Tutorial 2
Questions
1. Discuss the reasons why a firm may (advantages) and may not want to go for an initial public
offering (IPO)(disadvantages).
Advantages:
(i) Access to new way of financing
-IPO brings to the company a new way of financing their investment having an
opportunity to sell their equity or issuing a new one in order to have a more capital
-After an IPO, the company has the opportunity to have their stocks in the market
for future equity-based financing strategies
(ii) Allows changes in ownership structure
-the company can decide if the share that came to the public is new issue shares and
with this, they will change the structure of the company or just sell the existing
shares maintaining the existing structure between debt and equity
(iii) Best corporate government practices
-Once the company enters into initial public offering, it starts to have its evaluation
being watched and evaluated by the market
-it will have to improve its corporate governance in order to achieve markets
standards so it cannot be harmed
(iv) Risk diversification
-With the entrance in the market, the company starts to have a new way of
financing which have a big difference from for instance debt and internal funds
-This way of financing is uncorrelated, not completely but with this new entrance
the diversification increases and the company’ wealth too
Disadvantages:
(i) Loss of control
-With the entrance in the marker, the number of shareholders increase and so the
founders and first equity owners’ loss the control of the company
(ii) Loss of confidentiality
-The entrance in the market brings the company the responsibility to have a clear
and transparent communication with the market giving all the information about
their state of nature, future goals, and investments for instance
All of this makes part of the market regulation
(iii) Costs increase
-As the company gets bigger and makes their IPO, the costs of this evolution also
increase such as issuing costs, auditing costs, and market information costs.
-Most of these costs increase due to improve communication to the investors i.e
being in the marker is responsibility that the company have to lead in accordance
with ethic and transparent information and to do that they have to incur in many
new and higher costs.
2. Why do firms choose to underprice their IPOs?
-Owners need to attract investors and achieve funding targets, investors will always be
skeptical
-Investors may assume the shares are undervalued and have a high opportunity to grow
-By pricing the issues lower, the cost to investors is lower making the investment more
appealing
Additional note:
-Underpricing is the practice of initial public offering at a price below its real value in the
stock market
-Underpricing is short-lived because investor demand will drive the price upwards to its
market value
3. Compare and contrast venture capital and angel investment. Which would be more suitable
for new business creation?
BASIS FOR
ANGEL INVESTOR VENTURE CAPITALIST
COMPARISON
Meaning Angel Investors are affluent Venture Capitalist refers to an
individuals, who help startup organization or a part of an
founders in starting their business by organization or a professional person
infusing their money, in exchange who invests in budding companies, by
for an ownership stake or providing them capital, to help them
convertible debt. grow and expand.
What is it? Individual investors, who are often Professionally managed public or
successful businessmen. private firm.
Investment Investment is made in the pre- Investment is made in the pre-
revenue business. profitability business.
Money Use their own money to make Pools money from insurance
investment. companies, funds, foundations, and
corporations, to make an investment.
Investment size Less Comparatively large
Screening Undertaken by the angel investor Undertaken by a team of experts or by
according to their own experience. an outside firm which specializes in the
same.
Post Investment Active Strategic
role
Stresses on Investment criteria related to ex-post Investment criteria related to initial
involvement. screening of investment opportunities.
Approach to Incomplete contracts approach Principal-agent approach
agency risk control
4. If you are an investor (venture capitalist or angel investor), what components of the business
will you pay attention to before making a decision?
-With so many investment opportunities and start-up pitches, VCs often have a set of criteria
that they look for and evaluate before making an investment.
-The management team, business concept and plan, market opportunity, and risk judgement
all play a role in making this decision for a VC.
5. What opportunities and challenges does crowdfunding create for firms in the 21 st century?
(i) Pros
-Simple, easy to use, accessible
-Global funding source
-Non-committal = funds are provided on a pledge / donation basis
-can be oversubscribed without restrictions
(ii) Cons
-Can be costly: crowding platform takes a% off the total funding secured
-Some platforms require you to achieve your funding target before disbursement
-International laws may restrict fund transfers
-No-face-to-face contact with funders / investors – difficult to build trust
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. (1 share = 2.5
rights)
Which approach will raise more money? Will your shareholders exercise these rights?
Explain your answer and show all the calculations.
Number of ordinary shares= 100 million
P0 = RM10
Issue price = RM8
Amount raised = RM200 million > Right > Benefit to existing shareholders when existing
shareholders have the rights to buy new shares at a discounted price
For shareholders to exercise their rights, the right issued must increase the value of the
share (P0 post right issuance must be more than issue price > exercise rights)
How many new shares have been issued during this right issuance?
(a)
RM200 million shares / RM8 = RM25 million per share OR,
RM100 million shares / 4 = RM25 million per share
Market value if the firm – market capitalization – P o x Number of shares
New market value of the firm = Existing market value of the firm x Amount raised
= RM10 x 100 million + RM200 million
=RM 1.2 billion
Total number of ordinary shares= existing number of ordinary shares + market value of the ordinary
shares
= 100 million + 25 million
= 125 million
P0 Post Right Issuance= New market value of the firm / number of shares
= 1.2 billion / 0.125 billion
= RM9.60
Decision: RM9.60 > RM8 = exercise rights
(b)
RM200million / RM 5 = 40 million OR,
RM100 million / 2.5 = 40 million [(RM100 million /5 ) x 2]
New market value of the firm = Existing market value of the firm x Amount raised
= RM10 x 100 million + RM200 million
=RM 1.2 billion
Total number of ordinary shares= existing number of ordinary shares + market value of the ordinary
shares
= 100 million + 40 million
= 140 million
P0 Post Right Issuance= New market value of the firm / number of shares
= 1.2 billion / 0.14 billion
= RM8.57
Decision: RM8.57 > RM5 = exercise rights
Analysis:
-The amount raised is RM200 million for both strategies.
-Both strategies increase shareholders’ wealth so both strategies will be exercised
Why did I compare with the right?
-Price fluctuates
-Issued new shares – dilution in shareholdings – Shares will fall
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 difference between the public offering price per share and the price received by the
Company per share multiplied by the number of shares sold in the Offering）. The IPO is a
big success with investors, and the share price rises to RM50 the first day of trading - Issue
shares to the public for the first time
P0 = RM20
P1 = RM50
a. How much did your firm raise from the IPO?
5 million shares x [RM20 – (RM20 x 7%)]
= RM93 million
b. What is the market value of the firm after the IPO?
15 million shares x RM50
= RM750 million (fair market value)
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 raise the same amount as in (a)?
Only enjoy RM93 million when I went through IPO
Value of firm without IPO / number of shares without going through IPO
Market value of firm assets absent new cash raised = RM750 million – RM93 million
= RM657 million
= RM657 million / 10 million
Shares
= RM65.70 per share
Check:
RM93 million / RM65.7
= 1.4155 million new shares
RM750 million / 1.4155 million new shares
= RM65.70
d. Comparing (b) and (c), what is the total cost to the firm’s original investors due to
market imperfections from the IPO?
Cost to investors = (RM65.70 – RM50) x 10 million
= RM157 million
Total shareholders’ cost = RM15.70 x 10 million
= RM157 million
Will be realized only if the firm sells the shares on IPO
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?
10 million shares / 5 x RM40
= RM80 million
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 be after this new plan?
Total shares = 10 million + 10 million / 5
= 12 million
Value = RM40 x 10 million + 80.0 million in new capital
= RM480 million
Share capital = RM480.00 million /12 million
= RM40
c. Which plan is better for the firm’s shareholders? Which is more likely to raise the full
amount of capital?
The firm is raising different amounts, so if both are fully subscribed, the firm’s use of
the cash will determine in which case they are better off. Absent this factor (or if the
first case is undersubscribed and the firm raises only $66m), shareholders are
indifferent.
However, the second plan is much more likely to be fully subscribed to, because
exercising the right is a good deal.
In the first case, shareholders are indifferent between exercising and not exercising.
In the first case, each share is worth RM40, and exercising the right has 0 NPV, so
the total value of a share is RM40.
In the second case, the share is worth RM24, but the right is worth (24 – 8) = RM16,
so the total value from owning a share is RM24 + RM16 = RM40 per share. If
shareholders do not exercise the right, they lose RM16.
Additional workings:
10 million x RM8
= RM80 million
Total shares
= 10 million + 10 million
=20 million
Value = RM40 x 10 million + 80 million in new capital
= RM480 million
Share price = RM24