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Pricing New Securities

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Explain how the price of a new security is determined.

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A security can be either a stock or a bond. For stocks, new securities are called initial public offerings (IPOs). A company's initial offering price will be set based on the company's market value and the number of its shares outstanding. If the company and its underwriters want to lower or raise the share price, the company can split its shares or effect a reverse split. They may want to do this because low prices that are too low are associated with weak companies, but prices that are too high will make it difficult ...

Solution Summary

Pricing of bonds and initial public offerings (IPOs).

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MBA - Week 5 Problems

FIN/554 class:

1. Brealey, Chapter 15, page 429, Challenge Question 3

Here is recent financial data on Pisa Construction.
Stock Price: $40 Market value of firm: $400,000
# of Shares: 10,000 Earnings per share: $4
Book net worth: $500,000 Return on Investment: 8%

Pisa has not performed spectacularly to date. However, it wishes to issue new shares to obtain $80,000 to finance expansion into a promising market. Pisa's financial advisers think a stock issue is a poor choice because, among other reasons, "sale of stock at a price below book value per share can only depress the stock price and decrease shareholders' wealth." To prove the point they construct the following example: "Suppose 2,000 new shares are issued at $40 and the proceeds are invested. (Neglect issue costs.) Suppose return on investment doesn't change. Then
Book net worth = $580,000
Total earnings = .08(580,000) = $46,400
Earnings per share = 46,400/12,000 = $3.87
Thus, EPS declines, book value per share declines, and share price will decline proportionately to $38.70"

Evaluate this argument with particular attention to the assumptions implicit in the numerical example.

2. Brealey, Chapter 15, page 429, Challenge Question 4

Do you think that there could be a shortage of finance for new ventures? Should the government help to provide such finance and, if so, how?

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