Question

Batman Enterprises has just completed an initial public offering. The firm sold 500,000 new shares (the primary offering). In addition, existing shareholders sold 300,000 shares (the secondary issue). The new shares were offered to the public at $18.50 per share and underwriters received a spread of $1.00 a share. The legal, administrative, and other costs were $50,000 and were split proportionately between the company and the selling stockholders.

How much money did the company receive before paying its proportion of the direct costs? Answer: 8,750,000

Suppose that on the first day of trading, the price of Batman's stock is $21.50 per share. What is the cost to the firm from the underpricing? Answer: 1,500,000

Given that the company receives $8,750,000 from the issue before paying the direct costs and that the cost from underpricing is $1,500,000, what are the total costs of the issue to the firm? Give your answer rounded to the nearest dollar.

Answer 1

The total cost of the issue to the firm = Direct cost + Underwriting cost + underpricing cost

Direct Cost:

Direct cost includes Legal, Administrative and other costs. Which is $50,000 in this case, however, this amount will be divided proportionally between the firm and existing shareholder.

So, total share issued is 500,000 + 300,000 = 800,000

Out of those 800,000 firm issued 500,000 shares. so, proporton of share issued by firm is 500,000/800,000 = 62.5%.

As the firm's proportion is 62.5% firm will bear 62.5% of direct cost.

62.5% of 50,000 is $31,250

Underwriting cost:

As the firm is underwriters are receiving spread of $1 per share. It is a cost of $1 per share to the firm.

So, total Underwriting cost to the firm is 500,000 * $1 = $500,000

Underpricing cost:

As given that underpricing cost is $1,500,000 to the firm. ( it's $3*500,000)

= $1,500,000

So, Total cost = Direct cost + Underwriting cost + underpricing cost

= $31,250 + $500,000 + $1,500,000

= $2,031,250

Answer: $2,031,250

However, some analysts do not consider underpricing cost as cost to the firm, in that case, the cost to the firm comes at $531,250.