Dilution effect of stock issue
Dilution effect of stock issue
(LO15-3)
1. Louisiana Timber Company currently has 5 million shares of stock outstanding and will report earnings of $9 million in the current year. The company is considering the issuance of 1 million additional shares that will net $40 per share to the corporation.
a. What is the immediate dilution potential for this new stock issue?
b. Assume the Louisiana Timber Company can earn 11 percent on the proceeds of the stock issue in time to include it in the current year’s results. Should the new issue be undertaken based on earnings per share?
Dilution effect of stock issue
(LO15-3)
Page 495
2. The Hamilton Corporation Company has 4 million shares of stock outstanding and will report earnings of $6,910,000 in the current year. The company is considering the issuance of 1 million additional shares that can only be issued at $30 per share.
a. Assume the Hamilton Corporation Company can earn 7.0 percent on the proceeds. Calculate the earnings per share.
b. Should the new issue be undertaken based on earnings per share?
Dilution effect of stock issue
(LO15-3)
3. American Health Systems currently has 6,400,000 shares of stock outstanding and will report earnings of $10 million in the current year. The company is considering the issuance of 1,700,000 additional shares that will net $30 per share to the corporation.
a. What is the immediate dilution potential for this new stock issue?
b. Assume that American Health Systems can earn 9 percent on the proceeds of the stock issue in time to include them in the current year’s results. Calculate earnings per share. Should the new issue be undertaken based on earnings per share?
Dilution effect of stock issue
(LO15-3)
4. Using the information in Problem 3, assume that American Health Systems’ 1,700,000 additional shares can only be issued at $18 per share.
a. Assume that American Health Systems can earn 6 percent on the proceeds. Calculate earnings per share.
b. Should the new issue be undertaken based on earnings per share?
Dilution and pricing effect of stock issue
(LO15-3)
5. Jordan Broadcasting Company is going public at $50 net per share to the company. There also are founding stockholders that are selling part of their shares at the same price. Prior to the offering, the firm had $26 million in earnings divided over 11 million shares. The public offering will be for 5 million shares; 3 million will be new corporate shares and 2 million will be shares currently owned by the founding stockholders.
a. What is the immediate dilution based on the new corporate shares that are being offered?
b. If the stock has a P/E of 30 immediately after the offering, what will the stock price be?
c. Should the founding stockholders be pleased with the $50 they received for their shares?
Underwriting spread
(LO15-2)
6. Solar Energy Corp. has $4 million in earnings with 4 million shares outstanding. Investment bankers think the stock can justify a P/E ratio of 21. Assume the underwriting spread is 5 percent. What should the price to the public be?
Underwriting spread
(LO15-2)
7. Tiger Golf Supplies has $25 million in earnings with 7 million shares outstanding. Its investment banker thinks the stock should trade at a P/E ratio of 31. Assume there is an underwriting spread of 7.8 percent. What should the price to the public be?
Underwriting spread
(LO15-2)
8. Assume Sybase Software is thinking about three different size offerings for issuance of additional shares.
Page 496
| Size of Offer | Public Price | Net to Corporation |
| a. 1.1 million | $30 | $27.50 |
| b. 7.0 million | $30 | 28.44 |
| c. 28.0 million | $30 | 29.15 |
What is the percentage underwriting spread for each size offer?
Underwriting spread
(LO15-2)
9. Walton and Company is the managing investment banker for a major new underwriting. The price of the stock to the investment banker is $23 per share. Other syndicate members may buy the stock for $24.25. The price to the selected dealers group is $24.80, with a price to brokers of $25.20. Finally, the price to the public is $29.50.
a. If Walton and Company sells its shares to the dealer group, what will the percentage return be?
b. If Walton and Company performs the dealer’s function also and sells to brokers, what will the percentage return be?
c. If Walton and Company fully integrates its operation and sells directly to the public, what will its percentage return be?
Underwriting spread
(LO15-2)
10. The Wrigley Corporation needs to raise $44 million. The investment banking firm of Tinkers, Evers & Chance will handle the transaction.
a. If stock is utilized, 2,300,000 shares will be sold to the public at $20.50 per share. The corporation will receive a net price of $19 per share. What is the percentage underwriting spread per share?
b. If bonds are utilized, slightly over 43,700 bonds will be sold to the public at $1,009 per bond. The corporation will receive a net price of $994 per bond. What is the percentage of underwriting spread per bond? (Relate the dollar spread to the public price.)
c. Which alternative has the larger percentage of spread? Is this the normal relationship between the two types of issues?
Secondary offering
(LO15-2)
11. Kevin’s Bacon Company Inc. has earnings of $9 million with 2,100,000 shares outstanding before a public distribution. Seven hundred thousand shares will be included in the sale, of which 400,000 are new corporate shares, and 300,000 are shares currently owned by Ann Fry, the founder and CEO. The 300,000 shares that Ann is selling are referred to as a secondary offering, and all proceeds will go to her.
The net price from the offering will be $16.50, and the corporate proceeds are expected to produce $1.8 million in corporate earnings.
a. What were the corporation’s earnings per share before the offering?
b. What are the corporation’s earnings per share expected to be after the offering?
Market stabilization and risk
(LO15-2)
12. Becker Brothers is the managing underwriter for a 1.45-million-share issue by Jay’s Hamburger Heaven. Becker Brothers is “handling” 10 percent of the issue. Its price is $27 per share, and the price to the public is $28.95.Page 497
Becker also provides the market stabilization function. During the issuance, the market for the stock turns soft, and Becker is forced to purchase 50,000 shares in the open market at an average price of $27.50. It later sells the shares at an average value of $27.20.
Compute Becker Brothers’ overall gain or loss from managing the issue.
Underwriting costs
(LO15-2)
13. Trump Card Co. will issue stock at a retail (public) price of $32. The company will receive $29.20 per share.
a. What is the spread on the issue in percentage terms?
b. If the firm demands receiving a new price only $2.20 below the public price suggested in part a, what will the spread be in percentage terms?
c. To hold the spread down to 2.5 percent based on the public price in part a, what net amount should Trump Card Co. receive?
Underwriting costs
(LO15-2)
14. Winston Sporting Goods is considering a public offering of common stock. Its investment banker has informed the company that the retail price will be $16.85 per share for 550,000 shares. The company will receive $15.40 per share and will incur $180,000 in registration, accounting, and printing fees.
a. What is the spread on this issue in percentage terms? What are the total expenses of the issue as a percentage of total value (at retail)?
b. If the firm wanted to net $15.99 million from this issue, how many shares must be sold?
Intermediate Problems
P/E ratio for new public issue
(LO15-2)
15. Richmond Rent-A-Car is about to go public. The investment banking firm of Tinkers, Evers & Chance is attempting to price the issue. The car rental industry generally trades at a 20 percent discount below the P/E ratio on the Standard & Poor’s 500 Stock Index. Assume that index currently has a P/E ratio of 25. The firm can be compared to the car rental industry as follows:
| Richmond | Car Rental Industry | |
| Growth rate in earnings per share | 15% | 10% |
| Consistency of performance | Increased earnings 4 out of 5 years | Increased earnings 3 out of 5 years |
| Debt to total assets | 52% | 39% |
| Turnover of product | Slightly below average | Average |
| Quality of management | High | Average |
Assume, in assessing the initial P/E ratio, the investment banker will first determine the appropriate industry P/E based on the Standard & Poor’s 500 Index. Then a half point will be added to the P/E ratio for each case in which Richmond Rent-A-Car is superior to the industry norm, and a half point will be deducted for an inferior comparison. On this basis, what should the initial P/E be for the firm?
Dividend valuation model for new public issue
(LO15-1)
Page 498
16. The investment banking firm of Einstein & Co. will use a dividend valuation model to appraise the shares of the Modern Physics Corporation. Dividends (D1) at the end of the current year will be $1.64. The growth rate (g) is 8 percent and the discount rate (Ke) is 13 percent.
a. What should be the price of the stock to the public?
b. If there is a 7 percent total underwriting spread on the stock, how much will the issuing corporation receive?
c. If the issuing corporation requires a net price of $31.30 (proceeds to the corporation) and there is a 7 percent underwriting spread, what should be the price of the stock to the public? (Round to two places to the right of the decimal point.)
Comparison of private and public debt offering
(LO15-1)
17. The Landers Corporation needs to raise $1.60 million of debt on a 20-year issue. If it places the bonds privately, the interest rate will be 10 percent. Twenty thousand dollars in out-of-pocket costs will be incurred. For a public issue, the interest rate will be 9 percent, and the underwriting spread will be 2 percent. There will be $120,000 in out-of-pocket costs. Assume interest on the debt is paid semiannually, and the debt will be outstanding for the full 20-year period, at which time it will be repaid.
For each plan, compare the net amount of funds initially available—inflow—to the present value of future payments of interest and principal to determine net present value. Assume the stated discount rate is 12 percent annually. Use 6 percent semiannually throughout the analysis. (Disregard taxes.)
Advanced Problems
Features associated with a stock distribution
(LO15-3)
18. Midland Corporation has a net income of $19 million and 4 million shares outstanding. Its common stock is currently selling for $48 per share. Midland plans to sell common stock to set up a major new production facility with a net cost of $21,120,000. The production facility will not produce a profit for one year, and then it is expected to earn a 13 percent return on the investment. Stanley Morgan and Co., an investment banking firm, plans to sell the issue to the public for $44 per share with a spread of 4 percent.
a. How many shares of stock must be sold to net $21,120,000? (Note: No out-of-pocket costs must be considered in this problem.)
b. Why is the investment banker selling the stock at less than its current market price?
c. What are the earnings per share (EPS) and the price-earnings ratio before the issue (based on a stock price of $48)? What will be the price per share immediately after the sale of stock if the P/E stays constant?
d. Compute the EPS and the price (P/E stays constant) after the new production facility begins to produce a profit.
e. Are the shareholders better off because of the sale of stock and the resultant investment? What other financing strategy could the company have tried to increase earnings per share?
Dilution and rates of return
(LO15-3)
Page 499
19. The Presley Corporation is about to go public. It currently has aftertax earnings of $7,200,000, and 2,100,000 shares are owned by the present stockholders (the Presley family). The new public issue will represent 800,000 new shares. The new shares will be priced to the public at $25 per share, with a 5 percent spread on the offering price. There will also be $260,000 in out-of-pocket costs to the corporation.
a. Compute the net proceeds to the Presley Corporation.
b. Compute the earnings per share immediately before the stock issue.
c. Compute the earnings per share immediately after the stock issue.
d. Determine what rate of return must be earned on the net proceeds to the corporation so there will not be a dilution in earnings per share during the year of going public.
e. Determine what rate of return must be earned on the proceeds to the corporation so there will be a 5 percent increase in earnings per share during the year of going public.
Dilution and rates of return
(LO15-3)
20. Tyson Iron Works is about to go public. It currently has aftertax earnings of $4,400,000, and 4,200,000 shares are owned by the present stockholders. The new public issue will represent 500,000 new shares. The new shares will be priced to the public at $25 per share with a 3 percent spread on the offering price. There will also be $280,000 in out-of-pocket costs to the corporation.
a. Compute the net proceeds to Tyson Iron Works.
b. Compute the earnings per share immediately before the stock issue.
c. Compute the earnings per share immediately after the stock issue.
d. Determine what rate of return must be earned on the net proceeds to the corporation so there will not be a dilution in earnings per share during the year of going public.
e. Determine what rate of return must be earned on the proceeds to the corporation so there will be a 10 percent increase in earnings per share during the year of going public.
Aftermarket for new public issue
(LO15-4)
21. I. B. Michaels has a chance to participate in a new public offering by Hi-Tech Micro Computers. His broker informs him that demand for the 700,000 shares to be issued is very strong. His broker’s firm is assigned 25,000 shares in the distribution and will allow Michaels, a relatively good customer, 1.3 percent of its 25,000 share allocation.
The initial offering price is $30 per share. There is a strong aftermarket, and the stock goes to $32 one week after issue. The first full month after issue, Mr. Michaels is pleased to observe his shares are selling for $33.50. He is content to place his shares in a lockbox and eventually use their anticipated increased value to help send his son to college many years in the future. However, one year after the distribution, he looks up the shares in The Wall Street Journal and finds they are trading at $28.50.
a. Compute the total dollar profit or loss on Mr. Michaels’s shares one week, one month, and one year after the purchase. In each case, compute the profit or loss against the initial purchase price.
b. Also compute this percentage gain or loss from the initial $30 price.
c. Why might a new public issue be expected to have a strong aftermarket?
Leveraged buyout
(LO15-5)
Page 500
22. The management of Mitchell Labs decided to go private in 2002 by buying in all 2.80 million of its outstanding shares at $24.80 per share. By 2006, management had restructured the company by selling off the petroleum research division for $10.75 million, the fiber technology division for $8.45 million, and the synthetic products division for $20 million. Because these divisions had been only marginally profitable, Mitchell Labs is a stronger company after the restructuring. Mitchell is now able to concentrate exclusively on contract research and will generate earnings per share of $1.10 this year. Investment bankers have contacted the firm and indicated that if it reentered the public market, the 2.80 million shares it purchased to go private could now be reissued to the public at a P/E ratio of 15 times earnings per share.
a. What was the initial cost to Mitchell Labs to go private?
b. What is the total value to the company from (1) the proceeds of the divisions that were sold, as well as (2) the current value of the 2.80 million shares (based on current earnings and an anticipated P/E of 15)?
c. What is the percentage return to the management of Mitchell Labs from the restructuring? Use answers from parts a and b to determine this value.
COMPREHENSIVE PROBLEM
Bailey Corporation
(Impact of new public offering)
(LO15-4)
The Bailey Corporation, a manufacturer of medical supplies and equipment, is planning to sell its shares to the general public for the first time. The firm’s investment banker, Robert Merrill and Company, is working with Bailey Corporation in determining a number of items. Information on the Bailey Corporation follows:
| BAILEY CORPORATION Income Statement For the Year 20X1 | |
| Sales (all on credit) | $42,680,000 |
| Cost of goods sold | 32,240,000 |
| Gross profit | $10,440,000 |
| Selling and administrative expenses | 4,558,000 |
| Operating profit | $ 5,882,000 |
| Interest expense | 600,000 |
| Net income before taxes | 5,282,000 |
| Taxes | 2,120,000 |
| Net income | $ 3,162,000 |
Page 501
| BAILEY CORPORATION Balance Sheet As of December 31, 20X1 | |
| Assets | |
| Current assets: | |
| Cash | $ 250,000 |
| Marketable securities | 130,000 |
| Accounts receivable | 6,000,000 |
| Inventory | 8,300,000 |
| Total current assets | $14,680,000 |
| Net plant and equipment | 13,970,000 |
| Total assets | $28,650,000 |
| Liabilities and Stockholders’ Equity | |
| Current liabilities: | |
| Accounts payable | $ 3,800,000 |
| Notes payable | 3,550,000 |
| Total current liabilities | $ 7,350,000 |
| Long-term liabilities | 5,620,000 |
| Total liabilities | $12,970,000 |
| Stockholders’ equity: | |
| Common stock (1,800,000 shares at $1 par) | $ 1,800,000 |
| Capital in excess of par | 6,300,000 |
| Retained earnings | 7,580,000 |
| Total stockholders’ equity | $15,680,000 |
| Total liabilities and stockholders’ equity | $28,650,000 |
a. Assume that 800,000 new corporate shares will be issued to the general public. What will earnings per share be immediately after the public offering? (Round to two places to the right of the decimal point.) Based on the price-earnings ratio of 12, what will the initial price of the stock be? Use earnings per share after the distribution in the calculation.
b. Assuming an underwriting spread of 5 percent and out-of-pocket costs of $300,000, what will net proceeds to the corporation be?
c. What return must the corporation earn on the net proceeds to equal the earnings per share before the offering? How does this compare with current return on the total assets on the balance sheet?
d. Now assume that, of the initial 800,000 share distribution, 400,000 belong to current stockholders and 400,000 are new shares, and the latter will be added to the 1,800,000 shares currently outstanding. What will earnings per share be immediately after the public offering? What will the initial market price of the stock be? Assume a price-earnings ratio of 12, and use earnings per share after the distribution in the calculation.
Page 502
e. Assuming an underwriting spread of 5 percent and out-of-pocket costs of $300,000, what will net proceeds to the corporation be?
f. What return must the corporation now earn on the net proceeds to equal earnings per share before the offering? How does this compare with current return on the total assets on the balance sheet?
WEB EXERCISE
1. Initial public offerings (IPOs) were covered in the chapter. Let’s take a closer look at two actual issues. Go to www.hoovers.com/global/ipoc/index.xhtml. For the first two issues under “Latest Pricings,” do the following steps all the way through, one company at a time. Use the menu in the left margin to navigate the IPO.
2. a. Click on and write down the company name.
b. Write a short paragraph about what the company does or its products.
c. Scroll down and record the date the company went public.
d. Write down the actual offer price.
e. Write down the offering amount (mil.).
f. Record the name of the lead underwriter.
Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for.
