Fall 2022 Midterm Test on Expenses Incurred During IPOS- Finance, Louisiana State University

The midterm test done in Fall 2022 at Louisiana State University was on the expenses incurred during IPOs. We have prepared the below blog to include the four questions that were examined on this test to help you know what to expect in future. These questions include detailed solutions to guide you in preparation of upcoming finance exams. You can also hire our finance exam solvers to take your exam for you.

Exam Question:

When going public, a company incurs certain expenses. What are the major expenses payable to professionals during the underwriting of the issue?

Exam Solution

The major amounts payable to the various professional firms are as follows:

Merchant banks

Underwriting fees vary widely from market to market, being perhaps most expensive in the US where fees for underwriting a small initial public offering can go as high as 10%. In the UK and markets influenced by the UK, underwriting fees tend to be about 2% of the amount raised. The total fee will be split into two. A management fee will be retained by the lead merchant bank(s) as their reward for bringing the company to market, putting their name to the prospectus and underwriting and managing the issue. The bulk of the fee, however, will be passed on to the underwriting or selling syndicate, for their risk in taking sub- underwriting or their efforts in selling.

On the whole, there seems to be little competition among institutions on pricing. Underwriting fees suggested by merchant banks for similar types of issues are not likely to vary sharply in a particular market. The major participants in the market probably know each other well enough to avoid a price war.

From the company's point of view, though the expense of underwriting is important, it is greatly outweighed by whether the issue can be underwritten at all. Bargaining takes place at the outset when the promoters may be ill-informed about the flotation process. Promoters pre-occupied about the overall success of the issue in the later stages are in a poor position to argue hard about the precise underwriting expense.

Underwriting and selling fees may be paid directly as such, or may be built into a spread between the price at which securities are acquired from the company or the vendor shareholders and the price at which they are sold to the market, depending on the type of issue being made.

In addition to underwriting fees, the merchant bank will sometimes charge a financial advisory or documentation fee to cover the work involved on the structure of the issue and in drafting the prospectus. As the merchant bank's major reward will come from underwriting fees, any additional fee is likely to be negotiable. Merchant banks would far rather reduce or even eliminate this element than disturb a relatively fixed underwriting fee structure,

Accountants and lawyers

The fees of the merchant bankers will not vary significantly with the amount of work done. The accountants and lawyers on the other hand will charge primarily on a time spent basis. Most accountants and lawyers will also have a system of weighting a particular job by urgency, complexity and other factors. However, the final bill will principally depend on the number of man hours absorbed in the work required.

Stockbrokers

The stockbrokers will be paid a fee (perhaps 1% of the amount of the issue) directly by the company or by the merchant bank out of their overall underwriting fee for their involvement in putting together the sub-underwriting syndicate. They will also charge a flat fee for their processing work as regards the stock exchange.

The principal reward for a broker in being associated with a flotation may come later, from commissions when market dealings begin. The broker sponsoring the launch of a company is likely to be seen as a leader in the market for the securities of that company and would hope to gain a lion's share of the trading.

Valuers

Valuers may be members of an association which publishes fixed fees for its members. In the context of a flotation, it may prove possible to negotiate a fee separately from the standard rate.

Receiving bankers, registrars and printers

The costs incurred will depend on variable factors such as the number of applications received, shares allotted and prospectuses printed.

Exam Question:

What are the two principal taxes and listing fees likely to be incurred when a company is going public?

Exam Solution:

Capital duty

Capital duty may arise when the authorized share capital of a company is increased or when new shares are issued. The tax is usually based on a percentage (perhaps 1%) of the amount involved. If authorized share capital is used as the basis, it will be calculated on the face amount of the increase. If the tax is based on the issued share capital, it is likely to include any premium at which the shares are issued over par value. If no acquisitions are made for shares and existing shares are sold via an offer for sale, no capital duty will be payable.

Capital duty will be hard to avoid if a new company is set up to act as the holding company for the group to be floated and acquires its subsidiaries by an exchange of shares. Capital duty will be payable in effect not only on any new shares issued at the time of the flotation but on the entire value of the group as reorganized for going public. There is a substantial cost saving if an existing company controlling as many of the interests to be floated as possible is suitable for use as the new listed company. Any reorganization of the group should be designed with an eye to minimizing the capital duty impact.

Transfer duty

Transfer duty can arise in two ways. In the first instance it can arise upon the reorganization of the group when assets or businesses are transferred to the new holding company. Transfer tax may be incurred whatever form of payment the holding company uses. Different rates may apply, however, on assets and shares so that it may be advantageous for example to transfer the share capital of a company which holds an asset rather than transfer the asset itself. Various tax avoidance schemes are available (depending on the jurisdiction involved) to limit the extent to which transfer duty may be incurred. Such schemes tend to be subject to periodic attack by tax authorities and changes of legislation. The second area where transfer duty is involved is if existing shares are sold. In this case both the vendors and the purchasers will be obliged to pay transfer duty at the relevant rate, based on the issue price. The payment of some tax is almost inevitable. A new issue does not involve transfer duty but will probably incur capital duty, an offer for sale of existing shares vice versa. The use of renounceable certificates may help in some jurisdictions. A corporate reorganization prior to flotation may also trigger transfer duty and capital duty if a share exchange is used.

Listing fees

The stock exchange will charge an initial listing fee, normally on a scale varying with the market value (at the issue price) of the entire class of capital for which a listing is granted. Thereafter, a lower annual fee is payable by all listed companies.

Exam Question:

If the issue is over-subscribed, how can a company offset the expenses incurred during the flotation?

Exam Solution

If the issue is over-subscribed, there may be a considerable amount of funds available for placing in the money markets until the over-subscription moneys are returned. The money cannot be returned until the basis of allotment is arrived at and refund cheques are prepared and posted out which may take a number of days. It is customary for the interest earned on over-subscriptions to be retained by the company to defray the expenses of the issue. It is not unknown for a heavy over-subscription at a period of high interest rates to result in expenses being covered and an overall profit being made. Although there may be a suspicion in investors' minds that return of over-subscription moneys is delayed deliberately. the merchant and receiving banks are sensitive to possible criticism and do not themselves benefit from delay. It is sometimes suggested that an attempt should be made to pay the interest back to unsuccessful applicants. Their funds generate the interest in the first place and they perhaps deserve a consolation prize for not achieving their desired investment. However, this possibility seems to be too burdensome for the organizers of issues to consider worthwhile.

Exam Question:

Who pays the different expenses incurred when a company is going public?

Exam Solution

If the whole issue is devoted to raising new funds for the company, all the expenses incurred are payable by the company. If the prospectus involves solely the sale of existing shares, the underwriting costs will be borne by the holders of those shares. There is some flexibility in who bears the remaining costs, with some proportion normally borne by the company.

Where a new issue and an offer for sale are combined, the expenses of underwriting are shared in the same proportion as the proceeds. The administrative expenses involved in gaining the listing (such as printing and advertising costs and professional fees) may be borne wholly by the company going public, on the grounds that the listing is a corporate matter and has long- term benefits to the company. Alternatively, they may be split in the same proportion as the proceeds of the issue. Any transfer duty payable on the offer for sale shares is borne by the shareholders who sell those shares. The capital duty on new shares issued to the public will be borne entirely by the company.