Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
15
Raising
Capital
LEARNING
OBJECTIVES
(Slide 15-2)
IN
A
NUTSHELL
This chapter is about how entrepreneurs and firms go about raising funds for growth and
development. As a firm progresses through the various phases of its business cycle, its
needs, focus, and conditions change requiring it to use different sources of capital. Firms
typically sell bonds and stock to raise capital and so the author explains the process
followed by issuing companies. Besides bonds and stock, firms also borrow short-term
funds by issuing commercial paper and bankers acceptances. The chapter closes with a
discussion of the options and regulations that come into play when a firm decides to
cease operations and close permanently.
LECTURE
OUTLINE
15.1
The
Business
Life
Cycle
(Slide 15-3)
A firm typically goes through 5 stages in its life cycle: start-up, growth, maturity, decline,
and closing.
Business life cycles vary considerably. Some firms go through the early stages fairly
rapidly and then settle into maturity for a long time, while others skip to the closing stage
in a few years.
The US Census Bureaus Business Information Tracking System estimates that roughly
60% of businesses that employ others besides the owners will close within their first 6
years.
The life cycle approach is a useful way to discuss financing opportunities and sources for
businesses.
Personal funds
Borrowed funds from family and friends
Commercial bank loans
Borrowed funds through business start-up programs like the U.S. Small Business
Administration (SBA)
5. Angel financing or venture capital
15.2
(A)
Personal
Funds
and
Family
Loans: although limited in scope, are often good
available to qualified small business applicants via a variety of loan programs, the most
common of which is the 7(a) Loan Guaranty Program.
The 7(a) Loan Guaranty Program administers business loans to individuals or businesses
that might not be eligible for a loan through the normal lending agencies.
Loan proceeds can be used for working capital and fixed assets, with repayment
schedules extending up to 25 years.
These loans are delivered through commercial lenders and guaranteed by the SBA.
The interest rates tend to be quite competitive but the major advantage of this program
accrues to the banks since the loans are backed by the SBA.
15.2
(D)
Angel
Financing
and
Venture
Capital: is generally sought by entrepreneurs and
businesses that would not qualify for commercial bank or SBA-backed financing.
Angel investors are wealthy individuals and groups that are interested in providing initial
funding for high-risk ideas. They typically have very short loan investment horizons (less
than 10 years) and upside limits of about $2 million.
Venture capitalist firms or funds are also willing to fund high-risk projects, but have
longer time horizons and higher funding limits. They generally provide the funding in
stages.
Table 15.1 presents some of the key differences between angel investors and venture
capitalists.
Table 15.2 provides an example of stages of financing provided by venture capital firms.
Entrepreneurs with strong, promising ideas could be in a position to choose from a group
of angel investors and venture capitalists.
Factors to look for when picking a financier or group of financiers include:
Financial strength i.e. Will the financier have the necessary funding ability to back the
project until its completion?
Contacts: i.e. Can the financier provide valuable contacts to help the entrepreneur reach
his or her goal?
Exit strategy: i.e. how much equity is the investor looking to acquire as a condition of
providing the funding and how much of control is the entrepreneur willing to give up?
Given that there is a high probability of failure among start-ups, angel investors and
financiers commonly look for 60% 100% potential annual rates of return on their
successful ventures in order to provide funding.
Example
1:
Expected
rate
of
return
for
a
venture
capitalist
The Quick Start Funding Group is looking to fund only those projects which have the
potential to return $10 million dollars for every $1 million that they have invested within
a 5-year period. Calculate the firms expected rate of return on its investment.
FV = $10 million; PV = 1 million; N=5; CPT I% 58.49%
Commercial banks provide much of the short-term financing required for the operating
needs of a business via straight loans, discount loans, and lines of credit with or without
compensating balances.
15.3
(A)
Straight
loans: represent the simplest of all types of bank loans, and are offered
will the face value of the loan have to be set at and what rate of interest is the company
effectively paying?
Loan amount (face value) = Amount needed/(1-discount rate) $2m/.9 $2.209m.
Effective rate = discount paid/Amount used = 209,000/2000000 10.497%
15.3
(C)
Letter
of
Credit
or
Line
of
Credit: is a preapproved borrowing amount that
the loan is not available to the borrower, even though interest is paid on the full face
value of the loan. For example, if a firm takes a loan of $100,000 at a rate of 7.5% per
year and a compensating balance requirement of 15%, it will be able to use only $85,000
and be charge $7,500 in interest for the year. The effective rate of interest will therefore
be:
Effective rate = Interest paid/Amount used $7,500/$85,000 8.82%
The other major source of capital for a firm to avail of is common stock or equity.
Equity holders get voting rights as part owners and share in the residual profits of the
firm.
Stocks are sold as initial public offerings (IPOs) when the firm first goes public and
seasoned offerings for subsequent issues.
15.5
(A)
Initial
Public
Offerings
and
Underwriting: Firms sell stock to the public with
the help of investment banking firms, who perform due diligence and are experts in
marketing the issue.
Investment banks partner with issuing firms in exchange for compensation that can be set
up on a best-efforts basis or on a fixed-commitment basis.
Under a best-efforts arrangement the investment bank pledges to use its best efforts to
sell all the authorized shares and takes a cut on each individual share sold, but provides
no guarantee as to how many shares will be sold. The more shares sold, the higher the
payoff to the investment bank.
Under a fixed-commitment arrangement, also known as an underwriting arrangement,
the investment banker guarantees a fixed amount of proceeds to the issuer. The
investment banker makes up/keeps the difference between the actual selling price and the
guaranteed price.
Example
5:
Best
efforts
versus
fixed
commitment
underwriting
The Wed Link Inc. wants to raise capital by issuing common stock. They contact a few
investment bankers and the one with the best offer has presented them with 2 options:
1) A fixed commitment offer of $8,500,000
2) A best efforts arrangement in which the investment banker will receive $1.50 per
share for every share of stock sold up to $$1,500,000 for the 1,000.000 shares to be
offered to the public at $11 per share.
a) If 100% of the shares are sold, what are Wed Links proceeds? What is the
payment to the investment banking firm under each method of issuing securities?
b) What if 85% of the shares are sold? At what percentage of shares sold are the
proceeds to you the same under the two compensation arrangements?
c) At what percentage is the payment to the investment banking firm the same?
a) If 100% of the shares are sold i.e. 1,000,000 shares at $11 per share, to the public, the
proceeds are as follows:
1) With the firm commitment arrangement, the issuer gets $8,500,000
The investment banker gets $11,000,000 $8,500,000 = $2,500,000
2) With the best efforts arrangement, the issuer gets ($11$1.50)*1,000,000$9,500,000
15.5 (B) Registration, Prospectus, and Tombstone: All new issues of shares have to be
registered with the SEC prior to being sold in the capital markets.
Once an application is filed, the approval process could take anywhere from 20 to 40
days (cool-off period.)
During the waiting period, the issuer can circulate a preliminary prospectus (red herring)
informing potential investors of the issue.
No commitments can be obtained from buyers until after SEC approval.
If information is missing, the SEC issues a comment letter, requiring corrections and a
new application to be filed.
Once re-filed, the cool-off period starts again.
During the waiting period the issuer and investment bank place large advertisements
(tombstone ads.) in newspapers and magazines, containing the name of the issuer, some
details about the issue, and a list of participating investment banks.
There are 2 exceptions to the usual SEC registration process requirement:
1. If the issue has a maturity of less than 270 days e.g. commercial paper issues.
2. If the issue is worth less than $5 million (Regulation A)
15.5
(C)
The
Marketing
Process:
Road
Show:
involves taking the issue on the road to
This process usually last about 2 weeks and enables the investment banker to get a feel
for what the price should be set at.
After a successful road show and marketing campaign, a price is set and the issue
proceeds forward to be auctioned off in the primary capital market.
15.5
(D)
The
Auction: takes place on a single trading day, during which time buyers
submit their bids at pre-set prices. If over-subscribed, the bids are filled on a pro-rata
basis until all the shares are sold.
15.5
(E)
The
Aftermarket:
Dealer
in
the
Shares: After completion of the auction the
outstanding shares trade in the secondary market and the investment banker typically
functions as a dealer in the stock for a minimum of 18 months, for which the bank is
given a green-shoe provision.
The green shoe provision allows the investment banker the right to purchase up to 15%
of additional shares over a thirty-day period beyond that offered to the public during the
auction so as to maintain inventory and fill any pent-up demand.
Another standard agreement is a lock-up agreement, which requires the original owners
of the firm to maintain their shares of stock for 180 days, so as to prevent dumping of
stock and free-fall in its price due to profit-taking on part of the original owners.
investor with both principal and interest repaid within 270 days just like a treasury bill.
These issues typically have a face value of $100,000, putting them out of the reach of
most small investors. It is generally assumed institutions and sophisticated investors
purchase commercial paper.
The reason firms issue commercial paper over other forms of borrowing is that they can
get lower rates than through commercial banks and since they mature within 270 days,
they qualify for short-form registration with the SEC.
Example
6:
The Large-Scale Industrial Corporation, a large well established company, is about to
issue $6,000,000 worth of commercial paper. The paper has a maturity of 9 months (270
days), and commands a price worth 97.5% of par value in the market. The paper will be
sold with a face or par value of $100,000. How many commercial papers will be sold?
What is the cost of this borrowing to the firm?
Proceeds from the issue = Face Value *Discounted Value = $6m*.975=$5.85m
Cost of this borrowing over 270 days = ($6m-$5.85m)/$5.85m.02564
APR = .02564*365/270 = 0.034663.47%
EAR = (1.02564)365/270 13.48%
2013
Pearson
Education,
Inc.
Publishing
as
Prentice
Hall
guaranteed by a bank, and it is ordinarily used to finance inventories or other assets that
will be self-liquidated over a relatively short period of time. Its specific purpose is to
promote trade.
It typically involves an importing firm having its invoice guaranteed (accepted) by a bank
and sent over to the exporter as assurance of payment in the next few months (typically
60-90 days). The exporter turns in the bankers acceptance to his bank in exchange for a
reduced payment and in return the bank in the exporting country takes title to the
exported goods until payment is received. The importing firm is able to finance its
purchases and releases funds as inventory is liquidated.
15.7
The
Final
Phase:
Closing
the
Business
(Slides
15-42
to
15-46)
Sometimes, successful solvent firms decide to cease operations, in which case they sell
off their assets, pay off all outstanding debts and expenses, and distribute the residual
value to the stockholders.
When firms are unsuccessful, they may decide to cease operations, declare bankruptcy,
and liquidate their assets; or they may decide to re-organize, attempt to re-establish
themselves, and try to re-emerge as stronger firms.
15.7
(A)
Straight
Liquidation: Chapter 7 of the Federal Bankruptcy Reform Act (1978)
deals with the process that has to be followed when a firm decides to close its business
and liquidate its assets.
Once a firm files for Chapter 7, the bankruptcy court judge appoints a trustee to oversee
the process of liquidation, the order of which is as follows:
Note that common stockholders are last on the list and typically get little to nothing of the
proceeds from the sale of the remaining assets.
15.7
(B)
Reorganization:
Chapter
11
is what some firms file for if their managers feel
that there is a chance that they could re-structure the firm and be worth more alive than
dead. Ina typical re-organization the process is as follows:
First, a petition for Chapter 11 is filed by either the company or by a creditor, and a
bankruptcy court judge either accepts or denies the petition.
If accepted, a date is set by the judge for all claimants to show proof of their claims and
for the firm to establish who exactly the claimants are.
A reorganization plan is presented to the court and must be approved by a majority of the
members of a claimant class.
If the claimants cannot agree on the reorganization plan, the judge may issue a ruling on
all or parts of a plan and thus decree the reorganization plan.
If a minority of classes does not agree to the plan, the judge may listen to their objections
and alter the reorganization plan.
Often, the current managers continue to run the business while it operates under the
reorganization plan, but the court may also appoint a trustee to oversee the operations and
protect the rights of the claimants during this period of time.
The reorganization plan may allow the issuance of new securities and thus add another
set of claimants to the firm.
Old debt may be restructured in terms of both maturity and rates.
The plan itself holds off claimants while the company tries to reorganize and come out of
bankruptcy as a new operating firm.
If a firm fails to make the reorganization plan work, it will probably fall into Chapter 7
bankruptcy.
Questions
1. What are the five stages of a business life cycle? Do all companies go through all
five stages?
There are a number of classifications of the business life cycle; here we will use the
five active phases of startup, growth, maturity, decline, and closing. Not all
companies move through all five phases, some never get past the start-up phase.
2. According to the U.S. Census Bureaus Business Information Tracking System,
what is the failure rate of companies over the first six years?
According to the U.S. Census Bureaus Business Information Tracking System
(BITS), three out of every five employer businesses (businesses that employ others
besides the owners) will close within their first six years.
3. What is the function of the Small Business Administration in regard to business
loans? Who receives the guaranty on the loans?
10. What is the difference between Chapter 7 and Chapter 11 bankruptcies? Why
might Chapter 11 be better for claimants than Chapter 7?
Chapter 7 of the Federal Bankruptcy Reform Act of 1978 deals with straight
liquidation the selling off of the assets of the firm. In Chapter 7 filings, the company
is ceasing all business operations, and the final act of selling off all remaining assets
and distributing these proceeds to the legal claimants is governed by a bankruptcy
court. A Chapter 11 filing entails reorganization of a companys business affairs and
restructuring of its debt. The company in effect asks the court to step between it and
its legal claimants in order to provide the company with an opportunity to work out its
financial difficulties without the claimants taking action. Chapter 11 is for a specific
time period only and is not a permanent solution to the financial difficulties of a
company.
Problems
1. Venture capital required rate of return. Blue Angel Investors has a success ratio of
10% with its venture funding. Blue Angel requires a rate of return of 20% for its
portfolio of lending, and the average length on its loan is five years. If you were to
apply to Blue Angel for a $100,000 loan, what is the annual percentage rate you
would be required to pay for this loan?
ANSWER
Your loan rate means that if one out of ten succeed you need to cover the nine failures
after five years, so if Blue Angel makes 10 loans of $100,000 each, i.e. $1,000,000 and
requires a return of 20% on its lending portfolio, it will have to accumulate the following
amount after 5 years:
$1,000,000 (1.20)5 = $2,488,320. So given a success rate of 1 out of 10 loans, it will
charge you the following rate ($2,488,320 / $100,000)1/5 1 = 0.901872 or 90.1872%
2. Venture capital required rate of return. Red Devil Investors has a success rate of one
project for every four funded. Red Devil has an average loan period of two years and
requires a portfolio return of 25%. If you borrow from Red Devil, what is your annual
cost of capital?
ANSWER
Hint, do this on a per dollar borrowed basis per project funded.
Your loan rate means that if one out of four succeed you need to cover the three failures
after two years:
$4 (1.25)2 = $6.25
Your rate is ($6.25 / $1)1/2 1 = 1.50 or 150%
3. Straight bank loan. Left Bank has a standing rate of 8% (APR) for all bank loans,
and requires monthly payments. What is a monthly payment if a loan is for (a)
$100,000 for five years, (b) $250,000 for ten years, or (c) $1,000,000 for 25 years?
What is the effective annual rate of each of these loans?
ANSWER
For $100,000 over five years
Mode: P/Y = 12, C/Y =12
Input
60
8.0
Keys
N
I/Y
CPT
-100,000
PV
PMT
$2,027.64
0
FV
-250,000
PV
PMT
$3,033.19
0
FV
-1,000,000
PV
PMT
$7,718.16
0
FV
ANSWER
The APR = (1 + 0.0938)1/12 1 12 = 9.0%
For $200,000 over six years
Mode: P/Y = 12, C/Y =12
Input
72
9.0
Keys
N
I/Y
CPT
-200,000
PV
PMT
$3,605.11
0
FV
-450,000
PV
PMT
$5,121.14
0
FV
-1,250,000
PV
PMT
$10,057.78
0
FV
5. Discount loan. Up-Front Bank uses discount loans for all its customers who want
one-year loans. Currently, the bank is providing one-year discount loans at 8%. What
is the effective annual rate on these loans? If you were required to repay $250,000 at
the end of the loan for one year, how much would the bank give you on your loan at
the start of the loan?
ANSWER
Loan Size = $250,000 (1 0.08) = $230,000
Interest Rate = $20,000 / $230,000 = 8.6956522%
6. Discount loan. Up-Front Bank is now offering a two-year discount loan for 10%.
Working backwards, what are the available funds at the start of the loan and the
implied balance at the end of the first year if the total lump sum repayment at the end
of the second year is $400,000? What is the EAR on this loan?
ANSWER
Loan Size = $400,000 (1 0.10) (1 0.10) = $324,000
Implied Balance End of Year One: $324,000 / (1 0.10) = 360,000
EAR = ($400,000 / $324,000)1/2 1 = 11.11%%
Outstanding
Balance
Outstanding
Balance
Outstanding
Balance
Loan A
Loan B
Loan C
Loan D
January
$22,500
$68,000
$0
$53,500
February
$31,000
$82,500
$0
$0
March
$16,000
$96,000
$0
$40,300
April
$24,300
$45,000
$98,000
$0
May
$31,500
$13,200
$92,000
$80,100
June
$48,600
$0
$95,000
$0
July
$37,000
$0
$60,000
$65,900
August
$28,900
$0
$54,000
$0
September
$23,300
$22,000
$36,000
$48,000
October
$24,700
$36,700
$22,000
$0
November
$27,600
$48,200
$0
$46,100
December
$18,500
$55,900
$0
$0
ANSWER
Multiply each balance at the end of each month by 12% / 12 or 1% for that months
interest:
Example: Loan A for January is $22,500 0.01 = $225.00
Interest
Interest
Interest
Interest
Loan A
Loan B
Loan C
Loan D
January
$225.00
$680.00
$0
$535.00
February
$310.00
$825.00
$0
$0
March
$160.00
$960.00
$0
$403.00
April
$243.00
$450.00
$980.00
$0
May
$315.00
$132.00
$920.00
$801.00
June
$486.00
$0
$950.00
$0
July
$370.00
$0
$600.00
$659.00
August
$289.00
$0
$540.00
$0
September
$233.00
$220.00
$360.00
$480.00
October
$247.00
$367.00
$220.00
$0
November
$276.00
$482.00
$0
$461.00
December
$185.00
$559.00
$0
$0
$3,339.00
$4,675.00
$4,570.00
$3,339.00
TOTAL
8. Letter of credit/line of credit. In Problem 7, Loan A and Loan D borrow the same
amount each year. However, Loan A borrows every month, and Loan D borrows
every other month (note that the borrowing for Loan D for January equals the
borrowing for Loan A for January and February). If As We Go Bank charges its
customers for the unused balance, which loan strategy is better if the unused balance
is charged 3% (APR) per month for the bank? Which loan borrowing strategy is
better for the customer?
ANSWER
First find the unused balance each month. Then total that balance and multiply by 0.03/12
for the annual charge on the unused balance.
Outstanding
Balance
Unused Balance
Loan A
Loan A
Outstanding
Balance
Unused Balance
Loan D
Loan D
January
$22,500
$77,500
$53,500
$46,500
February
$31,000
$69,000
$0
$100,000
March
$16,000
$84,000
$40,300
$59,700
April
$24,300
$75,700
$0
$100,000
May
$31,500
$68,500
$80,100
$19,900
June
$48,600
$51,400
$0
$100,000
July
$37,000
$63,000
$65,900
$34,100
August
$28,900
$71,100
$0
$100,000
Septembe
r
$23,300
$66,700
$48,000
$52,000
October
$24,700
$75,300
$0
$100,000
Novembe
r
$27,600
$72,400
$46,100
$53,900
December
TOTAL
$18,500
$81,500
$0
$100,000
$333,900
$856,100
$333,900
$866,100
Interest
$3,339.00
$2,140.25
$3,339.00
$2,165.25
charge
Monthly borrowing under Option A is charged slightly less interest due to its lower
overall unused balance of $10,000.
9. Selling bonds. Astro Investment Bank has the following bond deals under way:
Company
Bond Yield
Commission
Coupon Rate
Maturity
Gravity Belts
8.0%
2% of Sale Price
8.0%
10 years
Invisible Rays
9.0%
3% of Sale Price
12.0%
10 years
Solar Glasses
7.0%
2% of Sale Price
5.0%
20 years
Space Ships
12.0%
4% of Sale Price
0%
20 years
10%
3% of Sale Price
10%
50 years
Lunar Vacations
Determine the net proceeds of each bond and the cost of the bonds for each company in
terms of yield. The bond yield in the table is the market yield before the commission is
charged. Assume that all bonds are semiannual and issued at a par value of $1,000.
ANSWER
For Gravity Belts the market price is:
Mode: P/Y = 2, C/Y =2
Input
20
8.0
Keys
N
I/Y
CPT
PV
$1,000.00
40
PMT
1000
FV
40
PMT
1000
FV
60
PMT
1000
FV
-980.00
PV
Answer:
For Invisible Rays the market price is:
Mode: P/Y = 2, C/Y =2
Input
20
9.0
Keys
N
I/Y
CPT
PV
$1,195.12
-1,159.27
PV
60
PMT
1000
FV
25
PMT
1000
FV
25
PMT
1000
FV
0
PMT
1000
FV
0
PMT
1000
FV
50
PMT
1000
FV
50
PMT
1000
FV
PV
$786.45
-770.72
PV
PV
$97.22
-93.33
PV
Answer:
For Lunar Vacations the market price is:
Mode: P/Y = 2, C/Y =2
Input
100
10.0
Keys
N
I/Y
CPT
PV
$1,000.00
-970.00
PV
CPT
10.3114
10. Selling bonds. Lunar Vacations needs to raise $6,000,000 for its new project (a golf
course on the moon). Astro Investment Bank will sell the bond for a commission of
2.5%. The market is currently yielding 7.5% on twenty-year semiannual bonds. If
Lunar wants to issue a 6% semiannual coupon bond, how many bonds will it need to
sell to raise the $6,000,000?
ANSWER
First find the price of each bond in the market and then discount the bond by the
commission. Take the net price to Lunar Vacations and divide this into the $6,000,000
for the number of bonds needed.
Market price is:
Mode: P/Y = 2, C/Y =2
Input
40
7.5
Keys
N
I/Y
CPT
PV
$845.87
30
PMT
1000
FV
Bond Yield
Commission
Coupon Rate
Maturity
Rawlings
7.0%
2% of Sale Price
0.0%
20 years
Wilson
7.5%
3% of Sale Price
8.5%
20 years
Louis Sluggers
7.5%
2% of Sale Price
9.0%
10 years
Spalding
8.0%
4% of Sale Price
7.0%
20 years
Champions
8.5%
3% of Sale Price
6.5%
30 years
Determine the net proceeds of each bond and the cost of the bonds for each company in
terms of yield. The bond yield in the table is the market yield before the commission is
charged. Assume that all bonds are semiannual and issued at a par value of $1,000.
ANSWER
For Rawlings the market price is:
Mode: P/Y = 2, C/Y =2
Input
40
7.0
Keys
N
I/Y
CPT
PV
$252.57
0
PMT
1000
FV
Yield is:
Mode: P/Y = 2, C/Y =2
Input
40
Keys
N
I/Y
CPT
7.1046
-247.52
PV
0
PMT
1000
FV
42.5
PMT
1000
FV
42.5
PMT
1000
FV
45
PMT
1000
FV
45
PMT
1000
FV
35
PMT
1000
FV
35
PMT
1000
FV
PV
$1,102.75
-1,069.67
PV
PV
$1,104.22
-1,082.14
PV
PV
$901.04
-864.99
PV
PV
$784.07
32.5
PMT
1000
FV
32.5
PMT
1000
FV
-760.55
PV
12. Selling bonds. Rawlings needs to raise $40,000,000 for its new manufacturing plant
in Jamaica. Berkman Investment Bank will sell the bond for a commission of 2.5%.
The market is currently yielding 7.5% on twenty-year zero-coupon bonds. If
Rawlings wants to issue a zero-coupon bond, how many bonds will it need to sell to
raise the $40,000,000?
ANSWER
First find the price of each bond in the market and then discount the bond by the
commission. Take the net price to Rawlings and divide this into the $40,000,000 for the
number of bonds needed.
Market price is:
Mode: P/Y = 2, C/Y =2
Input
40
7.5
Keys
N
I/Y
CPT
PV
$229.34
0
PMT
1000
FV
ANSWER
Proceeds for Lunar Vacations under each type of sales agreement:
Best Efforts 1,000,000 $12 (1 0.025) = $11,700,000
Firm Commitment $10,000,000
Best choice for Lunar Vacations is Best Efforts
Proceeds for Astro Investments under each type of sales agreement:
Best Efforts 1,000,000 $12 (0.025) = $300,000
Firm Commitment 1,000,000 $12 $10,000,000 = $2,000,000
Best choice for Astro Investments is Firm Commitment
14. Firm commitment versus best efforts. Using the information in Problem 13, what is
the break-even sales percentage for Lunar Vacations? What are the proceeds to Lunar
Vacations and Astro Investment Bankers at the break-even sales percentage?
ANSWER
Sales Units $12 (1 0.025) = $10,000,000
Sales Units = $10,000,000 / $11.70 = 854,700 shares
Best Efforts at 854,700 shares
To Lunar Vacations: 854,700 $12 (1 0.025) = $10,000,000
To Astro Investment: 854,700 ($12 $11.70) = $256,410
Firm Commitment at 854,000 sales:
To Lunar Vacations: $10,000,000
To Astro Investments: 854,700 $12 $10,000,000 = $256,410
15. Issuing securities. Bruce Wayne is going public with his new business. Berkman
Investment Bank will be his banker and is doing a best-efforts sale with a 4%
commission fee. Wayne has been authorized 5,000,000 shares for this issue. He plans
on keeping 1,000,000 shares for himself, holding back an additional 200,000 shares
for a green-shoe provision for Berkman Bank, paying off Venture Capitalists with
500,000 shares, and selling the remaining shares at $16 a share. Given the following
bids at the auction, distribute the shares to all bidders using a pro-rata share procedure
and assume Berkman Bankers takes its green-shoe provision. What is the total cash
flow to Wayne after the sale? To Berkman Bankers?
Bidder
Quantity Bid
2,000,000
1,100,000
600,000
Arthur Curry
400,000
Barry Allen
300,000
ANSWER
First determine the number of shares available for the auction:
Authorized:
5,000,000
minus Waynes Holdings 1,000,000
minus Venture Capitalists 500,000
minus green-shoe
200,000
Available
3,300,000
Total bid quantity is 4,400,000 so each bidder receives 3,300,000/4,400,000 or just under
75% of their bid
Gotham Pension gets (3.3 / 4.4) 2,000,000 = 1,500,000
Clark Kent gets (3.3 / 4.4) 1,100,000 = 825,000
Central City gets (3.3 / 4.4) 600,000 = 450,000
Arthur Curry gets (3.3 / 4.4) 400,000 = 300,000
Barry Allen gets (3.3 / 4.4) 300,000 = 225,000
Total Issued at auction is 3,300,000
Proceeds for Wayne is 3,300,000 $16 (1 0.04) = $50,688,000
Proceeds to Berkman Bankers is 3,300,000 $16 0.04 = $2,112,000
16. Issuing securities. Use the same information from Problem 15. What if the auction
bids total only 2,640,000 shares, as follows:
Bidder
Quantity Bid
1,200,000
500,000
400,000
Arthur Curry
300,000
Barry Allen
240,000
What is the distribution of the shares and cash flow to Bruce Wayne if Berkman
Investment Bank declines its green-shoe provision?
ANSWER
First determine the number of shares available for the auction:
Authorized:
5,000,000
minus Waynes Holdings 1,000,000
minus Venture Capitalists 500,000
Available
3,500,000
Total bid quantity is only 2,640,000 so each bidder receives their entire bid.
XYZ Pension gets 1,200,000
Clark Kent gets 500,000
Central City gets 400,000
Arthur Curry gets 300,000
Barry Allen gets 240,000
Total Issued at auction is 2,640,000 and Bruce Wayne (the company) keeps the
remaining shares (3,500,000 2,640,000 = 860,000) as authorized but unissued stock.
Proceeds for Wayne is 2,640,000 $16 (1 0.04) = $40,550,400
Proceeds to Berkman Bankers is 2,640,000 $16 0.04 = $1,689,600
17. Commercial paper. Criss-Cross Manufacturers will issue commercial paper for a
short-term cash inflow. The paper is for 91 days, has a face value of $50,000, and is
anticipated to sell at 96% of par value. Criss-Cross wants to raise $3,000,000, so what
is the cost of this borrowing (annual terms) and how many papers will be sold?
ANSWER
Selling price is 0.96 $50,000 = $48,000
The cost of this borrowing is:
Three-Month Interest Rate = ($50,000 $48,000) / $48,000 = 0.041667
Stated annually we have:
Annual Percentage Rate = 0.041667 4 = 16.67%
Effective Annual Rate = (1 + 0.04167)4 1 = 17.738%.
The total number of papers sold will be:
Number issued
= $3,000,000 / $48,000 = 63(must sell in whole units)
18. Commercial paper. Criss-Cross has decided that it will need to raise more than
$3,000,000 in commercial paper (see Problem 17). Criss-Cross must now raise
$5,000,000, and the paper will have a maturity of 182 days. If this paper has a
maturity value of $50,000 and is selling at an annual interest rate of 9%, what are the
proceeds from each paper, that is, what is the discount rate on the commercial paper?
ANSWER
Discount rate is the stated annual 9% APR but to determine the 182 rate (six month rate)
you need to divide 9% by 2 for the 4.5% or 95.5% of par selling price.
Selling price is $50,000 (1 0.045) = $47,750
Total number of sold is $5,000,000 / $47,750 = 105 (must sell in whole units)
19. Bankruptcy, Chapter 7. Gigantic Furniture is having its annual Going Out of
Business Sale. If Gigantic Furniture is filing under Chapter 7, will it be back next
year for another going out of business sale?
ANSWER:
In a word, NO. Chapter 7 bankruptcy is for the selling off of the assets of the firm and
ceasing all business operations.
20. Bankruptcy, Chapter 7. A customer and an employee are waiting for payment from
Gigantic Furniture after the company has filed for bankruptcy under Chapter 7 of the
IRS bankruptcy laws. The employees claim against Gigantic Furniture is for $500
for health care benefits that were not paid to the health care carrier during the last
month of company operations, plus $300 for the pension plan. The customers claim
is for $400 for a deposit on a specialty sofa that was never shipped. In what order will
the bankruptcy courts pay these claims?
ANSWER
The claims will be paid in this order,
1. The $500 health care claim not paid to the health care carrier for used benefits.
2. The sofa deposit of $400.
3. The unfunded pension plan of $300.
19.00
Scenario 1
400,000
120,000
630,000
180,000
130,000
140,000
1,600,000
Scenario 2
400,000
160,000
630,000
220,000
160,000
230,000
1,800,000
Scenario 3
500,000
200,000
630,000
220,000
200,000
250,000
2,000,000
Scenario 4
500,000
200,000
630,000
280,000
240,000
350,000
2,200,000
Scenario 5
600,000
260,000
630,000
280,000
280,000
350,000
2,400,000
Scenario 6
650,000
350,000
630,000
370,000
400,000
400,000
2,800,000
400,000
120,000
630,000
180,000
130,000
140,000
400,000
2,000,000
400,000
160,000
630,000
220,000
160,000
230,000
200,000
2,000,000
500,000
200,000
630,000
220,000
200,000
250,000
0
2,000,000
454545
181818
572727
254545
218182
318182
0
2,000,000
500000
216667
525000
233333
233333
291667
0
2,000,000
464286
250000
450000
264286
285714
285714
0
2,000,000
$ 7,600,000.00
$ 2,280,000.00
$ 11,970,000.00
$ 3,420,000.00
$ 2,470,000.00
$ 2,660,000.00
$ 7,600,000.00
$ 38,000,000.00
$ 7,600,000.00
$ 3,040,000.00
$ 11,970,000.00
$ 4,180,000.00
$ 3,040,000.00
$ 4,370,000.00
$ 3,800,000.00
$ 38,000,000.00
$ 9,500,000.00
$ 3,800,000.00
$ 11,970,000.00
$ 4,180,000.00
$ 3,800,000.00
$ 4,750,000.00
$
$ 38,000,000.00
$ 8,636,363.64
$ 3,454,545.45
$ 10,881,818.18
$ 4,836,363.64
$ 4,145,454.55
$ 6,045,454.55
$
$ 38,000,000.00
$ 9,500,000.00
$ 4,116,666.67
$ 9,975,000.00
$ 4,433,333.33
$ 4,433,333.33
$ 5,541,666.67
$
$ 38,000,000.00
$ 8,821,428.57
$ 4,750,000.00
$ 8,550,000.00
$ 5,021,428.57
$ 5,428,571.43
$ 5,428,571.43
$
$ 38,000,000.00
4,000,000
5.50
3,800,000
3,768,252
Shares Available
Price Per Share
Volume
3768252.5
350,000 $
900,000
$ 168,500
$ (168,500)
725,389 $
3,700,000
1,000,000
700,000
400,000
3.50
2.64
0.50
$ (3,500,000) $ (1,850,000) $ (200,000) $
3,600,000
Volume
Firm Commitment
Proceeds To Client
Proceeds from Sale
Compensation to McEwing:
Shares Purchased
Cost per Share
NET Compensation
3,000,000
3,300,000
3,600,000
3,700,000
3,768,252
3,800,000
$ 15,922,500 $ 17,514,750 $ 19,107,000 $ 19,637,750 $ 20,000,000 $ 20,168,500
$ 577,500 $ 635,250 $ 693,000 $ 712,250 $ 725,389 $ 731,500
$ 16,500,000 $ 18,150,000 $ 19,800,000 $ 20,350,000 $ 20,725,389 $ 20,900,000
3,300,000
Best Efforts
Volume
Proceeds To Client
Compensation to McEwing:
Total Proceeds from Auction
3,000,000
Difference
Best Efforts vs. Firm Commitment
Client Company
McEwing Investments Bankers
Break Even Quantity for McEwing/Client
$1,500,000
$1,000,000
$500,000
$-
$(500,000)
$(1,000,000)
$(1,500,000)
$(2,000,000)
$(2,500,000)
$(3,000,000)
$(3,500,000)
$(4,000,000)
Solutions
to
Mini-Case
AK Web Developers.com
This case reviews the life cycle of a successful business from angel financing, through
the venture capital stage, and IPO liquidity event. It also covers shorter-term borrowing
decisions and requires computations to determine the lowest cost of borrowing.
1. The 1-year Treasury bill rates for 2002 through 2006 are given below:
Year
2002
2.00%
2003
1.24%
2004
1.89%
2005
3.62%
2006
4.94%
How much interest did MR Venture Capital receive each year? What was the
average interest rate paid by AK Web Developers over the 5-year period?
1 yr T-Bill
Rate on
loan
Interest paid
2002
2.00%
7.00%
$ 420,000.00
2003
1.24%
6.24%
$ 374,400.00
2004
1.89%
6.89%
$ 413,400.00
2005
3.62%
8.62%
$ 517,200.00
2006
4.94%
9.94%
$ 596,400.00
.077296
Or 7.73%
The investment bankers conduct an auction to set the price of the stock.
2,000,000
1995
1996
1997
1998
1999
2000
2001
2,000,000
2002
2003
2004
2005
2006
2007
11,000,000
5. If MR Venture Capital sold its shares at the end of 2007 for the same $22 price,
what
was the rate of return on its investment? Include the interest payments
calculated in question 1.
The cash flows and timeline are as follows:
end of year
2001
(6,000,000.00)
2002
420,000.00
2003
374,400.00
2004
413,400.00
2005
517,200.00
2006
596,400.00
2007
132,000,000.00
irr
70.17%
b) Bancnet offers a one year loan discounted at 6%. How much would AK need
to borrow in order to meet its initial need for $2,000,000? What is the EAR
for this loan?
AK would need to borrow $2,000,000/(1 .06) = $2,127,659.57. The EAR is
.06/(1 .06) = 6.38%
c) Webster Bank offers a one year loan at 6% add-on interest with a
compensating balance of 10%. How much would AK need to borrow in order
to meet its initial need for $2,000,000? What is the EAR for this loan?
AK would need to borrow $2,000,000/(1 .10) = $2,222,222.22. The EAR is
.06/(1 .10) = 6.67%
Calculate the EAR under each option and indicate your choice with an explanation.
Option 1 is a straight loan with PV = $250,000; N=12; PMT = -35,000; FV=0; i9.05%
APR; EAR(1 + (.0905/12))12 1 = 9.43%
Option 2 is an 8% discounted loan, so to have $250,000 we would have to take on a loan
with a face value of $250,000/0.92 = $271, 739.13 which is what we would owe at the
end of 12 months. So our APR = Interest paid/Amount used$21,739.13/$250,000
8.695% which is also our EAR
Option 2 is better!
3. Bond proceeds. The Fire-Keepers Casino is in the process of issuing a 25-year, 9%
coupon (paid semi-annually) AA2-rated corporate bond with $1000 par value. If by
the time the bonds receive SEC clearance, the market yield on this bond goes to
9.35%, and the company sells 25000 of these bonds with the help of an investment
banker who charges them a commission rate of 2.5% on the proceeds, what will the
total proceeds be for the issuing company, and what is the cost of these bonds to the
firm in terms of the cost of capital? What are the firms future cash obligations?
ANSWER
P/Y=2;C/Y=2;N=50;PMT=45;FV=1000;I=9.35; PV$966.38
Gross proceeds from sale of bonds = 2500*$966.38=$2,415,9468.13
Investment bankers commission = .025*$2,415,943.13= $60,398.65
Total proceeds received by the issuing company = $2,355,547.47
Net proceeds per bond = $966.38*(1-.025) = $942.22
Cost of debt to Golden Corral based on net price:
P/Y=2; C/Y=2; PV=-942.22; N=50; PMT=45; FV=1000; I 9.61%
Future cash obligations:
Annual Coupon payments = $45*2*25=00 = $225,000
Principal payment at maturity = $1000*2500 = $2,500,000
4. Firm commitment versus best efforts. Big Apple Investment Bankers offers Northern
Diagnostics the following options on its initial public sale of equity: (1) a best-efforts
arrangement whereby Big Apple will keep 2 % of the retail sales or (2) a firmcommitment arrangement of $6,000,000. Lunar plans on offering 1,000,000 shares at
$7.50 per share to the public. If 100% of the shares are sold, which is the better
choice for Northern Diagnostics? Which is the better choice for Big Apple Investment
Bankers? What is the break-even sales percentage for Northern Diagnostics (point of
indifference) and what will each party receive at the break-even sales percentage?
ANSWER