Deck 23: The Mechanics of Raising Equity Capital

Question 1

Use the information for the question(s) below.
You founded your own firm three years ago. You initially contributed $200,000 of your own money and in return you received 2 million shares of stock. Since then, you have sold an additional 1 million shares of stock to angel investors. You are now considering raising capital from a venture capital firm. This venture capital firm would invest $5 million and would receive 2 million newly issued shares in return.
Assuming that this is the venture capitalist's first investment in your firm,what percentage of the firm will you own?

A) 50%
B) 40%
C) 33%
D) 25%

Answer 1

40%

Question 2

A(n)________ invests in the equity of existing privately held firms.

A) venture capital firm
B) private debt firm
C) vulture fund
D) private equity firm

Answer 2

private equity firm

Question 3

Which of the following statements is false?

A) The general partners work for the venture capital firm and run the venture capital firm; they are called venture capitalists.
B) An important consideration for investors in private companies is their exit strategy how they will eventually realize the return from their investment.
C) When a company founder decides to sell equity to outside investors for the first time, it is common practice for private companies to issue common stock rather than preferred stock to raise capital.
D) Institutional investors such as pension funds, insurance companies, endowments, and foundations manage large quantities of money.

Answer 3

When a company founder decides to sell equity to outside investors for the first time, it is common practice for private companies to issue common stock rather than preferred stock to raise capital.

Question 4

Which of the following statements is false?

A) After deciding to go public, managers of the company work with an underwriter, an investment banking firm that manages the offering and designs its structure.
B) The shares that are sold in the IPO may either be new shares that raise new capital, known as a secondary offering, or existing shares that are sold by current shareholders (as part of their exit strategy), known as a primary offering.
C) Many IPOs, especially the larger offerings, are managed by a group of underwriters.
D) At an IPO, a firm offers a large block of shares for sale to the public for the first time.

Question 5

Which of the following statements is false?

A) The process of selling stock to the public for the first time is called a seasoned equity offering (SEO).
B) Public companies typically have access to much larger amounts of capital through the public markets.
C) By going public, companies give their private equity investors the ability to diversify.
D) The two advantages of going public are greater liquidity and better access to capital.

Question 6

Use the following information to answer the question(s) below.
Suppose that Galt Ventures, a venture capital firm, raised $250 million of committed capital. Each year over the 10-year life of the fund, 2% if this committed capital will be used to pay Galt's management fee. As is typical in the venture capital industry, Galt will only invest $200 million (committed capital less lifetime management fees). At the end of 10 years, the investments made by the fund are worth $800 million. Galt also charges 20% carried interest on the profits of the fund (net of management fees). Assume that Galt collects the $250 if committed capital and invests $200 million of it immediately. Also assume that Galt collects all proceeds from its investments at the end of the ten year life.
The IRR on the investments made by Galt Ventures is closest to:

A) 9.9%
B) 12.4%
C) 14.9%
D) 15.8%

Question 7

Use the information for the question(s) below.
You founded your own firm three years ago. You initially contributed $200,000 of your own money and in return you received 2 million shares of stock. Since then, you have sold an additional 1 million shares of stock to angel investors. You are now considering raising capital from a venture capital firm. This venture capital firm would invest $5 million and would receive 2 million newly issued shares in return.
Assuming that this is the venture capitalist's first investment in your firm,the post-money valuation of the angel investor's shares are closest to:

A) $12.5 million
B) $4.0 million
C) $5.0 million
D) $2.5 million

Question 8

Which of the following statements is false?

A) A venture capital firm is a limited partnership that specializes in raising money to invest in the private equity of young firms.
B) Venture capitalists typically control about three-quarters of the seats on a start-up's board of directors, and often represent the single largest voting block on the board.
C) The initial capital that is required to start a business is usually provided by the entrepreneur herself and her immediate family.
D) Individual investors who buy equity in small private firms are called angel investors.

Question 9

Which of the following is not a common name for a corporation that invests in private companies?

A) Strategic investor
B) Corporate partner
C) Venture partner
D) Strategic partner

Question 10

Which of the following statements is not true regarding Angel Investors?

A) They are typically arranged as limited partnerships.
B) For many start-ups, the first round of outside private equity financing is often obtained from them.
C) Because their capital investment is often large relative to the amount of capital already in place at the firm, they typically receive a sizeable equity share in the business in return for their funds.
D) These investors are frequently friends or acquaintances of the entrepreneur.

Question 11

Use the information for the question(s) below.
You founded your own firm three years ago. You initially contributed $200,000 of your own money and in return you received 2 million shares of stock. Since then, you have sold an additional 1 million shares of stock to angel investors. You are now considering raising capital from a venture capital firm. This venture capital firm would invest $5 million and would receive 2 million newly issued shares in return.
Assuming that this is the venture capitalist's first investment in your firm,what percentage of the firm will the venture capitalist own?

A) 50%
B) 40%
C) 25%
D) 33%

Question 12

When a private equity firm purchases the outstanding equity of a publicly traded firm,thereby taking the company private,the transaction is called a(n)

A) private leveraged transaction.
B) leveraged buyout.
C) cash offer.
D) initial public offering.

Question 13

Which of the following statements regarding best efforts IPOs is false?

A) For smaller IPOs, the underwriter commonly accepts the deal on this basis.
B) The underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price.
C) Often these arrangements have an all-or-none clause: either all of the shares are sold in the IPO, or the deal is called off.
D) If the entire issue does not sell out, the underwriter is on the hook.

Question 14

Use the following information to answer the question(s) below.
Suppose that Galt Ventures, a venture capital firm, raised $250 million of committed capital. Each year over the 10-year life of the fund, 2% if this committed capital will be used to pay Galt's management fee. As is typical in the venture capital industry, Galt will only invest $200 million (committed capital less lifetime management fees). At the end of 10 years, the investments made by the fund are worth $800 million. Galt also charges 20% carried interest on the profits of the fund (net of management fees). Assume that Galt collects the $250 if committed capital and invests $200 million of it immediately. Also assume that Galt collects all proceeds from its investments at the end of the ten year life.
The IRR on the investment of a limited partner into Galt Ventures net of all management fees and expenses is closest to:

A) 7.8%
B) 9.9%
C) 12.4%
D) 14.9%

Question 15

The share of any positive return generated by venture capital firms that is taken by the firm's partners is known as

A) carried interest.
B) partner return.
C) carried capital.
D) angel interest.

Question 16

Which of the following statements is false?

A) The preferred stock issued by young companies typically does not pay regular cash dividends.
B) The preferred stock issued by young companies usually gives the owner an option to convert it into common stock on some future date, so it is often called callable preferred stock.
C) If the company runs into financial difficulties, the preferred stockholders have a senior claim on the assets of the firm relative to any common stockholders.
D) Preferred stock issued by mature companies such as banks usually has a preferential dividend and seniority in any liquidation and sometimes special voting rights.

Question 17

Which of the following statements is not true regarding venture capitalists?

A) They can provide substantial capital for young companies.
B) They firms offer limited partners a number of advantages over investing directly in start-ups themselves as angel investors.
C) They use their control to protect their investments, so they may therefore perform a key nurturing and monitoring role for the firm.
D) They might invest for strategic objectives in addition to the desire for investment returns.

Question 18

Use the information for the question(s) below.
You founded your own firm three years ago. You initially contributed $200,000 of your own money and in return you received 2 million shares of stock. Since then, you have sold an additional 1 million shares of stock to angel investors. You are now considering raising capital from a venture capital firm. This venture capital firm would invest $5 million and would receive 2 million newly issued shares in return.
The post-money valuation of your firm is closest to:

A) $12.5 million
B) $5.2 million
C) $10.0 million
D) $5.0 million

Question 19

Use the information for the question(s) below.
You founded your own firm three years ago. You initially contributed $200,000 of your own money and in return you received 2 million shares of stock. Since then, you have sold an additional 1 million shares of stock to angel investors. You are now considering raising capital from a venture capital firm. This venture capital firm would invest $5 million and would receive 2 million newly issued shares in return.
Assuming that this is the venture capitalist's first investment in your firm,the post-money valuation of your shares are closest to:

A) $5.0 million
B) $12.5 million
C) $4.0 million
D) $2.5 million

Question 20

Which of the following statements is false?

A) Once a company goes public, it must satisfy all of the requirements of public companies.
B) Organizations such as the Securities and Exchange Commission (SEC), the securities exchanges (including the New York Stock Exchange and the Nasdaq), and Congress (through the Sarbanes-Oxley Act of 2002) adopted new standards that focused on more thorough financial disclosure, greater accountability, and more stringent requirements for the board of directors.
C) The major advantage of undertaking an IPO is also one of the major disadvantages of an IPO: When investors diversify their holdings, the equity holders of the corporation become more concentrated.
D) Several high profile corporate scandals during the early part of the twenty-first century prompted tougher regulations designed to address corporate abuses.

Question 21

Describe the four characteristics of IPOs that puzzle financial economists.

Question 22

Which of the following statements is false?

A) In recent years, the investment banking firm of W.R. Hambrecht and Company has attempted to change the IPO process by selling new issues directly to the public using an online auction IPO mechanism called Open IPO.
B) The lead underwriter is the primary banking firm responsible for managing the deal. The lead underwriter provides most of the advice and arranges for a group of other underwriters, called the syndicate, to help market and sell the issue.
C) Because of the potential conflict of interest, the underwriter will not make a market in the stock after the issue.
D) The SEC requires that companies prepare a registration statement, a legal document that provides financial and other information about the company to investors, prior to an IPO. Company managers work closely with the underwriters to prepare this registration statement and submit it to the SEC.

Question 23

Use the information for the question(s) below.
Luther Industries is in the process of selling shares of stock in an auction IPO. At the end of the bidding period, Luther's investment bank has received the following bids:

What will the offer price of these shares be if Luther is selling 1 million shares?

A) $17.00
B) $17.50
C) $17.25
D) $16.75

Question 24

Use the information for the question(s) below.
Luther Industries is in the process of selling shares of stock in an auction IPO. At the end of the bidding period, Luther's investment bank has received the following bids:

What will the proceeds from the IPO be if Luther is selling 1.1 million shares?

Question 25

Use the information for the question(s) below.
Luther Industries is in the process of selling shares of stock in an auction IPO. At the end of the bidding period, Luther's investment bank has received the following bids:

What will the offer price of these shares be if Luther is selling 800,000 shares?

Question 26

Aaron Inc went public at $10 per share.Aaron's investment banker charged them $0.70 per share for the IPO.This fee is called a(n)

A) allocation spread.
B) underwriting spread.
C) greenshoe fee.
D) IPO fee.

Question 27

Use the information for the question(s) below.
Luther Industries is in the process of selling shares of stock in an auction IPO. At the end of the bidding period, Luther's investment bank has received the following bids:

The proceeds from the IPO be if Luther is selling 1.25 million shares is closest to:

A) $20.6 million
B) $21.6 million
C) $21.1 million
D) $20.9 million

Question 28

When referring to IPOs,what is book building?

Question 29

As part of the registration statement,called the preliminary prospectus,circulates to investors before the stock is offered.This preliminary prospectus is also called a(n)

A) IPO filing.
B) 10-K filing.
C) blue whale.
D) red herring.

Question 30

Which of the following statements is false?

A) Once the issue price (or offer price) is set, underwriters may invoke another mechanism to protect themselves against a loss-the over-allotment allocation.
B) Before the offer price is set, the underwriters work closely with the company to come up with a price range that they believe provides a reasonable valuation for the firm.
C) Before an IPO, the company prepares the final registration statement and final prospectus containing all the details of the IPO, including the number of shares offered and the offer price.
D) A "road trip" is where senior management and the lead underwriters travel around the country (and sometimes around the world) promoting the company and explaining their rationale for the offer price to the underwriters' largest customers-mainly institutional investors such as mutual funds and pension funds.

Question 31

Which of the following statements regarding exit strategies is false?

A) An alternative way to provide liquidity to its investors is for the company to become a publicly traded company.
B) An important consideration for investors in private companies is their exit strategy or how they will eventually realize the return from their investment.
C) Often large corporations purchase successful start-up companies. In such a case, the acquiring company purchases the outstanding stock of the private company, allowing all investors to cash out.
D) Roughly 25% of venture capital exits from 2001-2005 occurred through mergers or acquisitions.

Question 32

Use the following information to answer the question(s) below.
Wyatt Oil has 8 million shares outstanding and is about to issue 10 million new shares in an IPO. The IPO price has been set at $15 per share, and the underwriting spread is 6%. The IPO is a big success with investors, and the share price rises to $35 the first day of trading.
The amount that Wyatt Oil pays as an underwriting spread closest to:

A) $6 million
B) $7 million
C) $9 million
D) $17 million
E) $21 million

Question 33

Use the following information to answer the question(s) below.
Wyatt Oil has 8 million shares outstanding and is about to issue 10 million new shares in an IPO. The IPO price has been set at $15 per share, and the underwriting spread is 6%. The IPO is a big success with investors, and the share price rises to $35 the first day of trading.
The amount that Wyatt Oil raised during the IPO is closest to:

A) $113 million
B) $141 million
C) $150 million
D) $329 million
E) $350 million

Question 34

Use the following information to answer the question(s) below.
Wyatt Oil has 8 million shares outstanding and is about to issue 10 million new shares in an IPO. The IPO price has been set at $15 per share, and the underwriting spread is 6%. The IPO is a big success with investors, and the share price rises to $35 the first day of trading.
Suppose that the post IPO value of Wyatt is its fair market value.Suppose Wyatt could have issued shares directly to investors at their fair market value,in a perfect market with no underwriting spread and no under pricing.If you raise the same amount of funds that you would have with the investment banker handling the underwriting,the share price in this case is closest to:

A) $35
B) $37
C) $46
D) $61
E) $73

Question 35

Use the following information to answer the question(s) below.
Wyatt Oil has 8 million shares outstanding and is about to issue 10 million new shares in an IPO. The IPO price has been set at $15 per share, and the underwriting spread is 6%. The IPO is a big success with investors, and the share price rises to $35 the first day of trading.
The total cost to the firm's original investors due to the market imperfections from the IPO is closest to:

A) $141 million
B) $210 million
C) $280 million
D) $489 million
E) $630 million

Question 36

Which of the following is not one of the four characteristics of IPOs that puzzle financial economists?

A) On average, IPOs appear to be underpriced.
B) The long-run performance of a newly public company (three to five years from the date of issue) is superior to the overall market return.
C) The number of issues is highly cyclical.
D) The costs of the IPO are very high, and it is unclear why firms willingly incur such high costs.

Question 37

Which of the following statements regarding firm commitment IPOs is false?

A) If the entire issue does not sell out, the remaining shares must be sold at a lower price and the underwriter must take the loss.
B) The underwriter purchases the entire issue (at a the offer price) and then resells it at a slightly higher price to interested investors.
C) It is the most common underwriting arrangement.
D) The underwriter guarantees that it will sell all of the stock at the offer price.

Question 38

Use the information for the question(s) below.
During the most recent fiscal year, KD Industries had revenues of $400 million and earnings of $30 million. KD has filed a registration statement with the SEC for its IPO. Before it is offered, KD's investment bankers would like to estimate the value of the company using comparable companies. The investment bankers have assembled the following information based on data for other companies in the same industry that have recently gone public. In each case the ratios are based upon the IPO price.

Based upon the price/earnings ratio,what would be a reasonable value for KD?

Question 39

Use the following information to answer the question(s) below.
Wyatt Oil has 8 million shares outstanding and is about to issue 10 million new shares in an IPO. The IPO price has been set at $15 per share, and the underwriting spread is 6%. The IPO is a big success with investors, and the share price rises to $35 the first day of trading.
The market value of Wyatt Oil after the IPO is closest to:

A) $329 million
B) $350 million
C) $592 million
D) $609 million
E) $630 million

Question 40

Use the information for the question(s) below.
During the most recent fiscal year, KD Industries had revenues of $400 million and earnings of $30 million. KD has filed a registration statement with the SEC for its IPO. Before it is offered, KD's investment bankers would like to estimate the value of the company using comparable companies. The investment bankers have assembled the following information based on data for other companies in the same industry that have recently gone public. In each case the ratios are based upon the IPO price.

Based upon the price/revenue ratio,what would be a reasonable value for KD?

Question 41

Which of the following statements is false?

A) In a rights offer, the firm offers the new shares only to existing shareholders.
B) Secondary shares are shares sold by existing shareholders, including the company's founder.
C) If a firm's management is concerned that its equity may be under priced in the market, by using a rights offering the firm can continue to issue equity without imposing a loss on its current shareholders.
D) In the United States most offers are rights offers.

Question 42

Which of the following statements is false?

A) SEO rights offers have lower costs than cash offers.
B) The decision to raise financing externally usually implies that a firm plans to pursue an investment opportunity.
C) Although not as costly as IPOs, seasoned offerings are still expensive.
D) Researchers have found that, on average, the market greets the news of an SEO with a price increase.

Question 43

Which of the following statements is false?

A) More often than not, firms return to the equity markets and offer new shares for sale, a type of offering called a seasoned equity offering (SEO).
B) Usually, profitable growth opportunities occur throughout the life of the firm, and in some cases it is not feasible to finance these opportunities out of retained earnings.
C) When a firm issues stock using an SEO, it follows many of the same steps as for an IPO. The main difference is that a market price for the stock already exists, so the price-setting process is not necessary.
D) A firm's need for outside capital usually ends at the IPO.

Question 44

Use the following information to answer the question(s) below.
Nielson Motors sold 10 million shares of stock in an SEO. The market price of Nielson's stock at the time was $37.50. Of the 10 million shares sold, 4 million shares were primary shares sold by the company, and the remaining 6 million shares were being sold by the venture capital investors. Assume the underwriter charges 4% of the gross proceeds as an underwriting fee which is shared proportionately between the primary and secondary shares.
The amount of money the underwriter will earn on this transaction is closest to:

A) $4 million
B) $6 million
C) $9 million
D) $15 million

Question 45

Use the following information to answer the question(s) below.
Nielson Motors sold 10 million shares of stock in an SEO. The market price of Nielson's stock at the time was $37.50. Of the 10 million shares sold, 4 million shares were primary shares sold by the company, and the remaining 6 million shares were being sold by the venture capital investors. Assume the underwriter charges 4% of the gross proceeds as an underwriting fee which is shared proportionately between the primary and secondary shares.
The amount of money raised by Nielson Motors is closest to:

A) $144 million
B) $150 million
C) $216 million
D) $219 million

Question 46

Luther Industries currently has 100 million shares of stock outstanding at a price of $25 per share.The company would like to raise money and has announced a rights issue.Every existing shareholder will be sent one right per share of stock that he or she owns.The company plans to require twenty rights to purchase one share at a price of $20 per share.The amount of money that Luther will raise through its rights offering is closest to:

A) $500 million
B) $125 million
C) $100 million
D) $400 million

Question 47

Which of the following statements is false?

A) The one advantage of a cash offer is that the underwriter takes on a larger role and, therefore, can credibly certify the issue's quality.
B) SEO underwriting fees average about 5% of the proceeds of the issue and, as with IPOs, the variation across issues of different sizes is relatively small.
C) As with IPOs, evidence suggests that companies over perform following a seasoned offering.
D) Often the value destroyed by the price decline can be a significant fraction of the new money raised with a SEO.

Question 48

Use the information for the question(s) below.
Luther Industries sold 10 million shares of stock in an SEO. The market price of Luther at the time was $25 per share. Of the 10 million shares sold, 6 million shares were primary shares being sold by the company, and the remaining 4 million shares were being sold by venture capitalists. Luther's underwriters charges 5% of the gross proceeds as an underwriting fee.
How much money did Luther raise?

Question 49

Use the following information to answer the question(s) below.
Nielson Motors sold 10 million shares of stock in an SEO. The market price of Nielson's stock at the time was $37.50. Of the 10 million shares sold, 4 million shares were primary shares sold by the company, and the remaining 6 million shares were being sold by the venture capital investors. Assume the underwriter charges 4% of the gross proceeds as an underwriting fee which is shared proportionately between the primary and secondary shares.
The amount of money raised by the venture capitalists is closest to:

A) $144 million
B) $150 million
C) $216 million
D) $219 million

Question 50

Which of the following statements is false?

A) Primary shares are new shares issued by the company.
B) Today, investors become informed about the impending sale of stock by the news media, via a road show, or through the book-building process, so tombstones are purely ceremonial.
C) In a cash offer, the firm offers the new shares to existing shareholders.
D) Historically, intermediaries would advertise the sale of stock (both IPOs and SEOs) by taking out advertisements in newspapers called tombstones.

Question 51

Use the information for the question(s) below.
Luther Industries sold 10 million shares of stock in an SEO. The market price of Luther at the time was $25 per share. Of the 10 million shares sold, 6 million shares were primary shares being sold by the company, and the remaining 4 million shares were being sold by venture capitalists. Luther's underwriters charges 5% of the gross proceeds as an underwriting fee.
How much money did the venture capitalists receive?