Chapter 23

Raising Equity Capital

23-3. Starware Software was founded last year to develop software for gaming applications. Initially,
the founder invested $800,000 and received 8 million shares of stock. Starware now needs to
raise a second round of capital, and it has identified an interested venture capitalist. This venture
capitalist will invest $1 million and wants to own 20% of the company after the investment is

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er as
completed.

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a. How many shares must the venture capitalist receive to end up with 20% of the company?

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What is the implied price per share of this funding round?

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b. What will the value of the whole firm be after this investment (the post-money valuation)?
a.
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After the funding round, the founders 8 million shares will represent 80% ownership of the firm.
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To solve for the new total number of shares (TOTAL):
8,000,000 = .80 TOTAL
So TOTAL = 10,000,000 shares. If the new total is 10 million shares, and the venture capitalist
o

will end up with 20%, then the venture capitalist must buy 2 million shares. Given the investment
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of $1 million for 2 million shares, the implied price per share is $0.50.
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b. After this investment, there will be 10 million shares outstanding, with a price of $0.50 per share,
so the post-money valuation is $5 million.
ed d
ar stu
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 23-5. Three years ag
T go, you found ded your own company. Yoou invested $100,000
$ of yoour money an
nd
reeceived 5 milllion shares of
o Series A preferred
p stocck. Since then, your comp pany has beeen
th
hrough three additional
a rou
unds of financiing.

a.. What is thee pre-money valuation

v for the
t Series D fu
unding round??
b.. What is thee post-money valuation for the Series D funding
f round
d?
c.. Assuming that
t you own only the Seriees A preferred d stock (and th
hat each sharee of all series of
o
preferred stock
s is conveertible into one share of com
mmon stock), what percenttage of the firm m
do you ownn after the lastt funding roun
nd?

m
a. Before the Series D fundding round, thhere are (5,0000,000 + 1,000,000 + 500,0000 = 6,500,0000)

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shares outsttanding. Givenn a Series D fuunding price off $4.00 per shaare, the pre-money valuation is

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(6,500,000)) $4.00/sharee = $26 millionn.

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b.. After the fu
unding round, there will be (6,500,000
( + 500,000
5 = 7,0000,000) shares outstanding, so
s
the post-mooney valuation is (7,000,000) $4.00/share = $28,000,0000.

o.
c. You will ow
rs e
wn 5,000,000 / 7,000,000 = 71.4%
7 of the firrm after the lasst funding rounnd.
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23-6. W
What are the main
m advantagges and disadvvantages of going public?
Thhe two main advantages off going publicc are liquidityy and access to t capital. Onne of the majoor
o

diisadvantages of
o an IPO is thaat once a comppany becomes a public comppany, it must satisfy
s all of thhe
reequirements off being a publicc company succh as SEC filinngs and listing requirements of the securitiees
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exxchanges.
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23-7. Do underwriteers face the most

D m risk from
m a best-efforrts IPO, a firrm commitmeent IPO, or an
a
au
uction IPO? Why?
W
Underwriters faace the most risk from a firm
U m commitment IPO. With thiis method, theyy guarantee thhat
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thhey will sell alll of the stock at the offer prrice. If the enttire issue does not sell at thee IPO price, thhe
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reemaining sharees must be soldd at a lower pricce and the undeerwriter must take
t the loss.
With a best-effo
W orts IPO, the unnderwriter does not guaranteee that the stockk will be sold, but instead triees
too sell the stock using the bestt efforts. In an auction IPO, the
t underwriterrs let the markeet determine thhe
prrice by auctionning off the com
mpany.
sh is

23-8. Roundtree Soft

R ftware is goingg public usingg an auction IPO.
I The firm
m has received
d the followin
ng
Th

biids:

Assuming Rou
A undtree would
d like to sell 1.8 million shares in its IPO,
I what wiill the winnin
ng
au
uction offer prrice be?

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 First, compute the cumulaative total num
mber of shares demanded
d at orr above any givven price:
Price Cu
umulative Dem
mand
14.00 100,000
13.80 300,000
13.60 800,000
13.40 1,800,000
13.20 3,000,000
13.00 3,800,000
12.80 4,200,000
The winnin ng price shouldd be $13.40, because
b investoors have placeed orders for a total of 1.8 million
m
shares at a price
p of $13.400 or higher.

23-9. Three yearrs ago, you founded

fo Outddoor Recreatioon, Inc., a rettailer specialiizing in the sale
s of
equipment and clothingg for recreatioonal activities such as camping, skiing, and hiking. SoS far,
your company has gone through threee funding roun nds:

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o.
Currently, it is 2007 andd you need to raise addition nal capital to expand your business. You u have
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decided to take your fiirm public through an IPO O. You would d like to issuee an addition
nal 6.5
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million new
w shares throough this IPO O. Assuming th hat your firmm successfully completes itss IPO,
you forecasst that 2007 neet income willl be $7.5 millioon.
a. Your investment
i baanker advises you
y that the prices
p of otherr recent IPOs have been sett such
o

that thhe P/E ratios based

b on 20077 forecasted eaarnings averagge 20.0. Assumming that you
ur IPO
is set at
a a price that implies a simiilar multiple, what will your IPO price per share be?
aC s
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b. What percentage
p of the firm will you
y own afterr the IPO?
a. With a P/E ratio of 200.0x, and 2005 earnings of $77.5 million, thee total value off the firm at thee IPO
should be:
P
ed d

= 20.0
2 x P = $150 million.
7.5
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There are
a currently (5500,000 + 1,0000,000 + 2,0000,000) = 3,500,,000 shares outtstanding (befoore the
IPO). At
A the IPO, thee firm will issuue an additionaal 6.5 million shares, so therre will be 10 million
m
shares outstanding im
mmediately aft fter the IPO. With
W a total market
m value off $150 millionn, each
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share should be worthh $150 / 10 = $15

$ per share.
b. he IPO, you wiill own 500,000 of the 10 milllion shares ouutstanding, or 5%
After th 5 of the firm.
Th

23-10.. What is IP
PO underpriciing? If you deecide to try to buy shares in
n every IPO, will
w you necesssarily
make moneey from the un
nderpricing?
Underpricin ng refers to thhe fact that, onn average, underwriters pickk the IPO issuue price so thhat the
average firsst-day return iss positive. If yoou followed a strategy
s of placcing an order for
f a fixed nummber of
shares on evvery IPO, yourr order will be completely filled when the stocks price goees down, but yoou will
be rationed when it goes up. u In effect yoou only get subbstantial amouunts of stock whhen you do noot want
it. The winnners curse is substantial enouugh so that thee strategy of invvesting in everry IPO does not yield
above mark ket returns.

23-11.. Margoles Publishing

P recently compleeted its IPO. The stock waas offered at a price of $114 per
share. On the
t first day of
o trading, thee stock closed at $19 per sh
hare. What waas the initial return
r
on Margolees? Who beneefited from thiis underpricin
ng? Who lost, and why?

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 The initial return on Margoles Publishing stock is ($19.00 $14.00) / ($14.00) = 35.7%.
Who gains from the price increase? Investors who were able to buy at the IPO price of $14/share see
an immediate return of 35.7% on their investment. Owners of the other shares outstanding that were
not sold as part of the IPO see the value of their shares increase. To the extent that the investors who
were able to obtain shares in the IPO have other relationships with the investment banks, the
investment banks may benefit indirectly from the deal through their future business with these
customers.
Who loses from the price increase? The original shareholders lose, because they sold stock for $14.00
per share when the market was willing to pay $19.00 per share.

23-12. Chen Brothers, Inc., sold 4 million shares in its IPO, at a price of $18.50 per share. Management
negotiated a fee (the underwriting spread) of 7% on this transaction. What was the dollar cost of
this fee?
The total dollar value of the IPO was ($18.50) (4 million) = $74 million. The spread equaled (0.07)
($74 million) or $5.18 million.

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23-13. Your firm has 10 million shares outstanding, and you are about to issue 5 million new shares in
an IPO. The IPO price has been set at $20 per share, and the underwriting spread is 7%. The

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IPO is a big success with investors, and the share price rises to $50 the first day of trading.
a. How much did your firm raise from the IPO?

o.
rs e
b. What is the market value of the firm after the IPO?
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c. Assume that the post IPO value of your firm is its fair market value. Suppose your firm
could have issued shares directly to investors at their fair market value, in a perfect market
with no underwriting spread and no underpricing. What would the share price have been in
this case, if you raise the same amount as in part (a)?
o

d. Comparing part (b) and part (c), what is the total cost to the firms original investors due to
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market imperfections from the IPO?

vi y re

a. 5m (20 7% 20) = $93 million

b. 15m 50 = $750 million
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c. Market value of firm assets absent new cash raised = 750 93 = $657 million.
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$657m/(10m original shares) = $65.70 per share

Check: 93m/65.70 = 1.4155m new shares,
$750/11.4155 = $65.7
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d. (65.7 50) 10m = $157 million

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23-14. You have an arrangement with your broker to request 1000 shares of all available IPOs. Suppose
that 10% of the time, the IPO is very successful and appreciates by 100% on the first day,
80% of the time it is successful and appreciates by 10%, and 10% of the time it fails and
falls by 15%.
a. By what amount does the average IPO appreciate the first day; that is, what is the average
IPO underpricing?
b. Suppose you expect to receive 50 shares when the IPO is very successful, 200 shares when it
is successful, and 1000 shares when it fails. Assume the average IPO price is $15. What is
your expected one-day return on your IPO investments?
a. .10(100%) + .80(10%) + .10(15%) = 16.5%
b. Average investment = .10(50 15) + .80(200 15) + .10(1000 15) = $3975

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 Ave gain = .10(50 15 100%) + .80(200 15 10%)+.10(1000 15 15%) = $90
Return = 90/3975 = 2.3%

23-15. On January 20, Metropolitan, Inc., sold 8 million shares of stock in an SEO. The current market
price of Metropolitan at the time was $42.50 per share. Of the 8 million shares sold, 5 million
shares were primary shares being sold by the company, and the remaining 3 million shares were
being sold by the venture capital investors. Assume the underwriter charges 5% of the gross
proceeds as an underwriting fee (which is shared proportionately between primary and
secondary shares).
a. How much money did Metropolitan raise?
b. How much money did the venture capitalists receive?
a. The company sold 5 million shares at $42.50 per share, so it raised ($42.50) (5,000,000) =
$212.5 million. After underwriting fees, it will keep 212.50 (1 0.05) = $201.875 million.
b. The venture capitalists raised ($42.50) (3,000,000) = $127.5 million. After underwriting fees,

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they will keep 127.5 (1 0.05) = $121.125 million.

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So, in total, the SEO was worth $201.875 + $121.125 = ($42.50) (8,000,000) 0.95 = $323

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million.

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23-17. MacKenzie Corporation currently has 10 million shares of stock outstanding at a price of $40

o.
per share. The company would like to raise money and has announced a rights issue. Every
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existing shareholder will be sent one right per share of stock that he or she owns. The company
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plans to require five rights to purchase one share at a price of $40 per share.
a. Assuming the rights issue is successful, how much money will it raise?
b. What will the share price be after the rights issue? (Assume perfect capital markets.)
o
aC s

Suppose instead that the firm changes the plan so that each right gives the holder the right to
purchase one share at $8 per share.
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c. How much money will the new plan raise?

d. What will the share price be after the rights issue?
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e. Which plan is better for the firms shareholders? Which is more likely to raise the full
amount of capital?
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a. 10m shares/5 40 = $80 million

b. 12m total shares, Value = $400 million + 80 million in new capital = $480
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Share price = 480/12 = $40

c. 10m $8 = $80 million
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d. $480/20 = $24 per share

e. Shareholders are the same either way. In the first case, each share is worth $40, and exercising the
right has 0 npv, so the total value of a share is $40.
In the second case, the share is worth $24, but the right is worth (24 8) = $16, so the total value
from owning a share is $24 + $16 = $40 per share.
However, the second plan is much more likely to be fully subscribed, because exercising the right
is a good deal. In the first case, shareholders are indifferent between exercising and not exercising.

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 Chaptter 24
Debtt Fina
ancingg

24-1. Explain some of

o the differences between a public debt offering
o and a private debt offering.
o
Inn a public deb bt offering, a prospectus
p is created
c with details of the offering
o and a formal contraact
beetween the bon nd issuer and the
t trust company is signed. The trust com mpany makes suure the terms of o
thhe contract are enforced. In a private offeriing there is noo need for a prrospectus or a formal contracct.
Innstead a promisssory note cann be enough. Moreover,
M the contract in a private placemennt does not havve
too be standard.

24-2. Why do bonds with lower seniority haave higher yieelds than equ
W uivalent bond
ds with higheer
seeniority?

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Requiring coupon payments protects the bondholders
R b froom waiting a long time in case the debtoor
deefaults. Without coupon payyments defaultt only happenns when the boond matures, but b by then thhe

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coorporation mig ght have depletted all of its asssets. In contraast, with coupoon payments thhe debtor woulld

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bee in default thee moment it miisses one of thee coupon paym ments, and the bondholders
b caan then force thhe
firrm into bankrruptcy. At thiss stage, they might
m be able to get a larger fraction of the
t value of thhe

o.
orriginal debt thaan if they waiteed until maturitty.
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24-3. Explain the diffference betweeen a secured corporate
c and
d an unsecured
d corporate bond.
A secured corpo orate bond givves the bondholder the right over
o particularr assets that serve as collaterral
inn case of defauult. An unsecuured corporatee bond does not offer such protection to the bondholdeer.
o

Thhus, with an unsecured coorporate bond the bondholdders are residuual claimants in the case of o
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baankruptcy afterr the secured assets have beenn given to the corresponding
c bondholders.
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24-10. Explain why bo

ond issuers might
m voluntarrily choose to put restrictivee covenants in
nto a new bon
nd
issue.
Bond issuers beenefit from plaacing restrictinng covenants because by doinng so they cann obtain a lower
ed d

innterest rate.
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24-13. Explain why th he yield on a convertible bond

b is lower than the yielld on an otheerwise identical
boond without a conversion feeature.
Thhe option to co
onvert the bondd into stock is valuable,
v hencee its price will be higher and its yield lowerr.
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24-14. You own a bo

Y ond with a faace value of $10,000 and a conversion
n ratio of 4500. What is th
he
Th

coonversion pricce?
Thhe conversion price is the facce value of the bond divided by
b the converssion ratio. In thhis case:
Face vallue $10, 000
P= =
Conversionn ratio 4500
P = $22.22.

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