Question

Firm commitment versus best efforts. Astro Investment Bank offers Lunar Vacations the following options on its initial public sale of? equity:??

?(a?) a best efforts arrangement whereby Astro will keep 2.8% of the retail sales or ?(b?) a firm commitment arrangement of $9,600,000.

Lunar plans on offering 1,000,000 shares at ?$12.34 per share to the public. If it sells 100% of the? shares, which is the better choice for Lunar? Vacations? Which is the better choice for Astro Investment? Bank?

Please provide the proceeds for each option. Essentially show each step of the process.

Answer 1

In a best effort underwriting arrangement, astro will do its best to sell the entire issue and charge 2.8% of the proceeds as its fees. However there will be no guarantee of number of shares it will be able to sell. In a firm commitment arrangement, it will buy the entire issue with a promised amount of $9.6 million to Lunar. If it manages to get higher proceeds, it will keep the excess amount as its fee/commission. However if it fails sell shares worth the promised amount, it will have to provide the additional amount from its own pocket to make up for the difference.

If Lunar manages to sell 100% of the issue, it will receive $12,340,000. Under best efforts arrangement, Lunar will pay Astro 2.8% of 12,340,000 or $345,520. Under firm commitment arrangement, Astro will receive the difference amount of 12,340,000 - 9,600,000 = $2,740,000.

For Lunar, the best efforts offer is much cheaper than the firm commitment offer and the opposite is true for Astro. However firm commitment offers are like dual edged swords. There is high risk associated with it.