Fundamentals of Corporate Finance

Third European Edition

Solutions Manual
Chapter 14

Basic
1. Long-Term Financing New equity issues are generally only a small portion of all new
issues. At the same time, companies continue to issue new debt. Why do companies
tend to issue little new equity but continue to issue new debt?
Answer: A company has to issue more debt to replace the old debt that comes due if the
company wants to maintain its capital structure. There is also the possibility that the market
value of a company continues to increase (we hope). This also means that to maintain a
specific capital structure on a market value basis the company has to issue new debt, since
the market value of existing debt generally does not increase as the value of the company
increases (at least by not as much).

2. Rights Issues Again plc. is proposing a rights offering. Currently there are 350,000
shares outstanding at £85 each. There will be 70,000 new shares offered at £70
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) Ignoring regulations, why might a company have a rights offering rather than a
general cash offer?
Answer:
a. The new market value will be the current shares outstanding times the stock price plus the
rights offered times the rights price, so:

New market value = 350,000(£85) + 70,000(£70) = £34,650,000

b. The number of rights associated with the old shares is the number of shares outstanding
divided by the rights offered, so:

Number of rights needed = 350,000 old shares/70,000 new shares = 5 rights per new share

c. The new share price will be the new market value of the company divided by the total
number of shares outstanding after the rights offer, which will be:

PX = £34,650,000/(350,000 + 70,000) = £82.50

d. The value of the right

Value of a right = £85.00 – 82.50 = £2.50

e. A rights offering usually costs less, it protects the proportionate interests of existing share-
holders and also protects against underpricing.

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3. Venture Capital What is the difference between venture capital financing and other
forms of external financing? What factors influence a firm’s choices of venture
capital financing versus other forms of equity financing?
Answer: Venture capital funding is used when other forms of external financing are not
available to a firm. Small companies and those that are unable to attract stock exchange
funding will seek out private financing such as from venture capitalists.

4. Rights Issues Faff plc. has announced a rights issue to raise £50 million for a new
journal, the Journal of Financial Excess. This journal will review potential articles
after the author pays a non-refundable reviewing fee of £5,000 per page. The equity
currently sells for £40 per share, and there are 5.2 million shares outstanding.
(a) What is the maximum possible subscription price? What is the minimum?
(b) If the subscription price is set at £35 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.
Answer:
a. The maximum subscription price is the current share price, or £40. The minimum price is
anything greater than £0.

b. The number of new shares will be the amount raised divided by the subscription price, so:

Number of new shares = £50,000,000/£35 = 1,428,571 shares

And the number of rights needed to buy one share will be the current shares outstanding
divided by the number of new share offered, so:

Number of rights needed = 5,200,000 shares outstanding/1,428,571 new shares = 3.64

c. A shareholder can buy 3.64 rights on shares for:

3.64(£40) = £145.60

The shareholder can exercise these rights for £35, at a total cost of:

£145.60 + 35.00 = £180.60

The investor will then have:

Ex-rights shares = 1 + 3.64

Ex-rights shares = 4.64

The ex-rights price per share is:

PX = [3.64(£40) + £35]/4.64 = £38.92

So, the value of a right is:

Value of a right = £40 – 38.92 = £1.08

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d. Before the offer, a shareholder will have the shares owned at the current market price, or:

Portfolio value = (1,000 shares)(£40) = £40,000

After the rights offer, the share price will fall, but the shareholder will also hold the rights,
so:

Portfolio value = (1,000 shares)(£38.92) + (1000 rights)(£1.08) = £40,000

5. Rights Stone Shoe plc. has concluded that additional equity financing will be needed
to expand operations, and that the needed funds will be best obtained through a
rights issue. It has correctly determined that, as a result of the rights issue, the share
price will fall from £80 to £74.50 (£80 is the ‘rights-on’ price; £74.50 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 £40. 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.)
Answer: Using the equation we derived in Problem 4, part c to calculate the price of the equity
ex-rights, we can find the number of rights needed to buy a share which is:

PX = £74.50 = [N(£80) + £40]/(N + 1)

N = 6.273

The number of new shares is the amount raised divided by the per-share subscription price, so:

Number of new shares = £15,000,000/£40 = 375,000

And the number of old shares is the number of new shares times the number of rights needed
to buy one share, so:

Number of old shares = 6.273(375,000) = 2,352,273

6. IPO Underpricing Baden plc. and Powell plc. have both announced IPOs at £4.00 per
share. One of these is undervalued by £1.10, and the other is overvalued by £0.60,
but you have no way of knowing which is which. You plan on buying 1,000 shares of
each issue. If an issue is underpriced, it will be rationed, and only half your order will
be filled. If you could get 1,000 shares in Baden and 1,000 shares in Powell, what
would your profit be? What profit do you actually expect? What principle have you
illustrated?
Answer: If you receive 1,000 shares of each, the profit is:

Profit = 1,000(£1.10) – 1,000(£.60) = £500

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Since you will only receive one-half of the shares of the oversubscribed issue, your profit will
be:

Expected profit = 500(£1.10) – 1,000(£.60) = –£50

This is an example of the winner’s curse.

7. Calculating Flotation Costs Educated Horses plc. needs to raise £60 million to
finance its expansion into new markets. The company will sell new shares of equity
via a general cash offering to raise the needed funds. If the offer price is £21 per
share and the company’s underwriters charge a 9 per cent spread, how many shares
need to be sold?
Answer: Using X to stand for the required sale proceeds, the equation to calculate the total
sale proceeds, including flotation costs is:

X(1 – .09) = £60,000,000

X = £65,934,066 required total proceeds from sale.

So the number of shares offered is the total amount raised divided by the offer price, which is:

Number of shares offered = £65,934,066/£21 = 3,139,717

8. Calculating Flotation Costs In the previous problem, if the stock exchange filing fee
and associated administrative expenses of the offering are £900,000, the offer price is
£21 per share and the company’s underwriters charge a 9 per cent spread, how many
shares need to be sold?
Answer: This is basically the same as the previous problem, except we need to include the
£900,000 of expenses in the amount the company needs to raise, so:

X(1 – .09) = (£60,000,000 + 900,00)

X = £66,923,077 required total proceeds from sale.

Number of shares offered = £66,923,077/£21 = 3,186,813

9. Calculating Flotation Costs Groene Heuvels NV has just gone public. Under a firm
commitment agreement, Groene Heuvels received €19.75 for each of the 5 million
shares sold. The initial offering price was €21 per share, and the equity rose to €26
per share in the first few minutes of trading. Groene Heuvels paid €800,000 in direct
legal and other costs and €250,000 in indirect costs. What was the flotation cost as a
percentage of funds raised?
Answer: We need to calculate the net amount raised and the costs associated with the
offer. The net amount raised is the number of shares offered times the price received by the
company, minus the costs associated with the offer, so:

Net amount raised = (5M shares)(€19.75) – 800,000 – 250,000 = €97.7M

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The company received €97.7 million from the equity offering. Now we can calculate the direct
costs. Part of the direct costs are given in the problem, but the company also had to pay the
underwriters. The equity was offered at €21 per share, and the company received €19.75 per
share. The difference, which is the underwriters spread, is also a direct cost. The total direct
costs were:

Total direct costs = €800,000 + (€21 – 19.75)(5M shares) = €7.05M

We are given part of the indirect costs in the problem. Another indirect cost is the immediate
price appreciation. The total indirect costs were:

Total indirect costs = €250,000 + (€26 – 21)(5M shares) = €25.25M

This makes the total costs:

Total costs = €7.05M + 25.25M = €32.3M

The floatation costs as a percentage of the amount raised is the total cost divided by the
amount raised, so:

Flotation cost percentage = €32.3M/€97.7M = .3306 or 33.06%

10. Price Dilution Yksinäinen Oyj has 100,000 shares of equity outstanding. Each share is
worth €5. Suppose Yksinäinen firm issues 20,000 new shares at the following prices:
€5, €4.5 and €4. What will the effect be of each of these alternative offering prices
on the existing price per share?
Answer: The number of rights needed per new share is:
Number of rights needed = 100,000 old shares/20,000 new shares = 5 rights per new share.

Using PRO as the rights-on price, and P S as the subscription price, we can express the price per
share of the equity ex-rights as:

PX = [NPRO + PS]/(N + 1)

a. PX = [5(€5) + €5]/6 = €5; No change.

b. PX = [5(€5) + €4.50]/6 = €4.92; Price drops by €0.08 per share.

c. PX = [5(€5) + €74]/6 = €4.83; Price drops by €.17 per share.

INTERMEDIATE

11. Dilution Larme SA wishes to expand its facilities. The company currently has 10
million shares outstanding, and no debt. The equity sells for €50 per share, but the
book value per share is €40. Net income for Larme is currently €15 million. The new
facility will cost €35 million, and it will increase net income by €500,000.

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(a) Assuming a constant price–earnings ratio, what will the effect be of issuing new
equity to finance the investment? To answer, calculate the new book value per
share, the new total earnings, the new EPS, the new share price, and the new
market-to-book ratio. What is going on here?
(b) What would the new net income for Larme have to be for the share price to remain
unchanged?
Answer:
a. The number of shares outstanding after the equity offer will be the current shares
outstanding, plus the amount raised divided by the current share price, assuming the
share price doesn’t change. So:

Number of shares after offering = 10M + €35M/€50 = 10.7M

The old book value is €40 per share. From the previous calculation, we can see the
company will sell 700,000 shares, and these will have a book value of €50 per share. The
sum of old book value per share (€40) times number of old shares outstanding (10M) and
book value per share for new shares issued (€50) times number of new shares issued
(.7M)will give us the total book value of the company. If we divide this by the new number
of shares outstanding we find the new book value per share:

New book value per share = [10M(€40) + .7M(€50)]/10.7M = €40.65

The current EPS for the company is:

EPS0 = NI0/Shares0 = €15M/10M shares = €1.50 per share

And the current P/E is:

(P/E)0 = €50/€1.50 = 33.33

If the net income increases by €500,000, the new total earnings will be:
NI1 = €15 M + €0.5M = €15.5 M
And the new EPS will be:

EPS1 = NI1/shares1 = €15.5M/10.7M shares = €1.45 per share

Assuming the P/E remains constant, the new share price will be:

P1 = (P/E)0(EPS1) = 33.33(€1.45) = €48.29

The current market-to-book ratio is:

Current market-to-book ratio = €50/€40 = 1.25

Using the new share price and book value per share, the new market-to-book ratio will be:

New market-to-book ratio = €48.29/€40.65 = 1.1877

Accounting dilution has occurred if we look at the EPS numbers as EPS 1 <EPS0. However, if
we look at BVPS numbers, they suggest there is no accounting dilution as BVPS 1 > BVPS0.
Market value dilution has occurred because the firm financed a negative NPV project. The

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cost of the project is given at €35 million. The NPV of the project is the new market value
of the firm minus the current market value of the firm minus the cost of the project, or:

NPV = –€35M + [10.7M(€48.29) – 10M(€50)] = –€18,333,333

b. For the price to remain unchanged when the P/E ratio is constant, EPS must remain
constant. The new net income must be the new number of shares outstanding times the
current EPS, which gives:

NI1 = (10.7M shares)(€1.50 per share) = €16.05M

12. Dilution Elvis Heavy Metal Mining (EHMM) plc. wants to diversify its operations.
Some recent financial information for the company is shown here:

Share price (£) 98

Number of shares outstanding 14,000
Total assets (£) 6,000,000
Total liabilities (£) 2,400,000
Net income (£) 630,000

EHMM is considering an investment that has the same P/E ratio as the firm. The cost
of the investment is £1,100,000, and it will be financed with a new equity issue. The
return on the investment will equal EHMM’s current ROE. What will happen to the
book value per share, the market value per share, and the EPS? What is the NPV of this
investment? Does dilution take place?
Answer: The current ROE of the company is:

ROE0 = NI0/TE0 = £630,000/£3,600,000 = .1750 or 17.50%

The new net income will be the ROE times the new total equity, or:
NI1 = (ROE0)(TE1) = .1750(£3,600,000 + 1,100,000) = £822,500

The company’s current earnings per share are:

EPS0 = NI0/Shares outstanding0 = £630,000/14,000 shares = £45.00

The number of shares the company will offer is the cost of the investment divided by the
current share price, so:

Number of new shares = £1,100,000/£98 = 11,224

The earnings per share after the equity offer will be:

EPS1 =£822,500/25,224 shares = £32.61

The current P/E ratio is:

(P/E)0 = £98/£45.00 = 2.178

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Assuming the P/E remains constant, the new stock price will be:

P1 = 2.178(£32.61) = £71.01

The current book value per share and the new book value per share are:

BVPS0 = TE0/shares0 = £3,600,000/14,000 shares = £257.14 per share

BVPS1 = TE1/shares1 = (£3,600,000 + 1,100,000)/25,224 shares = £186.33 per share

So the current and new market-to-book ratios are:

Market-to-book0 = £98/£257.14 = 0.38

Market-to-book1 = £71.01/£186.33 = 0.38

The NPV of the project is the new market value of the firm minus the current market value
of the firm minus the cost of the project, or:

NPV = –£1,100,000 + [£71.01(25,224) – £98(14,000)] = –£680,778

Accounting dilution takes place here because the market-to-book ratio is less than one.
Market value dilution has occurred since the firm is investing in a negative NPV project.

13. Dilution In the previous problem, what would the ROE on the investment have to be
if we wanted the price after the offering to be £98 per share? (Assume the P/E ratio
remains constant.) What is the NPV of this investment? Does any dilution take place?
Answer:
The current P/E ratio is:
(P/E)0 = £98/£45 = 2.178
Using the P/E ratio to find the necessary EPS after the equity issue, we get:

P1 = £98 = 2.178(EPS1)
EPS1 = £45.00

The number of shares the company will offer is the cost of the investment divided by the current
share price, so:
Number of new shares = £1,100,000/£98 = 11,224.

The additional net income level must be the EPS times the new shares issued, so:

Additional NI = £45(11,224 shares) = £505,102

And the new ROE on the investment is:
ROE1 = £505,102/£1,100,000 = .4592

Next, we need to find the NPV of the project. The NPV of the project is the new market value
of the firm minus the current market value of the firm minus the cost of the project, or:

NPV = –£1,100,000 + [£98(25,224) – £98(14,000)] = £0

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The current book value per share and the new book value per share are:
BVPS0 = TE0/shares0 = £3,600,000/14,000 shares = £257.14 per share
BVPS1 = TE1/shares1 = (£3,600,000 + 1,100,000)/25,224 shares = £186.33 per share

Accounting dilution still takes place, as BVPS still falls from £257.14 to £186.33, but no
market dilution takes place because the firm is investing in a zero NPV project.

14. Rights Hoobastink Manufacturing is considering a rights offer. The company has
determined that the ex-rights price would be €52. The current price is €55 per share,
and there are 5 million shares outstanding. The rights issue would raise a total of €60
million. What is the subscription price?
Answer: The number of new shares is the amount raised divided by the subscription price, so:

Number of new shares = €60M/PS

And the number of rights needed to buy a share (N) is equal to:

N = Old shares outstanding/New shares issued

N = 5M/(€60M/PS)
N = 0.0833PS

We know the equation for the ex-rights share price is:

PX = [NPRO + PS]/(N + 1)

We can substitute in the numbers we are given, and then substitute the two previous
results. Doing so, and solving for the subscription price, we get:

PX = €52 = [N(€55) + PS]/(N + 1)

€52 = [55(0.0833PS) + PS]/(0.0833PS + 1)
€52 = 5.58PS/(1 + 0.0833PS)
PS = €41.60

CHALLENGE

15. Value of a Right Show that the value of a right just prior to expiration can be written
as

Value of a right = PRO  PX = (PRO  PS)/(N + 1)

where PRO, PS and PX stand for the rights-on price, the subscription price and the ex-
rights price, respectively, and N is the number of rights needed to buy one new share
at the subscription price.

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Answer: Using PRO as the rights-on price, and PS as the subscription price, we can express the
price per share of the equity ex-rights as:

PX = [NPRO + PS]/(N + 1)

And the equation for the value of a right is:

Value of a right = PRO – PX

Substituting the ex-rights price equation into the equation for the value of a right and
rearranging, we get:

Value of a right = PRO – {[NPRO + PS]/(N + 1)}

Value of a right = [(N + 1)PRO – NPRO – PS]/(N+1)
Value of a right = [PRO – PS]/(N + 1)

16. Selling Rights Wuttke plc. wants to raise £3.65 million via a rights issue. The
company currently has 490,000 ordinary shares outstanding that sell for £30 per
share. Its underwriter has set a subscription price of £22 per share, and will charge
Wuttke a 6 per cent spread. If you currently own 6,000 shares of equity in the
company and decide not to participate in the rights issue, how much money can you
get by selling your rights?

The net proceeds to the company on a per share basis is the subscription price times one
minus the underwriter spread, so:
Net proceeds to the company = £22(1 – 0.06) = £20.68 per share
So, to raise the required funds, the company must sell:
New shares offered = £3.65M/£20.68 = 176,499
The number of rights needed per share is the current number of shares outstanding divided by
the new shares offered, or:
Number of rights needed = 490,000 old shares/176,499 new shares
Number of rights needed = 2.78 rights per share
The ex-rights share price will be:
PX = [NPRO + PS]/(N + 1)
PX = [2.78(£30) + 20.68]/3.78 = £27.53
So, the value of a right is:
Value of a right = £30 – 27.53 = £2.47
And your proceeds from selling your rights will be:
Proceeds from selling rights = 6,000(£2.47) = £14,808.46

17. Valuing a Right Mitsi Inventory Systems has announced a rights offer. The company
has announced that it will take four rights to buy a new share in the offering at a
subscription price of €40. At the close of business the day before the ex-rights day
the company’s shares sell for €80 per share. The next morning you notice that the
equity sells for €72 per share and the rights sell for €6 each. Are the equity and/or
the rights correctly priced on the ex-rights day? Describe a transaction in which you

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could use these prices to create an immediate profit.

Answer: Using the equation for valuing an equity ex-rights, we find:

PX = [NPRO + PS]/(N + 1)
PX = [4(€80) + €40]/5 = €72

The equity is correctly priced. Calculating the value of a right, we find:

Value of a right = PRO – PX

Value of a right = €80 – 72 = €8

So, the rights are underpriced. You can create an immediate profit on the ex-rights day if the
equity is selling for €72 and the rights are selling for €6 by executing the following transactions:
Buy 4 rights in the market for 4(€6) = €24. Use these rights to purchase a new share at the
subscription price of €40. Immediately sell this share in the market for €72, creating an instant
€8 profit.

18. Equity Finance “In a public share issue, the probability of receiving an allocation of
an underpriced security is less than or equal to the probability of receiving an
allocation of an overpriced issue.” Discuss this statement in the context of initial
public offerings.
Answer: This is known as the winner’s curse. Underpriced securities will be oversubscribed and
so bidders will only receive a fractional amount of shares that they bid for. In contrast,
overpriced IPOs will be undersubscribed meaning that bidders will receive the full amount of
their order.

Mini-Case Questions

Questions 1-3
West Coast Yachts Goes Public
Larissa Warren and Dan Ervin have been discussing the future of West Coast Yachts. The
company has been experiencing fast growth, and the future looks like clear sailing. However,
the fast growth means that the company's growth can no longer be funded by internal sources,
so Larissa and Dan have decided the time is right to take the company public. To this end, they

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have entered into discussions with the bank of Crowe & Mallard. The company has a working
relationship with Robin Perry, the underwriter who assisted with the company's previous bond
offering. Crowe & Mallard has helped numerous small companies in the IPO process, so Larissa
and Dan feel confident with this choice.
Robin begins by telling Larissa and Dan about the process. Although Crowe & Mallard charged
an underwriter fee of 4 per cent on the bond offering, the underwriter fee is 7 per cent on all
initial equity offerings of the size of West Coast Yachts' initial offering. Robin tells Larissa and
Dan that the company can expect to pay about £1,200,000 in legal fees and expenses, £12,000
in registration fees, and £15,000 in other filing fees. Additionally, to be listed on the London
Stock Exchange, the company must pay £100,000. There are also transfer agent fees of £6,500
and engraving expenses of £450,000. The company should also expect to pay £75,000 for other
expenses associated with the IPO.
Finally, Robin tells Larissa and Dan that to file with the London Stock Exchange the company
must provide three years' worth of audited financial statements. She is unsure of the costs of
the audit. Dan tells Robin that the company provides audited financial statements as part of its
bond indenture, and the company pays £300,000 per year for the outside auditor.

Question 1
In discussing the IPO with Larissa and Dan, Crowe and Mallard say that they will underwrite
the issue on a firm commitment basis. Is this a good thing for West Coast Yachts?

Answer: Firm commitment underwriting allows the firm to transfer the risk of there being
unsold shares and the full amount not being raised from the issuer to the underwriter. From
the perspective of West Coast Yachts then this is a good thing, as they will receive the full
agreed-upon amount.

Question 2
Since Crowe and Mallard are willing to underwrite the issue on a firm commitment basis,
what does this signal about the West Coast Yacht IPO?

Answer: Firm commitment underwriting is a signal that the underwriter is confident in the
quality of the issue and that all shares will be sold on going to the market. If the issue is not
completely sold, then the underwriter is left with full financial responsibility for the unsold
shares, and this is a cost to the underwriter.

Question 3
Since Larissa has to explain to the employees about their options, she has to explain why a
lock-up period exists and asks you to explain this to her. A lock-up period exists because it:

Answer: Lock-up periods exist to prevent the market being flooded with shares. In many
instances the number of shares that are locked-up can exceed the amount in public hands.
As a result, if all of these shares were to hit the market at one time on the IPO, then the
price of the newly issued shares could fall substantially as there is an oversupply.

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