Exam 18: Initial Public Offerings, investment Banking, and Financial Restructuring

When a firm refunds a debt issue,the firm's stockholders gain and its bondholders lose.This points out the risk of a call provision to bondholders and explains why a non-callable bond will typically command a higher price than an otherwise similar callable bond.

Exhibit 18.1 Five years ago, NorthWest Water (NWW) issued $50,000,000 face value of 30-year bonds carrying a 14% (annual payment) coupon. NWW is now considering refunding these bonds. It has been amortizing $3 million of flotation costs on these bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest rate of 11.67% in today's market. A call premium of 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. NWW's marginal tax rate is 40%. The new bonds would be issued when the old bonds are called. -Refer to Exhibit 18.1.The amortization of flotation costs reduces taxes and thus provides an annual cash flow.What will the net increase or decrease in the annual flotation cost tax savings be if refunding takes place?

The appropriate discount rate to use when analyzing a refunding decision is the after-tax cost of new debt,in part because there is relatively little risk of not realizing the interest savings.

Five years ago,the State of Oklahoma issued $2,000,000 of 7% coupon,20-year semiannual payment,tax-exempt bonds.The bonds had 5 years of call protection,but now the state can call the bonds if it chooses to do so.The call premium would be 5% of the face amount.Today 15-year,5%,semiannual payment bonds can be sold at par,but flotation costs on this issue would be 2%.What is the net present value of the refunding? Because these are tax-exempt bonds,taxes are not relevant.

In its negotiations with its investment bankers,Patton Electronics has reached an agreement whereby the investment bankers receive a smaller fee now (6% of gross proceeds versus their normal 10%)but also receive a 1-year option to purchase an additional 200,000 shares at $5.00 per share.Patton will go public by selling $5,000,000 of new common stock.The investment bankers expect to exercise the option and purchase the 200,000 shares in exactly one year,when the stock price is forecasted to be $6.50 per share.However,there is a chance that the stock price will actually be $12.00 per share one year from now.If the $12 price occurs,what would the present value of the entire underwriting compensation be? Assume that the investment banker's required return on such arrangements is 15%,and ignore taxes.

Which of the following statements is NOT CORRECT?

Stanovich Enterprises has 10-year,12.0% semiannual coupon bonds outstanding.Each bond is now eligible to be called at a call price of $1,060.If the bonds are called,the company must replace them with new 10-year bonds.The flotation cost of issuing new bonds is estimated to be $45 per bond.How low would the yield to maturity on the new bonds have to be in order for it to be profitable to call the bonds today,i.e.,what is the nominal annual "breakeven rate"?