Question

Suppose that Minecrafter goes public at the offer price of $22 per share. Minecrafter wishes to raise $10,000,000 net of all fees. The underwriting spread is 7% and listing fees are $1,000,000.

Part One – IPO fees and overallotment option

a) How many shares does Minecrafter need to issue in order to raise the required amount?

b) What is the discounted price at which Minecrafters’ underwriter purchase the shares prior to resale at the offer price?

c) Minecrafter’s IPO includes an overallotment option of 15%. What is the total expected payoff from the overallotment option if with 50% probability the opening price is $30 per share and with 50% probability the opening price of Minecrafter’s IPO is $20 per share?

Part Two– Executive compensation

The founder of Minecrafter, Ed Smith, received 37,000 executive stock options prior to the IPO. These options expire in five years. The exercise price of these options is $15 per share. Of these options, 25,000 are exercisable and 12,000 have yet to vest and are therefore un‐exercisable. 2

a) What is the total intrinsic value of the exercisable options at the offer price of $22? What is the total intrinsic value of the un‐exercisable options at the offer price of $22?

b) Why might Ed Smith wish to exercise the exercisable options prior to expiry?

c) Explain why some options grants may not vest immediately. Why are vesting periods a common feature of executive compensation?

d) Assume Ed Smith’s only form of compensation consists of the executive stock options described above. If six months after the IPO, shares in Minecrafter decline to $0.50 per share, how does this decline affect Ed Smith’s incentives to put in effort into the firm? How might the board of directors of Minecrafter adjust Ed’s option compensation package to address this issue?

Answer 1

(1)

Offer Price = $ 22 (this is the price at which shares are being offered to investors on the exchange)

Net Amount to be Raised = $ 10 million,

Underwriting Spread = 7% of the Net Amount to be Raised

Listing Fees = $ 1 million

Net Proceeds to be Recovered = Net Amount Raised + Underwriting Spread (fees) + Listing Fees  

= 10 + 0.07 x 10 + 1

= $ 11.7 million

(a) Net Proceeds to be Recovered = $ 11.7 million and Offer Price = $ 22

Therefore, number of shares to be issued = 11.7 million / 22 = 0.531818 million or approximately 53182 shares

(b) Let the discounted price be K $ per share for the underwriter (The underwriter's effective discounted price per share is equal to the net proceeds to be raised by the IPO issuer divided by the number of shares issued. Net Proceeds is total IPO proceeds minus any IPO issue related fees/charges).

Then, K x 53182 = Net Proceeds to be Raised

K = 1000000 / 53182 = $ 18.80 per share

(c) The underwriter has an option of issuing 15% more shares than originally planned through a 15% overallotment option.

Size of the overallotment option = 15% of planned issue = 0.15 x 53182 = 7977.3 or approximately 7977 shares (over and above the 53182 originally planned to be issued)

Offer Price = $ 22 and Opening Price 1 = $ 30. Therefore, Profit in Scenario 1 = P1 = 30 - 22 = $ 8 per share

Offer Price = $ 22 and Opening Price 2 = $ 20. Therefore, Loss in Scenario 2 = L1 = 20 - 22 = - $ 2 per share

Expected Payoff from Overallotment Option = Over allotment option size x Expected Payoff Per Share

= 7977 x [P1 x Probability of P1 + L1 x Probbility of L1]

= 7977 x [8 x 0.5 - 2 x 0.5]

= 7977 x [4 - 1]

=7977 x 3

= $ 23931

NOTE: The expected payoff is calculated only on the overallotment option size and not the entire issue. Also, the opening price and offer price are not the same thing. Offer Price is the price at which IPO investors are offered the share and opening price is the price at which the first trade opens on this IPOed share in th exchange.

(2) Exercisable Lot Size = 25000 shares and Un exercisable lot size = 12000

Offer Price = $ 22 per share and Strike Price/Exercise Price = $ 15 per share

Intrinsic Value Per share = Offer Price - Exercise Price = 22 - 15 = $ 7 per share

Intrinsic Value of Exercisable Lot = 25000 x 7 = $ 175000 and Intrinsic Value of Unexercisable Lot = 12000 x 7 = $ 84000

NOTE: Please raise a separate query for answers to the remaining sub parts.