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Chapter 5: 18BP_b (page 498)

Midland Corporation has a net income of \(19 million and 4 million shares outstanding. Its common stock is currently selling for \)48 per share. Midland plans to sell common stock to set up a major new production facility with a net cost of \(21,120,000. The production facility will not produce a profit for one year, and then it is expected to earn a 13 percent return on the investment. Stanley Morgan and Co., an investment banking firm, plans to sell the issue to the public for \)44 per share with a spread of 4 percent.

b. Why is the investment banker selling the stock at less than its current market price?

Short Answer

Expert verified

The shares are sold at a price lower than its current market price due to the spread paid to the broker.

Step by step solution

01

Meaning of market price of shares

The market price of shares refers to the price at which the share is currently being traded in the stock market. This price is determined by the demand and supply mechanism of the market.

02

Explanation for selling the shares at a price lower than the current market price

The investment banker sells the shares at a lower price than the current market price due to spread. The spread is the commission paid to a broker for trading the shares on behalf of the company.

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Most popular questions from this chapter

What is the purpose of market stabilization activities during the distribution process?

Question: Barton Simpson, the chief financial officer of Broadband Inc. could hardly believe the change in interest rates that had taken place over the last few months. The interest rate on A2 rated bonds was now 6 percent. The \(30 million, 15-year bond issue that his firm has outstanding was initially issued at 9 percent five years ago. Because interest rates had gone down so much, he was considering refunding the bond issue. The old issue had a call premium of 8 percent. The underwriting cost on the old issue had been 3 percent of par, and on the new issue it would be 5 percent of par. The tax rate would be 30 percent and a 4 percent discount rate would be applied for the refunding decision. The new bond would have a 10-year life. Before Barton used the 8 percent call provision to reacquire the old bonds, he wanted to make sure he could not buy them back cheaper in the open market.

a. First compute the price of the old bonds in the open market. Use the valuation procedures for a bond that were discussed in Chapter 10 (use annual analysis). Determine the price of a single \)1,000 par value bond.

The Presley Corporation is about to go public. It currently has after-tax earnings of \(7,200,000, and 2,100,000 shares are owned by the present stockholders (the Presley family). The new public issue will represent 800,000 new shares. The new shares will be priced to the public at \)25 per share, with a 5 percent spread on the offering price. There will also be $260,000 in out-of-pocket costs to the corporation.

e. Determine what rate of return must be earned on the proceeds to the corporation so there will be a 5 percent increase in earnings per share during the year of going public.

Explain how the zero-coupon rate bond provides return to the investor. What are the advantages to the corporation? (LO16-2)

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