Tutorial 2 Answers PDF

Tutorial 2 Questions 1. Discuss the reasons why a firm may and may not want to go for an initial public offering (IPO). Benefits Challenges  To enhance firm reputation  Legal, accounting, marketing costs  To...

Tutorial 2 Questions 1. Discuss the reasons why a firm may and may not want to go for an initial public offering (IPO). Benefits Challenges  To enhance firm reputation  Legal, accounting, marketing costs  To attract analysts’ attention  Underwriting fees are substantial  To establish firm market value  Additional regulatory requirements  To diversify ownership base (remember (e.g. reporting, auditing, taxation) block-holders?)  Exposes firm to public scrutiny  To enhance transparency and  Management has additional disclosure of firm performance and responsibilities outside the firm operations  Corporate Governance compliance may  Shares issued can be used for future dilute control in management M&A  Funding target may not be achieved  May lower cost of capital (T&C apply) 2. Why do firms choose to underprice their IPOs? Over- or under-subscription of a firm’s IPO sends a strong signal to the financial markets on how appealing the firm is to investors. In other words, it reflects the level of confidence investors have of the firm after being provided necessary and relevant information of the firm through the prospectus. An oversubscription sends a positive signal to markets as it indicates a high level of confidence while an undersubscription sends a negative signal, indicating a low-level confidence. News of the under- subscription will eventually break out and may have adverse effects on the company’s share prices. Undersubscription also means the company is not able to raise the required amount of funding they need to launch their projects. To avoid undersubscription, firms deliberately underpriced their IPOs to make the firm a more appealing investment prospect to investors. The lower IPO price helps lower information asymmetries between the firm and investors thereby reducing the risks investors undertake when investing in the firm. By lowering the IPO price, the firm also makes the IPO more accessible to a wider pool of investors thereby ensuring a higher likelihood of full subscription.  3. Compare and contrast between venture capital and angel investment. Which would be more suitable for new business creation? Venture Capitalist Angel Investors Corporate entities that use funds Wealthy individuals or groups of from other investors; individuals – provide amount of finance between RM5k and RM500k) Take on larger projects; Take on smaller projects; Interested in more established Interested in the early formation companies that are looking for cash stage of new companies; to finance growth; More structure formation; and Have no structure in setting up company; and Involved in management and Less rigorous involvement in placement on the board. management but may require board seat or can be an active role on board. For a wholly new business that is yet to be established, angel investment would be more suitable as firstly, the funding amounts are much smaller and more suitable to be utilized for a starting up. VCs often seek to provide large sums of funding (above a million). Also, angel investment agreements are far more flexible, which allows the business owner more space to exercise his creative ability to build the company. VCs on the other hand often seek to be a part of the operations or management due to the amount of money invested. 4. If you are an investor (venture capitalist or angel investor), what components of the start-up will you pay attention to before making a decision? There are many possible factors to look out for in evaluating a business. Among the most common are (in no particular order): The founder’s / owner’s aptitude and attitude in running the business The scalability of the business, i.e. its ability to expand The unique selling point (USP) of its product / service offering If the business already has an operating history, how has it been conducting itself (e.g. sales, expenses) The strategic direction of the business  5. What opportunities and challenges do crowdfunding create for firms in the 21st century? Crowdfunding provides businesses with a simple, easy-to-use, and accessible source of funding by connecting it to a global pool of investors. As most crowdfunding platforms operate on a pledge or ‘donation’ basis, firms especially small start-ups do not have to bear large upfront costs of raising funds. The pledge-basis also somewhat eases the pressure on small firms to perform as it is non- committal i.e. the funders know that there is a chance they might not receive the product/service. This lowers the cost of failure, giving founders more space and flexibility to create new and innovative products/services. Its model of allowing overfunding (or oversubscription) also gives founders the incentive to create products/services that have global appeal. However, crowdfunding platforms can be costly since all of them take a cut off the total amount raised. Some platforms also impose restrictions that require the firm to reach its funding target before funds are disbursed. While some may argue that this limits the firm’s potential, others say that it acts as a motivator for the founders to work harder to produce a product/service that the market wants. Also, although crowdfunding is providing more funding opportunities for small businesses and start-ups, international laws especially on fund transfers and trade still create barriers for these enterprises to grow. Furthermore, as everything is online-based, business owners still face the difficult task of building trust with their target funders. Problems 1. You are the CFO of a company that has 100 million shares outstanding. Its shares are currently trading at RM10 per share from its issue price of RM8. You need to raise RM200 million and have announced a rights issue. Each existing shareholder is sent one right for every share he/she owns. You have not decided how many rights you will require to purchase a share of new stock. You can either: a. Require four rights to purchase one share at a price of RM8 per share or; b. Require five rights to purchase two shares at a price of RM5 per share. Which approach will raise more money? Will your shareholders exercise these rights? Explain your answer and show all the calculations. Strategy New Share Issuance New Firm Value Total Share Price per share post- Outstanding issue 1 RM200m / RM8 per RM1bn + RM200m = 100m + 25m = 125m RM1.2bn / 125m share = 25m units RM1.2bn shares shares = RM9.60 per share 2 RM200m / RM5 per RM1bn + RM200m = 100m + 40m = 140m RM1.2bn / 140m share = 40m units RM1.2bn shares shares = RM8.57 per share Strategy Price per share post- Original issue Decision issue price 1 RM1.2bn / 125m shares RM8 The post-issue price is greater than the = RM9.60 per share original price – shareholders will exercise their rights 2 RM1.2bn / 140m shares RM8 The post-issue price is greater than the = RM8.57 per share original price – shareholders will exercise their rights Note: What we are observing here is a dilution of share price, i.e., because the total number of shares has risen, its price falls. Whichever strategy is used, the amount of money raised is still the same (RM200 million). Also, we can expect shareholders to exercise their rights if the price per share post-issue is greater than the original issue price*. An alternative view (which does happen quite often in practice) is to compare the current traded share price and the post-issue price. In this question, the current traded price is RM10. If the shareholders and the markets believe that the firm’s shares are truly worth RM10, then even after this issue, prices will rise again to RM10. Even if share prices may be diluted now, shareholders will hold more shares, and when the price of the shares rise again to RM10, their wealth will effectively have grown as well. 2. Your firm has 10 million shares outstanding, and you are about to issue 5 million new shares in an IPO. The IPO price has been set at RM20 per share, and the underwriting spread is 7%. The IPO is a big success with investors, and the share price rises to RM50 on the first day of trading. a. How much did your firm raise from the IPO? b. What is the market value of the firm after the IPO? c. Assume that the post-IPO value of your firm is its fair market value. Suppose your firm could have issued shares directly to investors at their fair market value – assuming no underwriting spread and no underpricing. What would be the share price in this case if you raised the same amount as in (a)? d. Comparing (b) and (c), what is the total cost to the firm’s original investors due to market imperfections from the IPO? a. 5 million new shares x RM20 per share = RM100 million raised Less: 7% underwriting spread = RM100 million – (7% x RM100 million) = RM7 million Total raised = RM93 million b. 10mn shares outstanding + 5mn new shares = 15mn shares outstanding Current share price = RM50 Market value = RM50 x 15mn shares outstanding = RM750 million c. Amount raised = RM93 million The current market value of the firm = RM750 million If funds were not raised through IPO, firm market value = RM750 million – RM93 million = RM657 million Price per share would then be = RM657 million / 10mn shares [because no IPO issued] = RM65.70 The key to (c) is the assumption that the post-IPO value (RM750mn) is the firm’s fair market value, i.e., this RM750mn takes into consideration everything the firm is worth. We deduct the amount raised (RM93mn) to determine what the firm's value would be if the IPO was not issued, then divide this sum by 10mn shares, which were the original shares outstanding. d. In (b), the market price per share = RM50 In (c), the estimated price per share = RM65.70 The unrealized cost to current shareholders = (RM65.70 – RM50) x 10mn shares = RM157 mn  3. MK currently has 10 million shares of stock outstanding at a price RM40 per share. The company would like to raise money and has announced a right issue. Every existing shareholder will be sent one right per share of stock that he/she owns. The company plans to require five rights to purchase one share at a price of RM40 per share. a. Assuming the rights issue is successful, how much money will it raise? What will the share price be after the rights issue? b. Suppose the firm changes the plan so that each right gives the holder the right to purchase one share at RM8 per share. How much money will the new plan raise? What will the share price be after this new plan? c. Which plan is better for the firm’s shareholders? Which is more likely to raise the full amount of capital? a. Rights issue of 5:1, at RM40 per share If the rights issue is successful (i.e., fully exercised), then the total share issuance will be 10mn / 5 = 2mn shares issued. 2mn shares issued x RM40 per share (rights price) = RM80 million raised Total shares outstanding = 10mn + 2mn = 12mn Current price per share = RM40; Total shares outstanding = 10mn Current market value = RM40 x 10mn = RM400mn New share price = (RM400mn + RM80mn raised) / (10mn shares + 2mn issued) = RM40 b. Rights issue of 1:1, at RM8 per share 10mn / 1 = 10mn shares issued 10mn shares issued x RM8 per share (rights price) = RM80 million raised Total shares outstanding = 10mn outstanding + 10mn issued = 20mn Current price per share = RM40; total shares outstanding = 10mn Current market value = RM40 x 10mn = RM400mn New share price = (RM400mn + RM80mn raised) / (10mn shares + 10mn issued) = RM24 c. Strategy Post-issue price Original Issue Gain/Loss Value of owning price shares 1 RM40 RM40 RM40 – RM40 = 0 RM40 2 RM24 RM8 RM24 – RM8 = RM16 RM24 + RM16 = RM40 Mathematically, the outcomes of both strategies are the same and thus, shareholders should be indifferent to the strategies. However, the likelihood of shareholders fully exercising Strategy 1 is lower since the post-issue and original issue prices are the same, so shareholders may be indifferent (not to mention the price!). Strategy 2, in contrast, creates an unrealized gain of RM16 for shareholders (cost: RM8, post-issue price: RM24). Recall also from Problem 1 that even though share prices may be diluted now if the market truly believes that the firm is worth more, then prices will rise again to RM40, giving investors an additional unrealized gain of RM16 per share just for holding on to the rights issue.