CH 15

Format: True/False
Learning Objective: LO 1
Level of Difficulty: Easy
1.Most businesses are started when an entrepreneur is given a vision for a new business or
product by institutional investors.
A)
True
B)
False
Ans:
B
Format: True/False
2.The process by which many entrepreneurs raise seed money and obtain other resources
necessary to start their businesses is often called bootstrapping.
A)
True
B)
False
Ans:
A
Format: True/False
3.The initial seed money usually comes from the entrepreneur or other founders.
A)
True
B)
False
Ans:
A
Format: True/False
4.The bootstrapping period usually lasts about five years.
A)
True
B)
False
Ans:
B
Format: True/False
5.Venture capitalists are individuals or firms that help privately held businesses go public.
A)
True
B)
False
Ans:
B
Page 1
Format: True/False
6.Angel investors are investors who come to the rescue of firms threatened by takeovers.
A)
True
B)
False
Ans:
B
Format: True/False
7.A significant number of venture capital firms focus on high-technology investments.
A)
True
B)
False
Ans:
A
Format: True/False
8.A significant number of venture capital firms focus on mature businesses.
A)
True
B)
False
Ans:
B
Format: True/False
9.Traditional sources of funding work for new or emerging businesses despite the presence
of only intangible assets.
A)
True
B)
False
Ans:
B
Format: True/False
10.The key idea behind staged funding is that each funding stage gives the venture capitalist
an opportunity to reassess the management team and the firm's financial performance.
A)
True
B)
False
Ans:
A
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Format: True/False
11.A principal way for venture capitalists to exit is to sell part of the firm's equity back to
the entrepreneur.
A)
True
B)
False
Ans:
B
Format: True/False
12.A venture capitalist may exit an investment by selling common stock in an initial public
offering.
A)
True
B)
False
Ans:
A
Format: True/False
13.The amount of equity capital that can be raised in the public equity markets is typically
smaller than the amount that can be raised through private sources.
A)
True
B)
False
Ans:
B
Format: True/False
14.Privately held firms find it easier to attract top management talent and to better motivate
current managers.
A)
True
B)
False
Ans:
B
Format: True/False
15.To complete an IPO, a firm will need the services of investment bankers, who are experts
in bringing new securities to market.
Page 3
A)
B)
Ans:
True
False
A
Format: True/False
16.To complete an IPO, a firm will need the services of angel investors, who are experts in
bringing new securities to market.
A)
True
B)
False
Ans:
B
Format: True/False
17.Underwriting is the risk-bearing part of investment banking.
A)
True
B)
False
Ans:
A
Format: True/False
18.In the firm-commitment underwriting, which is more typical, the investment banker
guarantees the issuer a fixed amount of money from the stock sale.
A)
True
B)
False
Ans:
A
Format: True/False
19.With a firm-commitment underwriting, the investment banking firm makes no guarantee
to sell the securities at a particular price.
A)
True
B)
False
Ans:
B
Format: True/False
Page 4

20.At the closing of a best-efforts offering, the issuing firm delivers the security certificates
to the underwriter and the underwriter delivers the payment for the securities, net of the
underwriting fee, to the issuer.
A)
True
B)
False
Ans:
B
Format: True/False
21.Underpricing is defined as offering new securities for sale at a price below their true
value.
A)
True
B)
False
Ans:
A
Format: True/False
22.In a best-efforts offering, the underwriters will suffer a financial loss if the offer price is
set too high.
A)
True
B)
False
Ans:
B
Format: True/False
23.If the offer price is set too high, the issuing firm will lose under a best-efforts agreement.
A)
True
B)
False
Ans:
A
Format: True/False
24.A general cash offer is a sale of debt or equity, open to all investors, by a registered
public company that has previously sold stock to the public.
A)
True
B)
False
Ans:
A
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Format: True/False
25.Bootstrapping and venture capital financing are part of the public market.
A)
True
B)
False
Ans:
B
Format: True/False
26.Private placement occurs when a firm sells unregistered securities directly to investors
such as insurance companies, commercial banks, or wealthy individuals.
A)
True
B)
False
Ans:
A
Format: True/False
27.The biggest drawback of private placements involves restrictions on the resale of the
securities.
A)
True
B)
False
Ans:
A
Format: True/False
28.Transactions in which a public company sells unregistered stock to an investor are called
PIPE transactions.
A)
True
B)
False
Ans:
A
Format: True/False
29.The major disadvantage of a PIPE transaction to issuers is that it slows the firm's access
to capital.
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A)
B)
Ans:
True
False
B
Format: True/False
30.Term loans are defined as business loans with maturities greater than one month but less
than one year.
A)
True
B)
False
Ans:
B
Format: Multiple Choice
31.The initial seed money comes from
A)
public investors.
B)
investment banks.
C)
the entrepreneur or other founders.
D)
commercial banks.
Ans:
C
32.Bootstrapping is the process by which
A)
many entrepreneurs raise seed money and obtain other resources necessary to
start their businesses.
B)
the entrepreneur often fleshes out his or her ideas and makes them operational.
C)
most businesses are started by an entrepreneur.
D)
none of the above.
Ans:
A
33.Which one of the following statements is NOT true?
A)
The process by which many entrepreneurs raise seed money and obtain other
resources necessary to start their businesses is often called bootstrapping.
B)
Most businesses are started by an entrepreneur who has a vision for a new business
or product and a passionate belief in the concept's viability.
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C)
D)
Ans:
The initial seed money usually comes from the entrepreneur or other founders.
The seed money is spent on developing an initial public offering.
D

34.Which ONE of the following statements is true?
A)
The venture capital industry as we know it today emerged in the late 1960s with
the formation of the first venture capital limited partnerships.
B)
Modern venture capital firms tend to specialize in a specific line of business, such
as hospitality, food manufacturing, or medical devices.
C)
A significant number of venture capital firms focus on high-technology
investments.
D)
All of the above are true statements.
Ans:
D
A)
Approximately $23 billion was invested in venture capital funds in 2010.
B)
The venture capital industry as we know it today emerged in the late 1990s.
C)
Modern venture capital firms tend to specialize in a specific line of business, such
as hospitality, food manufacturing, or medical devices.
D)
A significant number of venture capital firms focus on high-technology
investments.
Ans:
B
36.Tactics that venture capitalists use to reduce the risk of their investment include
A)
funding the ventures in stages, requiring entrepreneurs to make no personal
investments, syndicating investments, and maintaining in-depth knowledge about
the industry in which they specialize.
B)
funding the ventures completely in the beginning, requiring entrepreneurs to make
personal investments, syndicating investments, and maintaining in-depth
knowledge about the industry in which they specialize.
C)
funding the ventures in stages, requiring entrepreneurs to make personal
investments, syndicating investments, and maintaining in-depth knowledge about
the industry in which they specialize.
D)
None of the above.
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Ans:

A)
Venture capitalists often require an entrepreneur to make a substantial personal
investment in the business.
B)
Syndication occurs when the originating venture capitalist buys off other venture
capitalists involved in the venture.
C)
Another factor that reduces risk is the venture capitalist's in-depth knowledge of
the industry and technology.
D)
The key idea behind staged funding is that each funding stage gives the venture
capitalist an opportunity to reassess the management team and the firm's financial
performance.
Ans:
B
38.Provisions that are part of venture capital agreements include
A)
timing of exit, number of board positions after exit, and what price is acceptable.
B)
timing of exit, the method of exit, and what price is acceptable.
C)
the method of exit, number of board positions after exit, and what price is
acceptable.
D)
None of the above.
Ans:
B
39.The three principal ways in which venture capital firms exit venture-backed companies
are
A)
selling to a strategic buyer, buying out the founder, and offering stock to the
public.
B)
selling to a strategic buyer, selling to a financial buyer, and buying out the founder.
C)
selling to a strategic buyer, selling to a financial buyer, and offering stock to the
public.
D)
None of the above.
Ans:
C
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A)
A typical venture capital fund may generate annual returns of 15 to 25 percent on
the money that it invests, compared with an average annual return for the S&P 500
of almost 12 percent.
B)
A typical venture capital fund may generate annual returns of 12 percent on the
money that it invests, compared with an average annual return for the S&P 500 of
about 20 percent.
C)
A typical venture capital fund may generate annual returns of 12 percent on the
money that it invests, compared with an average annual return for the S&P 500 of
about 25 percent.
D)
None of the above
Ans:
A
41.Advantages of going public include all EXCEPT
A)
Larger amount of capital can be raised this way than the amount that can be raised
through private sources.
B)
Publicly traded firms find it harder to attract top management talent.
C)
Going public can enable an entrepreneur to fund a growing business without
giving up control.
D)
Additional equity capital can usually be raised through follow-on seasoned public
offerings at a low cost.
Ans:
B
A)
After the IPO, there is a less active secondary market for the firm's shares.
B)
Only smaller amounts of capital can be raised through an IPO than the amount that
can be raised through private sources.
C)
Publicly traded firms find it easier to attract top management talent.
D)
Going public can enable an entrepreneur to fund a growing business but not
without giving up control.
Ans:
C
Level of Difficulty: Medium
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43.Disadvantages of going public include all EXCEPT

A)
Managers' tendency to focus on long-term profits.
B)
The high cost of the IPO itself.
C)
The costs of complying with ongoing SEC disclosure requirements.
D)
The transparency that results from this compliance can be costly for some firms.
Ans:
A
44.Basic services investment bankers provide when bringing securities to market include
A)
Origination
B)
Underwriting
C)
distribution.
D)
All of the above.
Ans:
D
A)
Investment bankers provide three basic services when bringing securities to market
origination, underwriting, and distribution.
B)
During the origination phase, the investment banker helps the firm determine
whether it is ready for an IPO.
C)
Origination is the risk-bearing part of investment banking.
D)
Origination includes giving the firm financial advice and getting the issue ready to
sell.
Ans:
C
46.All of the following about a firm-commitment underwriting is true EXCEPT:
A)
The investment banker guarantees the issuer a fixed amount of money from the
stock sale.
B)
The investment banker actually buys the stock from the firm.
C)
The issuer bears the risk that the resale price might be lower than the price the
underwriter pays.
D)
The underwriter bears the risk that the resale price might be lower than the price
the underwriter pays.
Ans:
C
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47.With a best-efforts underwriting
A)
the investment banking firm makes no guarantee to sell the securities at a
particular price.
B)
the investment banker does not bear the price risk associated with underwriting the
issue.
C)
compensation is based on the number of shares sold.
D)
All of the above.
Ans:
D
A)
In a best-efforts offering, the underwriters will suffer a financial loss if the offer
price is set too high.
B)
In a best-efforts agreement, the issuing firm will lose if the offer price is set too
high.
C)
If the underpricing is significant, the investment banking firm will suffer a loss of
reputation for failing to price the new issue correctly and raising less money for its
client than it could have.
D)
Underpricing is defined as offering new securities for sale at a price below their
true value.
Ans:
A
49.The three basic costs associated with issuing stock in an IPO are
A)
price premium, out-of-pocket expenses, and underpricing.
B)
underwriting spread, out-of-pocket expenses, and underpricing.
C)
underwriting spread, price premium, and underpricing.
D)
None of the above.
Ans:
B
50.Data from the marketplace show that the shares sold in an IPO are typically
A)
priced between 2 and 5 percent below the price at which they close at the end of
Page 12
B)
C)
D)
Ans:
first day of trading.

priced between 10 and 15 percent above the price at which they close at the end of
priced between 10 and 15 percent below the price at which they close at the end of
priced between 2 and 5 percent above the price at which they close at the end of
C

A)
In a competitive sale, the firm specifies the type and amount of securities it wants
to sell.
B)
In a negotiated sale, the issuer selects the underwriter at the beginning of the
origination process.
C)
In a general cash offer, management must decide whether to sell the securities on a
competitive or a negotiated basis.
D)
For equity securities, competitive sales generally provide the lowest-cost method
of sale.
Ans:
D
A)
Shelf registration gives firms less flexibility in bringing securities to market.
B)
During a two-year window, the firm can take the securities off the shelf and sell
them as needed.
C)
Shelf registration allows firms to periodically sell small amounts of securities.
D)
A shelf registration statement can cover multiple securities, and there is no penalty
if authorized securities are not issued.
Ans:
A
53.Benefits from shelf registration include all EXCEPT:
A)
Greater flexibility in bringing securities to market.
B)
Shelf registration allows firms to periodically sell small amounts of securities and
raise capital as needed.
C)
A shelf registration statement can cover multiple securities, but there is a penalty if
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D)
Ans:
authorized securities are not issued.

Costs associated with selling the securities are reduced because only a single
registration statement is required.
C

A)
For many smaller firms and firms of lower credit standing that have limited access,
or no access, to the public markets, the cheapest source of external funding is often
the private markets.
B)
Bootstrapping and venture capital financing are not part of the private market.
C)
Bootstrapping and venture capital financing are part of the private market.
D)
Many private companies that are owned by entrepreneurs, families, or family
foundations and are sizable companies of high credit quality prefer to sell their
securities in the private markets.
Ans:
B
A)
Private placement occurs when a firm sells unregistered securities directly to
investors such as insurance companies, commercial banks, or wealthy individuals.
B)
All corporate debt is sold through the private placement market.
C)
About half of all corporate debt is sold through the private placement market.
D)
Investment banks and money center banks often assist firms with private
placements.
Ans:
B
56.Advantages of private placements include:
A)
Cost of funds may be lower.
B)
Private lenders are more willing to negotiate changes to a bond contract.
C)
The speed of private placement deals and flexibility in issue size.
D)
All of the above.
Ans:
D
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A)
Private equity firms pool money from wealthy investors, pension funds, insurance
companies, and other sources to make investments.
B)
Private equity firms invest in more mature companies.
C)
Private equity firms invest in new companies.
D)
Private equity investors focus on firms that have stable cash flows because they
use a lot of debt to finance their acquisitions.
Ans:
C
58.Private equity firms improve the performance of firms in which they invest by:
A)
making sure that the firms have the best possible management teams.
B)
closely monitoring each firm's performance and providing advice and counsel to
the firm's management team.
C)
facilitating mergers and acquisitions that help improve the competitive positions of
the companies in which they invest.
D)
All of the above.
Ans:
D
A)
PIPE transactions are registered with the SEC.
B)
PIPE transactions are not registered with the SEC.
C)
In a PIPE transaction, investors purchase securities (equity or debt) directly from a
publicly traded company in a private placement.
D)
The securities are virtually always sold to the investors at a discount to the price at
which they would sell in the public markets.
Ans:
A
A)
Under federal securities law, they can be resold to investors in the public markets
immediately even if they are not registered.
B)
As part of the PIPE contract, the company often agrees to register the restricted
securities with the SEC, usually within 90 days of the PIPE closing.
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C)
D)
Ans:
As part of the PIPE contract, the company often agrees to register the restricted
securities with the SEC after 90 days of the PIPE closing.
PIPE transactions involving a healthy firm can also be executed without the use of
an investment bank but result in a cost increase of 7 to 8 percent of the proceeds.
B
Use the following to answer questions 61-63:

IPO pricing: Stump, Inc., a technology firm in Prairie View, Texas, issues a $66 million IPO
priced at $17 per share, and the offering price to the public is $22 per share. The firm's legal fees,
SEC registration fees, and other administrative costs are $350,000. The firm's stock price
increases 15 percent on the first day.
Reference: Ref 15-1
61.What is the underpricing spread?
A)
$51 million
B)
$15 million
C)
$66 million
D)
None of the above.
Ans:
B
Feedback:
Underwriter's gross spread ($22 $17) =$5 per share.
Number of shares outstanding = ($66 million/$22 per share) = 3 million.
Underwriting cost = ($5 per share x 3.0 million shares) = $15.0 million
Reference: Ref 15-1
62.What is the underpricing on this issue?
A)
$9,900,000
B)
$24,900,000
C)
$15,000,000
D)
None of the above.
Ans:
A
Feedback:
Stock price at end of first day = $22(1.15) = $25.30
First-day underpricing = ($25.30 - $22) = $3.30 per share.
Total underpricing = ($3.30 per share x 3,000,000 shares of stock) = $9,900,000
Page 16
Reference: Ref 15-1

63.What is the firm's total cost of issuing the securities?
A)
$24.9 million
B)
$15.35 million
C)
$25.25 million
D)
None of the above
Ans:
C
Feedback:
Total cost to the firm of selling the IPO = $15,000,000 + $350,000 + $9,900,000
= $25,250,000
64.IPO pricing: Pau, Inc., issues a $38.6 million IPO priced at $12.50 per share, and the
offering price to the public is $19.30 per share. The firm's legal fees, SEC registration
fees, and other administrative costs are $270,000. The firm's stock price increases 18
percent on the first day. What is the underpricing cost of issuing the securities to the
firm?
A)
$13.6 million
B)
$20.6 million
C)
$6.96 million
D)
$7.57 million
Ans:
C
Feedback:
Stock price at end of first day = $19.30 (1.18) = $22.78
First-day underpricing = ($22.78 $19.30) = $3.48 per share.
percent on the first day. What is the underwriting cost?
A)
$13.6 million
B)
$20.6 million
C)
$6.96 million
D)
None of the above.
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Ans:
A
Feedback:
Underwriter's gross spread ($19.30 $12.50) =$6.80 per share.
Number of shares outstanding = ($38.6 million/$19.30 per share) = 2 million.
Underwriting cost = ($6.80 per share x 2.0 million shares) = $13.6 million

percent on the first day. What is the total cost of issuing the securities to the firm?
A)
$13.6 million
B)
$20.83 million
C)
$20.6 million
D)
None of the above
Ans:
B
Feedback:
Stock price at end of first day = $19.30(1.18) = $22.78
Underwriter's gross spread ($19.30 - $12.50) =$6.80 per share.
Number of shares outstanding = ($38.6 million/$19.30 per share) = 2 million.
Underwriting cost = ($6.80 per share x 2.0 million shares) = $13.6 million
Total cost to the firm of selling the = $13,960,000 + $270,000 + $6,960,000
IPO
= $20,830,000
67.IPO underpricing: When Geo Corp. went public in September 2008, the offer price was
$19.00 per share and the closing price at the end of the first day was $24.70. The firm
issued 4 million shares. What was the loss to the company due to underpricing?
A)
$13.6 million
B)
$20.83 million
C)
$20.6 million
D)
$22.8 million
Ans:
D
Feedback:
Change in price on first day = $24.70 $19.00 = $5.70
Number of shares outstanding = 4.0 million
Loss due to underpricing = $5.70 4,000,000 = $22.8 million
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68.IPO: Bethesda Biosys issues an IPO sold on a best-efforts basis. The company's
investment bank demands a spread of 18 percent of the offer price, which is set at $25
per share. Four million shares are issued. However, the bank was overly optimistic and
eventually is able to sell the stock for only $23 per share. What are the proceeds for the
issuer?
A)
$74 million
B)
$92 million
C)
$100 million
D)
None of the above
Ans:
A
Feedback:
Gross proceeds from offer = $25.00 x 4,000,000 = $100,000,000
Underwriting spread = $100,000,000 x 0.18 = $18,000,000
Proceeds to issuer = ($23 x $4,000,000) $18,000,000 = $74 million
69.IPO: Fortune Hotels issues an IPO sold on a best-efforts basis. The company's
investment bank demands a spread of 20 percent. Five million shares are issued.
However, the bank was overly optimistic and could not sell at the offer price of $31. If
the net proceeds to the issuer were $110 million, what was the per share price at which
the shares were sold?
A)
$27.50
B)
$22
C)
$31
D)
None of the above
Ans:
A
Feedback:
Number of shares issued = 5 million
Net Proceeds to issuer = $110 million
Underwriting spread = 20%
Gross proceeds from offer = $110,000,000 / 0.80 = $137.5 million
Selling price per share = $137.5 million / 5 million = $27.50
70.IPO: Fortune Hotels issues an IPO sold on a best-efforts basis. The company's
Page 19
A)
B)
C)
D)
Ans:
investment bank demands a spread of 20 percent. Five million shares are issued.
However, the bank was overly optimistic and could not sell at the offer price of $31. If
the net proceeds to the issuer is $110 million, how much did the investment bank
receive?
$22.0 million
$27.5 million
$31.0 million
None of the above
B
Feedback:
Net proceeds to issuer = $110 million
Underwriting spread = 20%
Gross proceeds from offer = $110,000,000 / 0.80 = $137.5 million
Proceeds to underwriter = $137.5 million 0.20 = $27.5 million

71.IPO: Dienz Pharma issues an IPO sold on a best-efforts basis. The company's
investment bank demands a spread of 16 percent of the selling price. The offer price is
set at $32 per share. Three million shares are issued. However, the bank was able to see
the shares at $26.25 per share. What are the proceeds for the issuer?
A)
$96.00 million
B)
$78.75 million
C)
$66.15 million
D)
None of the above
Ans:
C
Feedback:
Gross proceeds from issue = ($26.25 3,000,000) = $78,750,000
Underwriting spread = $78,750,000 x 0.16 = $12,600,000
Proceeds to issuer = $78,750,000 $12,600,000 = $66.15 million
72.General cash offering: Star Corporation, an auto fuel cell maker, is planning a new
plant and needs to raise $30 million to finance it. The company plans to raise the money
through a general cash offering priced at $23.50 a share. Star's underwriters charge a 6
percent spread. How many shares does the company have to sell to achieve its goal?
A)
1,358,081 shares
B)
1,276,596 shares
C)
1,200,000 shares
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D)
Ans:
None of the above

A
Feedback:
Underwriter's spread = 6 %
Price per share the firm gets = 23.50*(1 0.06) = $22.09
Therefore, to raise $30 million, the company needs to issue:
$30,000,000 / $22.09 = 1,358,081 new shares

73.Bank lending: Jasper, Inc., is looking for a five-year term loan of $3 million. Its bank is
willing to make the loan. The firm will have to pay a premium of 1.5 percent for default
risk and another 0.75 percent for maturity risk. The current prime rate is 7.5 percent.
What is the loan rate on this bank loan?
A)
9%
B)
8.25%
C)
9.75%
D)
None of the above
Ans:
C
Feedback:
Prime rate = PR = 7.5%
Maturity risk premium = MAT = 0.75%
Default risk premium = DRP = 1.5%
Cost of loan = k = PR + DRP + MAT = 7.5% + 1.5% = 0.75% = 9.75%
74.Bank lending: Suppose two firms want to borrow money from a bank for a period of 10
years. Firm A has excellent credit and can borrow at the prime rate, whereas Firm B's
credit standing is prime + 2. The current prime rate is 5.75 percent, the 30-year Treasury
bond yield is 4.35 percent, the three-month Treasury bill yield is 3.54 percent, and the
10-year Treasury note yield is 4.24 percent. What are the appropriate loan rates for each
customer?
A)
6.45%, 7.75%
B)
6.45%, 8.45%
C)
5.75%, 8.45%
D)
None of the above
Ans:
B
Feedback:
Prime rate =PR = 5.75%;
Maturity risk premium = MAT = k10-year kT-bill = 4.24% - 3.54% = 0.70%
Borrowing rate for firm A = k = Prime rate + MAT
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= 5.75% + 0.70% = 6.45%

Borrowing rate for firm B
= k = Prime rate + 2% + MAT
= 5.75% + 2% + 0.70% = 8.45%
75.Bank lending: Marigold Corp. wants to borrow money from Howard Bank for a period
of five years. The firm's credit standing calls for a premium of 1.5 percent over the prime
rate. The current prime rate is 6.5 percent, the 30-year Treasury bond yield is 5.375
percent, the three-month Treasury bill yield is 3.525 percent, and the 5-year Treasury
note yield is 4.25 percent. What is the appropriate loan rate for this customer?
A)
8.725%
B)
7.225%
C)
6.500%
D)
None of the above
Ans:
A
Feedback:
Prime rate =PR = 6.5%;
Default risk premium = DRP = 1.5%
Maturity risk premium = MAT = k5-year kT-bill = 4.25% - 3.25% = 0.725%
Borrowing rate for firm A = k = PR +DRP+ MAT
= 6.5% + + 1.5% + 0.725% = 8.725%
76. The most likely reason that underpricing of new issues occurs more frequently than
overpricing is the:
A) Underwriters desire to reduce the risk of a firm commitment.
B) Demand for a new issue is typically too high.
C) Underwriters earn low rates of return
D) Issuing firms demand that equity be underpriced.
E)
Ans:A
ns:
77. A firm is making an initial public offering. The investment bankers agree to a firm
underwriting commitment of 500,000 shares priced to the public at $50 a share. The
underwriters spread is 12%. In addition, the underwriter charges $600,000 in legal fees.
On the first day of trading, the firms stock closed at $61. What were the total costs of the
issue?
a. $3,000,000
b. $3,600,000
Page 22
c. $8,500,000
d. $9,100,000
Ans:D
Feedback:
Stock price at end of first day = $61.00
Total underpricing = ($11.00 per share x 500,000 shares of stock) = $5,500,000
Underwriter's gross spread ($50.00 x .12) =$6.00 per share.
Underwriting cost = ($6.00 per share x 500,000 shares) = $3 million
Total cost to the firm of selling the = $3,000,000 + $600,000 + $5,500,000
IPO
= $9,100,000
78. Castle Co. needs to borrow $10 million for process improvement upgrades. Management
decides to sell 20-year bonds. They determine that the 3-month Treasury bill rate is 2.75
percent, the firm's credit rating is A, and the yield on 20-year Treasury bonds is 1.80 percent
higher than that for 3-month Treasury bills. Bonds with an A rating are selling for 50 basis
points above the 20-year Treasury bond rate. What is the borrowing cost to do this
transaction?
a. 4.55%
b. 5.05%
c. 7.75%
d. 9.55%
Ans:B
Feedback:
kl = 2.75 + 1.80 + 0.50 = 5.05%
79. Why is the total cost of bringing a general cash offer to the market lower than issuing an
IPO?
a. They do not include a large underpricing
b. Underwriting spreads are smaller
c. There is less risk involved with a general cash offer than an IPO
d. all of the above
Ans:D
Format: Essay
Page 23
80.Why do traditional sources of funding not work for new or emerging businesses?
Ans:
New firms cannot resort to traditional sources of funding for three main reasons.
First, starting a new business is a risky proposition. The fact is that most new
businesses fail, and it is difficult to identify which firms will be successful. Most
suppliers of capital, such as banks, pension funds, and insurance companies, are
averse to undertaking high-risk investments, and much of their risk-averse
behavior is mandated in regulations that restrict their conduct. Second, most new
firms do not have real or tangible assets against which they can borrow. Most
commercial loans are made to firms that have tangible assets, such as machines,
equipment, and physical inventory. Lenders understand the operations of these
traditional firms and their inherent risks; thus, they are comfortable making
loans to them. The third reason is the information gap that exists between the
entrepreneur and potential investors. An entrepreneur knows more about his or her
company's prospects than a lender does. When dealing with highly specialized
technologies or companies emerging in new business areas, most investors do not
have the expertise to distinguish between competent and incompetent
entrepreneurs. As a result, they are reluctant to invest in these firms.
For these reasons, many investorssuch as pension funds, insurance companies,
endowment funds, and university foundationsfind it difficult to participate
directly in the venture capital market. Instead, they invest in venture capital funds
that specialize in identifying attractive investments in new businesses, managing
those investments, and selling (exiting) them at the appropriate time.
Format: Essay
81.What are the advantages and disadvantages of going public?
Ans:
Going public has a number of potential advantages.
The amount of equity capital that can be raised in the public equity markets is
typically larger than the amount that can be raised through private sources.
Once an IPO has been completed, additional equity capital can usually be raised
through follow-on seasoned public offerings at a low cost.
Going public can enable an entrepreneur to fund a growing business without giving
up control.
After the IPO, there is an active secondary market in which stockholders can buy and
sell its shares.
Publicly traded firms find it easier to attract top management talent and to better
motivate current managers if a firm's stock is publicly traded.
There are also several disadvantages to going public.
One disadvantage of going public is the high cost of the IPO itself.
The costs of complying with ongoing SEC disclosure requirements also represent a
disadvantage of going public.
The transparency that results from this compliance can be costly for some firms.
Page 24
Finally, some investors argue that the SEC's requirement of quarterly earnings
forecasts and quarterly financial statements encourages managers to focus on shortterm profits rather than long-term wealth maximization.
Format: Essay
82.What are PIPE transactions and how do they help firms raise capital?
Ans:
Private investment in public equity (PIPE) transactions are transactions in which a
public company sells unregistered stock to an investor. In a PIPE transaction,
investors purchase securities (equity or debt) directly from a publicly traded
company in a private placement.
The securities are virtually always sold to the investors at a discount to the price at
which they would sell in the public markets to compensate the buyer for limits on
the liquidity associated with these securities and, often, for being able to provide
capital quickly. Because the securities sold in a PIPE transaction are not registered
with the SEC, they are restricted securities. As part of the PIPE contract, the
company often agrees to register the restricted securities with the SEC, usually
within 90 days of the PIPE closing. If the registration is delayed past a deadline
date, the issuer might be required to pay the investor liquidity damages, usually 1
or 1.5 percent per month, as compensation for the loss of liquidity.
The major advantage of a PIPE transaction to issuers is that it gives them faster
access to capital and a lower funding cost than a registered public offering. PIPE
transactions involving a healthy firm can also be executed without the use of an
investment bank, resulting in a cost saving of 7 to 8 percent of the proceeds. A
PIPE transaction can be the only way for a small financially distressed company to
raise equity capital.
Page 25

CH 15

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Format: True/False

Level of Difficulty: Easy

Format: Multiple Choice

Format: Multiple Choice

43.Disadvantages of going public include all EXCEPT

Format: Multiple Choice

first day of trading.

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authorized securities are not issued.

Format: Multiple Choice

Use the following to answer questions 61-63:

Reference: Ref 15-1

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Format: Multiple Choice

Format: Multiple Choice

None of the above

Format: Multiple Choice

= 5.75% + 0.70% = 6.45%

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