Mace and Thomas Buildings Inc. has decided to go public by selling $10,000,000 o

Question

Mace and Thomas Buildings Inc. has decided to go public by selling $10,000,000 of new common stock. Its investment bankers agreed to take a smaller fee now (7% of gross proceeds versus their normal 12%) in exchange for a 1?year option to purchase an additional 300,000 shares at $5.00 per share. The investment bankers expect to exercise the option and purchase the 300,000 shares in exactly one year, when the stock price is forecasted to be $4.50 per share. However, there is a chance that the stock price will actually be $10.00 per share one year from now. If the $10 price occurs, what would the present value of the entire underwriting compensation be?

Assume that the investment banker's required return on such arrangements is 18%, and ignore taxes.

Explanation / Answer

If the $10 price occurs, the profit the bank will make on exercising the option after 1 year will be

=300,000 * (10-5)

=$1,500,000

PV of this future profit = PV(18%,1,,-1500000) = $1,271,186

Also, for the entire arrangement the bank is losing 5% fee = $10,000,000 *5% = $500,000

Therefore, the present value of the entire underwriting compensation = 1,271,186 - 500,000 = $7,271,186

Note that the bank is overall making the 7% on gross proceeds i.e. $700,000 + the $1,271,186 = $1,9271,186

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