Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy(^574) 16. Raising Capital © The McGraw−Hill
Companies, 2002
Even though the IPO raised a gross sum of $7.15 million, Multicom got to keep less
than $6 million after expenses. The largest cost was the underwriter spread. Multicom
sold each of the 1.1 million shares to the underwriters for $5.98, and the underwriters
in turn sold to the public for $6.50 each. Thus, of the $7.15 million investors paid for
the shares, Multicom received only about $6.6 million. In addition, Multicom paid
$145,000 to the underwriters to defray expenses incurred.
But wait, there’s more. Multicom also spent $57,590 on fees to the Securities and Ex-
change Commission, along with exchange and listing fees. In addition, as a direct result
of the public offering, Multicom spent $100,000 for insurance for directors and officers,
$150,000 on accounting to obtain the necessary audits, $10,000 for a transfer agent to
physically transfer the shares and maintain a list of shareholders, $75,000 for printing
and engraving expenses, $200,000 for legal fees and expenses, and, finally, $12,049 for
miscellaneous expenses.
As Multicom’s outlays show, an IPO can be a costly undertaking! In the end, Multi-
com’s expenses totaled $1,321,639, of which $717,000 went to the underwriters and
$604,639 went to other parties. The total cost to Multicom was 18.5 percent of the issue
proceeds. Still, the company may have gotten off cheap at that price. As of December
31, 1996, Multicom’s stock closed at $1.625, never having traded for higher than $7.25
a share for the year.
RIGHTS
When new shares of common stock are sold to the general public, the proportional own-
ership of existing shareholders is likely to be reduced. However, if a preemptive right is
contained in the firm’s articles of incorporation, then the firm must first offer any new
issue of common stock to existing shareholders. If the articles of incorporation do not
include a preemptive right, the firm has a choice of offering the issue of common stock
directly to existing shareholders or to the public.
An issue of common stock offered to existing stockholders is called a rights offering
(or offer, for short) or a privileged subscription. In a rights offering, each shareholder is
issued rights to buy a specified number of new shares from the firm at a specified price
within a specified time, after which time the rights are said to expire. The terms of the
rights offering are evidenced by certificates known as share warrants or rights. Such
rights are often traded on securities exchanges or over the counter.
The Mechanics of a Rights Offering
To illustrate the various considerations a financial manager faces in a rights offering, we
will examine the situation faced by the National Power Company, whose abbreviated
initial financial statements are given in Table 16.7.
As indicated in Table 16.7, National Power earns $2 million after taxes and has one
million shares outstanding. Earnings per share are thus $2, and the stock sells for $20, or
10 times earnings (that is, the price-earnings ratio is 10). To fund a planned expansion, the
company intends to raise $5 million worth of new equity funds through a rights offering.
CONCEPT QUESTIONS
16.7a What are the different costs associated with security offerings?
16.7bWhat lessons do we learn from studying issue costs?
546 PART SIX Cost of Capital and Long-Term Financial Policy