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Exam 18: Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

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Question 1

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10 years ago,the City of Melrose issued $3,000,000 of 8% coupon,30-year,semiannual payment,tax-exempt muni bonds.The bonds had 10 years of call protection,but now the bonds can be called if the city chooses to do so.The call premium would be 6% of the face amount.New 20-year,6%,semiannual payment bonds can be sold at par,but flotation costs on this issue would be 2% of the amount of bonds sold.What is the net present value of the refunding? Note that cities pay no income taxes,hence taxes are not relevant.

A) $453,443
B) $476,115
C) $499,921
D) $524,917
E) $551,163

F) B) and E)
G) None of the above

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Question 2

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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.

A) True
B) False

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Question 3

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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.

In its negotiations with its investment bankers,Patton Electronics has reached an agreement whereby the investment bankers receive a smaller fee now (6% of gross proceeds versus their normal 10%) but also receive a 1-year option to purchase an additional 200,000 shares at $5.00 per share.Patton will go public by selling $5,000,000 of new common stock.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.

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.

Stanovich Enterprises has 10-year,12.0% semiannual coupon bonds outstanding.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"?

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.

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.

Which of the following statements is most CORRECT?

Refer to the data for NorthWest Water (NWW) .What is the required after-tax refunding investment outlay,i.e. ,the cash outlay at the time of the refunding?

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.

Which of the following statements is most CORRECT?

Which of the following statements concerning common stock and the investment banking process is NOT CORRECT?

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.

Refer to the data for NorthWest Water (NWW) .What will the after-tax annual interest savings for NWW be if the refunding takes place?

Palmer Company has $5,000,000 of 15-year maturity bonds outstanding.Each bond has a maturity value of $1,000,an annual coupon of 12.0%.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?

Which of the following factors would increase the likelihood that a company would call its outstanding bonds at this time?

To finance its ongoing construction project,Bowen-Roth Inc.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?

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.

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.