Question

In its negotiations with its investment bankers, Patton Electronics has reached an agreement whereby the investment bankers receive a smaller fee now (6% of gross proceeds versus their normal 10%) but also receive a 1-year option to purchase an additional 200,000 shares at $5.00 per share. Patton will go public by selling $5,000,000 of new common stock. The investment bankers expect to exercise the option and purchase the 200,000 shares in exactly one year, when the stock price is forecasted to be $6.50 per share. However, there is a chance that the stock price will actually be $12.00 per share one year from now. If the $12 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 15%, and ignore taxes.

a. $1,235,925

b. $1,300,973

c. $1,369,446 d. $1,441,522

e. $1,517,391

Answer 1

Present Value(PV) of Entire Underwriting Compensation=

Commission as a fixed % of Gross Proceeds + PV of Gain by exercising option to purchase shares.

Fixed Commission= 5000000*6/100

=300000

Gain by exercising option=200000*(12-5)

=1400000

PV of Gain =1400000/(1+.15)¹

=1400000/1.15

=1217391.30

PV of Total Compensation=300000+1217391.30

=1517391.30

Hence the answer is e.1517391

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