Bailey’s Dog Pens, Inc. raised through this bond issue. Underwriter’s fees = .05 x $112,500,000 = $5,625,000 => Funds received by Bailey’s Dog Pens = $112,500,000 - $5,625,000 = $106,875,000 Intermediate 16-7 Calculating Fees on a Loan Commitment You have approached your local bank for a start-up loan Problems commitment for $250,000 needed to open a computer repair store. You have requested that the term of the loan LG1 be one-year. Your bank has offered you the following terms: size of loan commitment = $250,000, term = 1 year, up-front fee = 50 basis points, back-end fee = 75 basis points, and rate on the loan = 8%. If you immediately take down $150,000 and no more during the year, calculate the total interest and fees you have paid on this loan commitment. Up-front fees = 0.0050 x $250,000 = $ 1,250 Interest income = 0.08 x $150,000 = 12,000 Back-end fee = 0.0075 x $100,000 = 750 Total interest and fees = $14,000 LG1 16-8 Calculating Fees on a Loan Commitment Casey’s One Stop has been approved for a $75,000 loan commitment from its local bank. The bank has offered the following terms: term = 1 year, up-front fee = 85 basis points, back-end fee = 35 basis points, and rate on the loan = 7.75%. Casey’s expects to immediately take down $70,000 and no more during the year unless there is some unforeseen need. Calculate the total interest and fees Casey’s One Stop can expect to pay on this loan commitment. Up-front fees = 0.0085 x $75,000 =$ 637.50 Interest income = 0.0775 x $70,000 = 5,425.00 Back-end fee = 0.0035 x $5,000 = 17.50 Total interest and fees =$ 6,080.00 LG4 16-9 Calculating Costs of Issuing Debt Sipe’s Paint and Wallpaper, Inc. needs to raise $1 million to finance plant expansion. In discussions with its investment bank, Sipe’s learns that the bankers recommend a debt issue with a gross proceeds of $1,000 per bond and they will 8
  • 9. Chapter 16, Solutions Cornett, Adair, and Nofsinger charge an underwriter’s spread of 6.5 percent of the gross proceeds. How many bonds will Sipe’s Paint and Wallpaper need to sell in order to receive the $1 million they need? Funds received by Sipe’s = issue size – (.065 x issue size) = $1,000,000 = issue size (1 –.065) => issue size = $1,000,000/(1-.065) = $1,069,519 => number of bonds = $1,069,519/$1,000 = 1,069.519 or 1,070 LG4 16-10 Calculating Costs of Issuing Debt Renee’s Boutique, Inc. needs to raise $100 million to finance firm expansion. In discussions with its investment bank, Renee’s learns that the bankers recommend a debt issue with an offer price of $1,000 per bond and they will charge an underwriter’s spread of 5 percent of the gross price. Calculate the net proceeds to Renee’s from the sale of the debt. How many bonds will Renee’s Boutique need to sell in order to receive the $100 million they need? Funds received by Renee’s = issue size – (.05 x issue size) = $100,000,000 = issue size (1 –.05) => issue size = $100,000,000/(1-.05) = $105,263,158 => number of bonds = $105,263,158/$1,000 = 105,263.158 or 105,263 LG4 16-11 Calculating Costs of Issuing Stock Kelly Girl’s Golf Games, Inc., with the help of its investment bank recently issued 2.5 million shares of new stock. The offer price on the stock was $20.50 per share and Kelly Girl’s received a total of $48,687,500 through this stock offering. Calculate the net proceeds and the underwriter’s spread on the stock offering. What percentage of the gross price is the investment bank charging Kelly Girl for underwriting the stock issue? Net proceeds = $48,687,500/2,500,000 = $19.475 Gross funds received = $20.50 x 2,500,000 = $51,250,000 Underwriter’s funds = $51,250,000 - $48,687,500 = $2,562,500 => Underwriter’s spread = $2,562,500/2,500,000 = $1.025 Investment bank’s percentage of gross = $1.025/$20.50 = .05 or 5% LG4 16-12 Calculating Costs of Issuing Stock Bailey’s Dog Pens, Inc., with the help of its investment bank recently issued 5 million shares of new stock. The offer price on the stock was $12.50 per share and Bailey’s received a total of $57.5 million from the stock offering. Calculate the net proceeds and the underwriter’s spread charged by the underwriter to Bailey’s Dog Pens, Inc. What percentage of the gross proceeds is the investment bank charging Bailey’s Dog Pens for underwriting the stock issue? Net proceeds = $57,500,000/5,000,000 = $11.50 Gross funds received = $12.50 x 5,000,000 = $62,500,000 Underwriter’s funds = $62,500,000 - $57,500,000 = $5,000,000 => Underwriter’s spread = $5,000,000/5,000,000 = $1.000 Investment bank’s percentage of gross = $1.000/$12.50 = .08 or 8% 9
  • 10. Chapter 16, Solutions Cornett, Adair, and Nofsinger LG4 16-13 Calculating Costs of Issuing Stock Zimba Technology Corp. recently went public with an initial public offering of 2.5 million shares of stock. The underwriter used a firm commitment offering in which the net proceeds was $8.05 per share and the underwriter’s spread was 8 percent of the gross proceeds. Zimba also paid legal and other administrative costs of $250,000 for the IPO. Calculate the gross proceeds and the total funds received by Zimba from the sale of the 2.5 million shares of stock. 2,500,000 x $8.05 = $20,125,000 = Total funds received by Zimba Underwriter’s spread + Net proceeds = Gross proceeds => (.08 x Gross proceeds) + $8.05 = Gross proceeds => Gross proceeds - (.08 x Gross proceeds) = $8.05 => Gross proceeds = $8.05/(1 - .08) = $8.75 LG4 16-14 Calculating Costs of Issuing Stock Howett Pockett, Inc. plans to issue 10 million new shares of its stock. In discussions with its investment bank, Howett Pocket learns that the bankers recommend a net proceed of $19.90 per share and they will charge an underwriter’s spread of 5.5 percent of the gross proceeds. In addition, Howett Pockett must pay $2 million in legal and other administrative expenses for the seasoned stock offering. Calculate the gross proceeds and the total funds received by Howett Pockett from the sale of the 10 million shares of stock. 10,000,000 x $19.90 = $199,000,000 = Total funds received by Howett Pockett Legal and other admin expenses per share = $2,000,000/10,000,000 = $0.20 Underwriter’s spread + Net proceeds = Gross proceeds => ((.055 x Gross proceeds) + $0.20) + $19.90 = Gross proceeds => Gross proceeds - (.055 x Gross proceeds) = 19.90 + $0.20 => Gross proceeds = $20.10/(1 - .055) = $21.270 Advanced 16-15 Calculating Fees on a Loan Commitment During the last year you have had a loan Problems commitment from your bank to fund inventory purchases for your small business. The total line available was $500,000, of which you took down $400,000. It is now the end of the loan commitment period and your bank had you pay the back-end fees. You have misplaced the LG1 paperwork that listed the terms of the commitment, but you know you paid total fees (this does not include any interest paid to borrow the $400,000) of $3,250 on this loan commitment. You remember that the up-front fee was 50 basis points, calculate the back-end fee on this loan commitment. Up-front fees = 0.0050 x $500,000 = $ 2,500 Back-end fee = 3,250 – 2,500 = 750 Total fees = $ 3,250 => Back-end fee = $750/($500,000 - $400,000) = .0075 = 75 basis points LG1 16-16 Calculating Fees on a Loan Commitment During the last year you have had a loan commitment from your bank to fund working capital for your business. The total line available was $10,000,000, of which you took down $8,000,000. It is now the end of the loan 10
  • 11. Chapter 16, Solutions Cornett, Adair, and Nofsinger commitment period and your bank had you pay the back-end fees. You have misplaced the paperwork that listed the terms of the commitment, but you know you paid total fees (this does not include any interest paid to borrow the $8,000,000) of $42,650 on this loan commitment. You remember that the back-end fee was 75 basis points, calculate the front-end fee on this loan commitment. Up-front fees = $42,650 - $15,000 = $27,650 Back-end fee = 0.0075 x ($10,000,000-$8,000,000) = 15,000 Total interest and fees = $42,650 => front-end fee = $27,650/$10,000,000 = .002765 = 27.65 basis points LG4 16-17 Calculating Costs of Issuing Stock Sipe’s Paint and Wallpaper, Inc. needs to raise $1 million to finance plant expansion. In discussions with its investment bank, Sipe’s learns that the bankers recommend a gross price of $25 per share and that 45,000 shares of stock be sold. If the net proceeds on the stock sale leaves Sipe’s with $1 million, calculate the underwriter’s spread on the stock issue. $25 x 45,000 = $1,125,000 = Gross funds received from sale $1,125,000 - $1,000,000 = $125,000 = Underwriter’s funds received => Underwriter’s spread = $125,000/45,000 = $2.78 LG4 16-18 Calculating Costs of Issuing Stock Renee’s Boutique, Inc. needs to raise $99.75 million to finance firm expansion. In discussions with its investment bank, Renee’s learns that the bankers recommend an offer price of $35 per share and that 3 million shares of stock be sold. If the net proceeds on the stock sale leaves Renee’s with $99.75 million, calculate the underwriter’s spread on the stock issue. $35 x 3,000,000 = $105,000,000 = Gross funds received from sale $105,000,000 - $99,750,000 = $5,250,000 = Underwriter’s funds received => Underwriter’s spread = $5,250,000/3,000,000 = $1.75 LG4 16-19 Calculating Costs of Issuing Stock Hughes Technology Corp. recently went public with an initial public offering in which they received a total of $60 million in new capital funding. The underwriter used a firm commitment offering in which the offer price was $10 and the underwriter’s spread was $0.75. Hughes also paid legal and other administrative costs of $1,050,000 for the IPO. Calculate the number of shares issued through this IPO. Net proceeds (not including legal and other administrative expenses) = $10 - $0.75 = $9.25 Funds received from sale plus legal and other administrative expenses = $61,050,000 Shares sold = $61,050,000/$9.25 = 6,600,000 LG4 16-20 Calculating Costs of Issuing Stock Howett Pockett, Inc. needs to raise $20 million in new capital funding from a seasoned equity offering. In discussions with its investment bank, Howett Pocket learns that the bankers recommend a gross price of $15.50 per share and they 11
  • 12. Chapter 16, Solutions Cornett, Adair, and Nofsinger will charge an underwriter’s spread of $1.50 percent of the gross price. In addition, Howett Pockett must pay $1 million in legal and other administrative expenses for the seasoned stock offering. Calculate the number of shares of stock that Howett Pockett will need to sell to raise the $20 million. Net proceeds (not including legal and other administrative expenses) = $15.50 - $1.50 = $14.00 Funds received from sale plus legal and other administrative expenses = $61,050,000 Shares sold = $21,000,000/$14.00 = 1,500,000 Research It! Underwriters Go to the Thomson Financial—Investment Banking and Capital Markets Group Web site at http://www.thomsonreuters.com/busines_units/financial/league_tables and find the latest information available for debt and equity securities underwriting. Go to the first date (the most recent information) listed under Debt and Equity and click on “Equity Capital Markets Review.” This will download a file onto your computer that will contain the most recent information on top underwriters for equity securities. Go back and repeat the last step, clicking on “Debt Capital Markets Review.” What is the most recent dollar value of global debt and equity underwritten by investment banks? Who are the top underwriters of debt and equity? How have the top writers’ market shares changed in the last year? SOLUTION: The solution will vary with the date the Web site is accessed. However, most often, corporate securities are offered publicly through investments banking firms as underwriters. Normally, the investment bank facilitates this transaction. Integrated Mini Case: Capital Funding in a Public Firm Nuran Security Systems, Inc. needs to raise $150,000,000 for asset expansion. As it raises the capital funding, Nuran wants to maintain its current debt ratio of 60 percent. Nuran has been approved for a loan commitment from its bank local bank. The bank has offered the following terms: term = 1 year, up-front fee = 60 basis points, back-end fee = 90 basis points. Nuran expects it will take down 90 percent of the loan commitment. Nuran’s will also issue new shares of stock to support this asset growth. Nuran’s investment bank will use a firm commitment offering in which the net proceeds are $23.875 per share and the underwriter’s spread was 7 percent of the gross proceeds. Nuran Security Systsms’ will also pay legal and other administrative costs of $750,000 for the stock issue. Calculate the amount of debt and equity funding Nuran Security Systems will need to keep its current debt ratio constant and the number of shares of stock the firm must issue to raise the 12
  • 13. Chapter 16, Solutions Cornett, Adair, and Nofsinger needed stock. What can Nuran Security Systems, Inc. expect to pay for fees on this loan commitment and stock issue? SOLUTION: Debt issued = $150,000,000 x .6 = $90million Equity issued = $150,000,000 x .4 = $60million Stock issue costs: Number of shares of stock issued = $60m./$23.875 = 2,513,089 Legal and administrative costs per share = $750,000/2,513,089 = $0.2984375 Gross price = ($23.875 + $0.2984375)/.93 = $25.99294 Total fees on stock issue = ($25.99294 - $23.875) x 2,513,089 = $5,322,580 Loan commitment fees: Loan commitment size: $90m./.9 = $100m. Up-front fees = 0.0060 x $100m. = $ 600,000 Back-end fee = 0.0090 x $100m.(.9) = 810,000 Total fees = $1,400,000 13