Question

An investment bank agrees to underwrite an issue of 16 million shares of stock for Looney Landscaping Corp.

a. The investment bank underwrites the stock on a firm commitment basis, and agrees to pay $15.00 per share to Looney Landscaping Corp. for the 16 million shares of stock. The investment bank then sells those shares to the public for $16.00 per share. How much money does Looney Landscaping Corp. receive? What is the profit to the investment bank? If the investment bank can sell the shares for only $13.25, how much money does Looney Landscaping Corp. receive? What is the profit to the investment bank?

b. Suppose, instead, that the investment bank agrees to underwrite the 16 million shares on a best efforts basis. The investment bank is able to sell 15.0 million shares for $15.00 per share, and it charges Looney Landscaping Corp. $0.275 per share sold. How much money does Looney Landscaping Corp. receive? What is the profit to the investment bank? If the investment bank can sell the shares for only $13.25, how much money does Looney Landscaping Corp. receive? What is the profit to the investment bank?

Answer 1

1. If the investment bank sells the stock for $16.00 per share, Looney Landscaping Corp. receives $15.00 x 16,000,000 shares = $240,000,000. The profit to the investment bank is ($16.00 - $15.00) x 16,000,000 shares = $16,000,000. From the perspective of Looney Landscaping Corp., the $16,000,000 represents the commission that it must pay to issue the stock. If the investment bank sells the stock for $13.25 per share, Looney Landscaping Corp. still receives $15.00 x 16,000,000 shares = $240,000,000. The profit to the investment bank in such case is ($13.25 - $15.00) x 16,000,000 shares = -$28,000,000. From the perspective of the investment bank, the -$28,000,000 represents a loss for the firm commitment it made to Looney Landscaping Corp. to issue the stock.
2. If the investment bank sells the stock for $15.00 per share, Looney Landscaping Corp. receives ($15.00 - $0.275) x 15,000,000 shares = $220,875,000. Investment bank's profit is $0.275 x 15,000,000 shares = $4,125,000. If the investment bank sells the shares for $13.25 per share, Looney Landscaping Corp. receives ($13.25 - $0.275) x 15,000,000 shares = $194,625,000 and the investment bank's profit is still $0.275 * 15,000,000 shares = $4,125,000.

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