If an investment banker has agreed to sell a new issue of securities on a best-efforts basis, the issue
- most likely involves an unusually large stock offering.
- most likely involves bonds instead of common stock.
- results in no assumption of underwriting risk by the investment banker.
- most likely involves a well-established, large company.
Answer: c. results in no assumption of underwriting risk by the investment banker.
Answer Explanation
Correct answer is (c) Because the investment banker does not assume any underwriting risk. A best-efforts basis refers to the fact that the investment banker does not agree to purchase the securities from the issuer when he or she sells a new issue of securities. However, investment bankers do not assume any underwriting risk, but instead use their best efforts to sell securities.
Best-effort underwriting involves the investment banker acting as a sales agent and earning a commission or fee when the securities are successfully sold. The issuer retains the risk of unsold securities and receives no funds from the investment banker until the securities are actually sold to investors.
Issuers who prefer not to take on the cost and risk associated with a firm commitment underwriting may opt for this type of underwriting for smaller or riskier offerings.
Why the other options are not correct
a. most likely involves an unusually large stock offering.
This option is not correct because the size of the offering is not directly related to whether it is sold on a best-efforts basis or not. Best-efforts underwriting can be used for both large and small offerings, depending on the issuer’s preferences and risk profile.
b. most likely involves bonds instead of common stock.
There is no guarantee that (b) will involve bonds rather than common stock, since whether the underwriting is best-efforts or firm commitment doesn’t determine the type of securities being offered. It depends on the issuer’s capital needs and market conditions whether either underwriting approach is used to offer both types of securities.
d. Most likely involves a, well-established large company:
This option is incorrect because best-efforts underwriting is not dependent on a company’s size or status. If best-efforts underwriting aligns with a company’s financing strategy, it is available to companies regardless of size or level of establishment.
Conclusion
The best-efforts basis means that an investment banker does not assume any underwriting risk when he or she sells a new issue of securities. The investment banker acts as a sales agent and earns a commission for successfully selling the securities, while the issuer retains the risk of unsold securities.
Other options (a) Most likely involves a large stock offering, (b) Most likely involves bonds instead of common stock, and (d) Most likely involves a well-established, large company are incorrect because they do not determine if the underwriting is best-efforts or firm commitment. It is crucial for investors and issuers to be aware of the different underwriting methods.