Slide 15:

You bid high to make sure you get in the auction, but the price you pay is probably lower.
Example: Company A wants to issue 10,000 shares.
Bidder Bid price Number of shares
A $19 3,000 shares
B $17 2,000 shares
C $16 4,000 shares
D $15 2,000 shares
E $13 5,000 shares
At what price the auction clears?
What is the proceeds of the offer (How much cash will be raised from the auction)?
Answer:
The auction clears at the price of
This is the price that everyone pays for the purchase of $10,000 shares. Therefore, the proceeds of the
offer is:

Slide 20:
IPO underpricing (IPO’s initial return) = (Close price on the first trading day – Offer price)/Offer price

Slide 29: Alternative way to calculate the value of a right:

Value of a right = (rights-on price - subscription price) / (N+1) where N is the number of rights needed
to purchase one new share.
Where:
rights-on price: current share price
N: number of rights needed to purchase one new share. Note that for every one share you currently
own, you receive one right, therefore:
N = number of current shares outstanding / number of new shares issued
Example in the slide:
rights-on price =
subscription price =
N=
Value of a right =

Note: Sometimes we need to calculate the number of new shares issued.

Example: Suppose a company wants to raise $200,000. The subscription price is $20.
 The number of new shares issued =
Another example of rights offering:
A company wants to raise $20 million. The subscription price is $40, and the current stock price is $50.
The firm currently has 5,000,000 shares outstanding. What is the value of a right?

The number of new shares issued =

The market value of the company after rights offering=
The ex-rights price (PX) =
The value of a right =

Using the formula to find the value of a right:

The number of new shares issued =
Rights-on price =
Subscription price =
N=
Value of a right =

Here is the proof of the formula: Value of a right = (rights-on price - subscription price) / (N+1) where N
is the number of rights needed to purchase one new share.
First, we use the equation of the ex-rights price:
PX = (PRO x nold + PS x nnew) / (nold + nnew)
Rearranging, we have:
PX = (PRO x N + PS) / (N + 1) where N = nold / nnew is the number of rights per new share
Value of a right = PRO - PX
= PRO - (PRO x N + PS) / (N + 1)
= [PRO x (N+1) - (PRO x N + PS)] / (N+1)
= (PRO x N + PRO – PRO x N – PS) / (N+1)
= (PRO – PS) / (N+1)

Questions and Practice problems_Chapter 20

Chapter 20:
Concept questions (page 650 textbook): 4, 8, 10, 11, 12, 13, 15

KEY  KEY CHAP 20.pdf

4. Underpricing in Debt Offerings Why is underpricing not a great concern with

bond offerings?

Bonds issued by reputable entities usually have stable demand from institutional investors. These
investors are more focused on the safety and predictability of returns rather than getting a bargain.
Besides, bonds are generally seen as safer and less speculative compared to stocks, thus, investors buy
bonds for their interest payments and return of principal, rather than for potential price appreciation. The
bond market also has efficient mechanisms for pricing, including the bookbuilding process and the
involvement of rating agencies. Therefore, these mechanisms help ensure that the bonds are priced fairly,
reducing the likelihood of significant underpricing.

(Yields on comparable bonds can usually be readily observed, so pricing a bond issue accurately is much
less difficult.)

8. Cash Offer versus Rights Offer Ren-Stimpy International is planning to raise

fresh equity capital by selling a large new issue of common stock. Ren-Stimpy is
currently a publicly traded corporation, and it is trying to choose between an
underwritten cash offer and a rights offering (not underwritten) to current
shareholders. Ren-Stimpy management is interested in minimizing the selling costs
and has asked you for advice on the choice of issue methods. What is your
recommendation and why?
The evidence suggests that a non-underwritten rights offering might be substantially cheaper than a cash
offer. However, such offerings are rare, and there may be hidden costs or other factors not yet identified
or well understood by researchers.

10. IPO Pricing The following material represents the cover page and summary of
the prospectus for the initial public offering of the Pest Investigation Control
Corporation (PICC), which is going public tomorrow with a firm commitment initial
public offering managed by the investment banking firm of Erlanger and Ritter.
Answer the following questions:

a. Assume that you know nothing about PICC other than the information contained
in the prospectus. Based on your knowledge of finance, what is your prediction for
the price of PICC tomorrow? Provide a short explanation of why you think this will
occur.

→ The price will probably go up because IPOs are generally underpriced. This is especially true for
smaller issues such as this one.

b. Assume that you have several thousand dollars to invest. When you get home
from class tonight, you find that your stockbroker, whom you have not talked to for
weeks, has called. She has left a message that PICC is going public tomorrow and
that she can get you several hundred shares at the offering price if you call her
back first thing in the morning. Discuss the merits of this opportunity.

 It is probably safe to assume that they are having trouble moving the issue, and it is likely that the
issue is not substantially underpriced.
11. Competitive and Negotiated Offers What are the comparative advantages
of a competitive offer and a negotiated offer, respectively?

In a competitive offer, the issuing firm sells its securities to the underwriter with the highest bid. In a
negotiated offer, the issuing firm works with one underwriter. Competitive offers and Negotiated offers
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. Seasoned Equity Offers What are the possible reasons why the stock price
typically drops on the announcement of a seasoned new equity issue?

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 overvalued, that is, the
intrinsic value is lower than the market price.

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.

15. IPOs Every IPO is unique, but what are the basic empirical regularities in IPOs?

Basic empirical regularities in IPOs include:

1) Underpricing of the offer price, IPOs are often priced below market value, leading to a significant first-
day price jump.

2) Order-efforts offerings are generationally used for small IPOs and firm commitments offerings are
generally used for large IPOs

3) Underwriters often stabilize the stock price in the aftermarket to prevent it from falling below the offer
price.

4) Issuing costs are generally higher in negotiated deals than in competitive ones.

Questions and Problems (page 652 textbook): 1, 2, 3, 8

1. Rights Offerings Again, Inc., is proposing a rights offering. Presently, there

are 550,000 shares outstanding at $87 each. There will be 85,000 new
shares offered at $81 each.

a. What is the new market value of the company?

b. How many rights are associated with one of the new shares?

c. What is the ex-rights price?

d. What is the value of a right?

e. Why might a company have a rights offering rather than a general cash
offer?
 Old shares = 550,000 shares → New shares = 85,000 shares

Current price per share = $87 → New price per share = $81

a. What is the new market value of the company?

New market value of company = (550,000 x $87) + (85,000 x $81) = $47,850,000 + $6,885,000 = $54,735,000

b. How many rights are associated with one of the new shares?

The rights required to purchase one new share is the ratio of existing shares to new share

Number of rights per new share =Old sharesNew shares= 550,00085,000 6.47 rights per
new share

c. What is the ex-rights price?

Total number of shares after offering = 550,000 + 85,000 = 635,000 shares

New value of company = $54,735,000

Ex - rights price = New Value of company/Total number of shares after offering

= 54,735,000/635,000 = $86.2

d. What is the value of a right?

Value of a right = Current share price - Ex-rights price = $87 - $86.2 = $0.80

e. Why might a company have a rights offering rather than a general cash offer?

Rights offering has lower underwriting and administrative cost. It also has lower impact by
market volatility and pricing uncertainty, thus, it protects against the underpricing. Moreover, it
offers shares to existing shareholders at a discount to maintain the ownership in the firm and
relationships with investors.

2. Rights Offering The Clifford Corporation has announced a rights offer to

raise $28 million for a new journal, the Journal of Financial Excess. This
journal will review potential articles after the author pays a nonrefundable
reviewing fee of $5,000 per page. The stock currently sells for $27 per share,
and there are 2.9 million shares outstanding.

a. What is the maximum possible subscription price? What is the minimum?

 b. If the subscription price is set at $25 per share, how many shares must be
sold?

How many rights will it take to buy one share?

c. What is the ex-rights price? What is the value of a right?

d. Show how a shareholder with 1,000 shares before the offering and no
desire (or money) to buy additional shares is not harmed by the rights offer.

3. Rights Stone Shoe Co. has concluded that additional equity financing will be
needed to expand operations and that the needed funds will be best
obtained through a rights offering. It has correctly determined that as a
result of the rights offering, the share price will fall from $65 to $63.18 ($65
is the “rights-on” price; $63.18 is the ex-rights price, also known as the
when-issued price). The company is seeking $15 million in additional funds
with a per-share subscription price equal to $50. How many shares are there
currently, before the offering? (Assume that the increment to the market
value of the equity equals the gross proceeds from the
offering.)

8. Price Dilution Raggio, Inc., has 135,000 shares of stock outstanding. Each
share is worth $75, so the company’s market value of equity is $10,125,000.
Suppose the firm issues 30,000 new shares at the following prices: $75, $70,
and $65. What will the effect be of each of these alternative offering prices
on the existing price per share?