Solutions to Chapter 14

Venture Capital, IPOs, and Seasoned Offerings

How Corporations Issue Securities

1. a. Subsequent issue. A rights issue requires that there are already existing
shareholders.

b. Seasoned offerings are security issues by firms that are already publicly
traded. Publicly traded firms usually find it advantageous to sell new shares in
a public offering because the public offering is less costly. In contrast, even
publicly traded firms may find it advantageous to make a private placement of
bonds. Such bonds can be issued with unusual terms and allow the firm to
negotiate directly with the bondholders should it later wish to make changes
in the terms of the debt. Therefore, it is more likely that the private placement
is used for the bond issue.

c. Bond issue of large industrial company

2. a. C
b. A
c. B

3. a. A large issue (economies of scale). See Figure 14.1.

b. A bond issue is less expensive

c. Private placements are less expensive for small amounts.

4. Issue costs for debt are less than for equity for several reasons. Underwriting
spreads are lower because there is less risk to the underwriters concerning the price
at which the debt can be placed. Debt is more standard than equity, so it can be
evaluated by and marketed to the public more easily. Underpricing is much less of a
concern because debt issues are far less likely to signal management assessments of
the value of the firm relative to the market price.

5. Issuing in stages rather than fully funding a project all at once serves at least two
goals. First, it keeps the entrepreneur on a “short leash.” There will not be any
excess funds available to squander on luxuries. Moreover, the firm will have to
show good evidence of progress and likely success in order to proceed successfully
to the next stage of financing. Second, staged financing limits the amount of money

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 initially put at risk by the venture capitalist. New money will not be committed
until evidence of the likely success of the firm is forthcoming.
6. You should be suspicious. If the issue were underpriced, preferred customers would
be likely to snap up the offering. If the underwriters have to aggressively market
the issue to the general public, it could be a sign that more knowledgeable investors
are staying away because they view the issue as overpriced.

7. a. Average underpricing may be estimated as the average initial return on the

sample of IPOs:

(7 + 12 – 2 + 23) / 4 = 10%

b. My initial return, weighted by amount invested, is calculated as follows:

Investment Initial Profit

(Shares × price) Return (%) (% return × investment)

A $ 5,000 7 $350
B 4,000 12 480
C 8,000 – 2 −160
D 0 23 0
Total $17,000 $670

Average return = 670/17,000 = .0394 = 3.94%

Alternatively, you can calculate average return as:

× 7 + × 12 + × (−2) = 3.94%

c. My average return is far below the average initial return on the sample of
IPOs. This is because I have received lower allocations of the best performing
IPOs and higher allocations of the poorly performing IPOs. I have suffered
the winner’s curse: On average, I have been awarded greater allocations of
the IPOs that other players in the market knew to stay away from, and my
average performance has suffered as a result.

8. Underwriting costs for Moonscape:

Underwriting spread: $.50 × 3 million = $ 1.5 million

Underpricing: $3.00 × 3 million = 9.0 million
Other direct costs: 0.1 million
TOTAL $10.6 million

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 Funds raised = $8 × 3 million = $24 million
= = .442 = 44.2%

9. a. The offering is both a primary and secondary offering. The firm is selling
500,000 shares (primary) and the existing shareholders are selling 300,000
shares (secondary).

b. Direct costs are as follows:

Underwriting spread: $1.30 × 800,000 = $1.04 million

Other direct costs: 0.40 million
TOTAL $1.44 million

Funds raised = 12 × $800,000 = $9.6 million

= = .15 = 15%

From Figure14.1, direct costs for IPOs in the range of $1 to $10 million (US)
have been around 12%. Direct costs for IPOs in higher ranges have been
lower. The direct costs of this $9.6 million IPO, at 15%, seem to be on the
higher side relative to the size of the issue.

c. If the stock price rises from $12 to $15 a share, we would infer underpricing
of $3 per share. Direct costs per share are $1.44 million/800,000 = $1.80.
Total costs are thus $4.80 per share, which is $4.80/$15 = .32 or 32% of the
market price.

d. Emma Lucullus will sell 25,000 shares and retain 375,000 shares. She will
receive $12 for each of her shares, less $1.80 per share direct costs:
($12 - $1.80) × 25,000 = $255,000.
Notice that we compute per share direct costs as the sum of the underwriting
discount of $1.30 per share and $0.50 per share as the proportion of expenses
payable by selling shareholders ($150,000/300,000).

Her remaining shares, selling at $15 each, will be worth $15 × 375,000 =
$5,625,000.

10. Unlike interest payments, which are made annually, the issue cost is a one time
cost. Rather than adjust the cost of capital, the issue costs should be deducted from
the project’s NPV. Remember that the cost of capital is the required rate of return
to investors in a project with a given level of risk. While flotation costs can reduce
the NPV of a project by requiring an extra cash outflow, they do not affect the rate
of return commensurate with the project’s risk.

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11. a. The price of each share net of the underwriting spread was $21 − $1.31 =
$19.69. Therefore, the firm raised 2 million × $19.69 = $39.38 million by
selling new stock in the primary issue.

b. The existing shareholders sold their 800,000 shares to the underwriters for
total proceeds of 800,000 × 19.69 = $15.752 million.

c. If the underwriters had paid $30 a share, only 1.313 million new shares would
have been required to obtain the same $39.38 million proceeds.

d. If the existing shareholders had sold their 800,000 shares to the underwriters
for $30 rather than $19.69, the increase in their proceeds would have been
800,000 × ($30 –$19.69) = $8.248 million.

12. The lost value to the original shareholders is 2 percent of $600 million = $12
million. This is 12 percent of the value of the funds raised.

13. a. The firm will receive only $30 × (1 – .08) = $27.60 per share. It will need to
issue $3,000,000/$27.60 = 108,696 shares. The gross proceeds from the issue
will be 108,696 × $30 = $3,260,880, and the firm will be left with
$3,000,000 (which it uses in part to pay the other direct costs of the issue).

b. The underwriting spread costs the firm $260,880. Therefore, total direct costs
are $260,880 + $60,000 = $320,880.

c. The total market value of the stock is $30 million. If the share price falls by
3% on the announcement of the offering, the existing shareholders suffer a
loss in value of .03 × $30 million = $0.9 million, or $900,000. This figure is
nearly three times the direct costs of the offering.

14. a. Net proceeds of public issue

= $10,000,000 – $150,000 – $80,000 = $9,770,000

Net proceeds of private placement = $9,970,000

b. The extra interest paid on the private placement equals .005 × $10 million =
$50,000 per year. The present value is $50,000 × annuity factor(8.5%,10
years) = $328,000. This exceeds the savings in direct issue costs, so the public
issue appears to be the better deal. (We use a discount rate of 8.5% rather than
9% because 8.5% is the yield to maturity at which public investors are willing
to invest in the bond when the company pays the cost of the issue directly to
the underwriters. In the private placement, part of the 9% coupon rate should

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 be considered compensation for issuance costs that are not charged for
explicitly.)

c. The private placement is more expensive, but it has the advantages that the
terms of the debt can be custom-tailored and its terms can be more easily
renegotiated.

15. a. The number of new shares is 10 million/4 = 2.5 million. Each share is sold for
$5, so new money raised is $12.5 million.

b. After the issue, there are 12.5 million shares. The total value of the firm is
$60 million (the original value of the firm) plus $12.5 million. The new share
price is $72.5 million/12.5 million shares = $5.80 per share.

16. If the new stock were issued at $4 a share, the company would have needed to issue
$12.5 million/$4 per share = 3.125 million shares. The stock would then sell for
$72.5/13.125 = $5.5238 per share. (The firm will need to issue 3.125 million rights,
meaning that one new share can be purchased for every 3.2 shares currently held.)

Despite the lower stock price, the shareholders are just as well off. In the original
plan an investor who owns 1000 shares would have the right to buy 250 additional
shares for $5 each. The total value of the position would be

1000 × $5.80 + 250 × ($5.80 – $5.00) = $6000

In the modified plan the investor will be able to buy 1000/3.2 = 312.5 shares for $4
each. Total value is the same:

1000 × $5.5238 + 312.5 × ($5.5238 – $4.00) = $6000

17. a. $2 million/200,000 = $10

b. The total value of the firm currently is $20 million, and there are 1 million
shares outstanding. When the rights are exercised, the firm will raise $2
million, and total value will increase to $22 million. Shares outstanding will
increase to 1.2 million. Price per share will be $22/1.2 = $18.3333.

c. The value of each right is the difference between the value of each share after
exercise, $18.3333, and the $10 subscription price (the price the right holder
pays for each share). Each right is therefore worth $8.3333.

d. An investor who holds 1000 shares would receive 200 rights. (The firm
distributes 200,000 rights among its 1 million shares, or 1 right per 5 shares.)

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 e. Before the announcement of the rights offering, the 1000 shares were worth
$20,000. After the announcement, the stock price falls and the shares fall in
value to $18,333. However, the rights are worth 200 × $8.3333 = $1,667.
The value of the rights plus the value of the shares is $20,000. Wealth is
unchanged.

18. a. New shares = 50,000 since one new share will be issued for every two of the
outstanding 100,000 shares.

b. New investment = 50,000 shares × $10 per share = $500,000

c. Value of company = $4,000,000 original value

+ 500,000 new investment
$4,500,000 new value

d. Total number of shares = 100,000 original shares

+ 50,000 new shares
150,000 total shares

e. New share price = $4.5 million/150,000 = $30

19. From the Market Insight Database Shaw Communications Inc. has the higher
price-earnings ratio (14.201 as of April 2008) where as Telus Corp. had a price-
earnings ratio of 10.509 in April 2008. Price-earnings ratio is a function of
dividend growth rate, retention rate and return on equity.

20. During the internet boom years (1999-2000) there were 858 IPOs, 63.6% average
first day returns and an average of US$33.32 billion was left on the table. In
comparison, during 2006-2007, there were 315 IPO’s, average first day returns of
approximately 13.05%, and average amount of money left on the table of US$4.44
billion. Free Markets (FMKT) provided the highest 1-day dollar gain to investor
during 1998-2000. With an IPO date of 10/12/99, Free Market had a US$232 1-day
gain. The offer price was US$48 and the first closing market price was US$280.

21. The payoffs in year 5 to George Pickwick and First Cookham (FC) are as follows:

a. FC buys 2 million shares at $1

This gives FC two-thirds of Pickwick. Thus the possible payoffs at the end of 5
years are determined by splitting up the company value in proportions of 1/3 and
2/3:

Company value in 5 years

after stage 2 financing

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 $2 million $12 million
Payoff to:
G. Pickwick (1 million shares) $0.67 million $ 4 million
FC (2 million shares) $1.33 million $ 8 million

b. FC buys 1 million shares now and invests an additional $1 million in shares in year 5

The possible payoffs are shown next:

Company value in 5 years

after stage 2 financing

$2 million $12 million

Company value in 5 years
before issue of $1 million $1 million $11 million
in 2nd stage financing

Price per share $ 0.50 $ 5.50

(Price = value/2 million shares)

No. of new shares issued to FC $1m/$.50 = $1m/$5.50 =

2 million 0.182 million

Total shares outstanding 4 million 2.182 million

Total shares owned by FC 3 million 1.182 million

% of shares owned by Pickwick .25 .4583

% of all shares owned by FC .75 .5417

Payoff* to:

G. Pickwick (1 million shares) $ 0.5 million $ 5.5 million

FC $ 1.5 million $ 6.5 million

*Payoff equals percentage ownership times total value of firm after issue of stage 2
financing.

Note that by putting up only part of the money now, FC takes on less risk. If the
company does not do well (future value = $2 million), then FC can buy a large
number of shares for the $1 million of stage 2 financing. If the firm does well, FC
receives fewer shares. Staged financing gives George Pickwick more risk and
makes it more important for him to make a success of stage 1.

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 22. As an example, we selected Cadman Resources Inc. Cadman Resources Inc. with
its head office in Mississauga, Ontario is pursuing an IPO offering and proposed
listing on the TSX venture exchange. As a capital pool company, Cadman
Resources Inc. identifies and evaluates assets or businesses in order to complete a
Qualifying Transaction.

Information about directors and management, use of proceeds, and risk factors are
very useful in analyzing a potential investment.

Some information may be quite technical in nature and, therefore, less useful to the
average investor. For instance, the information about the criteria and process of
identification of a Qualifying Transaction would perhaps be appreciated more by an
individual with a business or legal background than by the lay investor.

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 Solution to Minicase for Chapter 14

Underwriting costs for Mutt.com (including costs to the existing shareholders) are:

Underwriting spread: $1.25 × 1.25 million shares = $ 1.56 million

Other direct expenses: = $1.30 million
Underpricing*: $6 × 1.25 million shares = $7.50 million
TOTAL $10.36 million

* Underpricing based on the assumption that the shares could be sold for $24 rather than
$18.

Funds raised = $18 × 1.25 million shares = $22.5 million

Value of shares issued = $24 × 1.25 million shares= $30 million

= = .127 = 12.7%

= = .333 = 33.3%

= = .345 = 34.5%

Notice that we follow convention by reporting the direct costs as a percentage of the
issue price ($18), but total costs as a percentage of the market value of the shares ($24).

The underwriter’s comments miss the point. Of course managers and shareholders prefer
a high price to a low price. For any given price at which the shares are issued, they still
prefer the stock price to rise. However, a very high initial-day return (i.e., evidence of
considerable underpricing) indicates that the shares could have been issued at a higher
price − in other words, that the company “left some money on the table.” To the extent
that the shares are issued at a lower-than-necessary price, the firm gives up some value to
the new shareholders. This is correctly considered a cost of the issue.

Moreover, this is a cost to existing shareholders whether or not they plan to sell their
shares. Underpricing means the firm must sell more new shares to raise the same amount
of cash. Consequently, the existing shareholders end up owning a smaller fraction of the
firm than they would if the shares were issued at a higher price. Their wealth is lower.

Appendix 14A
.

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 1. If you go to the Canadian Venture Capital Association website (at www.cvca.ca),
you will be able to access the directory of venture capital firms which are
members of the association. This directory also lists website addresses of these
venture capital firms. Similarly, the National Venture Capital Association
(NVCA) is the trade association representing the venture capital industry in the
United States. Its website is at www.nvca.com . Through the NVCA website, you
will be able to access information about member venture capital firms. Similarly,
some relevant websites for angel investing include Invest Angels Network at
http://www.angelinvestmentnetwork.ca, and VentureDrive.com at
www.VentureDrive.com.

2. a. Table 14.A3 of the text provides details regarding venture capital investment
activity by stage of development in 2005 and 2006. From details provided by
venture capital firms at the CVCA website (for 2008), it appears that the type
of venture capital firm (i.e. private independent, labour sponsored, etc) does
not necessarily have an association with type of investment strategy. For
instance, New Brunswick Innovation Foundation (NBIF), a New Brunswick-
based private independent fund has a stated preference for seed and start-up
investing. On the other hand, Clairvest Group, another private independent
fund, based in Ontario, prefers to finance expansion (later stage), and
acquisition or buy-out, but no start-ups. Similarly, Canadian Medical
Discoveries Fund, a labour-sponsored venture capital fund, prefers
predominantly early-stage financings (Seed, Startup). But CAI Capital
Management Co., a corporate venture capital fund, prefers expansion,
acquisition or buyout, and turnaround investing.

b. Portfolio theory suggests that a venture capital fund manager may reduce the
portfolio risk of investments by diversification across industries and stages of
development. However, studies (for instance, Norton & Tennenbaum (1993)),
have found that venture capital firms prefer to reduce their risk through
specialization within industries and sometimes syndicating investments with
other venture capital firms. From the CVCA website (for 2008), we see that
different Canadian venture capital firms indeed have different investment
preferences. For instance, Canadian Medical Discoveries Fund prefers to
invest only in the life sciences sector, but ROI Capital, another labour-
sponsored fund states that it will consider Manufacturing, Health Sciences,
and Financial Services industries. Usually, corporate venture capital funds
tend to specialize in specific areas of investment which are tied to the overall
strategic goals of the corporation. However, here also differences abound with
regard to the range of activities. For example, whereas Cinnabar Ventures
Ltd. prefers investing in information technology field, CIBC Capital Partners
has a wider range of investment preferences (all industries). Overall,
according to the CVCA, in recent years there is a trend toward smaller
numbers of investments with larger dollar amounts.

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 c. Venture capital firms do appear to generally prefer investing in regions that
are in close proximity with their own operations. This could provide for easier
and cheaper monitoring of their investments. For instance, from the CVCA
website, as of 2008, InNOVAcorp, a Halifax based venture capital firm,
prefers to invest in businesses which have a presence in Nova Scotia.
Working Ventures has its head quarters in Toronto and branch offices in
Saskatoon and Halifax. Its geographic preferences are Ontario, Saskatchewan
and the Atlantic provinces of New Brunswick, Nova Scotia and Prince
Edward Island.

3. Venture capitalists and angel investors actively work with company management
by contributing their experience and business savvy gained from helping other
companies with similar growth challenges. They also assist investee firms in a
variety of other ways, for instance helping them with their product and marketing
strategies. Many angel investors are themselves successful entrepreneurs and
start-up firms in which they have invested are able to draw upon their skills and
business acumen. Of course, some angels are just “passive” investors and prefer
not to play an active role in the investee firms. When a reputable venture capital
organization invests in a start-up firm, it also provides a signal that the venture
capitalist believes that the start-up has high future growth prospects. This in turn
may enable the start-up firm to get favourable terms in its business dealings with
other organizations. Thus accounting firms may charge reduced audit fees or
advertising agencies may charge concessional rates in the hope that, by building
good relations with the firm now, they will get good business opportunities in the
future when the firm has matured. By working closely with investee firms,
venture capitalists and angels are better able to monitor their investments.
Usually, venture capital firms require one or more seats on the board of directors
of the start-up organization.

4. We note from the NVCA Yearbook 2008 that the level of venture capital
(VC) investment in 2007 was only about 30% of what it used to be during the
boom years (2007: about US$30 billion versus 2000: about US$105 billion).
Out of the 3,200 companies that received funding during 2007, 53% went to
firms in Information Technology sector, followed by firms in
Medical/Health/Life Science sector (31%). Majority of the VC funds went to
expansion (37%) and later stage companies (42%).

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