Discuss why the initial public offerings of small companies tend to be under priced, and suggest ways to minimize such under pricing.

NUTEC LIMITED
Nutec Limited is a small unquoted company, engaged in the manufacture of electronic
components. Bob Byte, the firms Chairman and major shareholder, proposes to obtain a
quotation on the Alternative Investment Market and issue new ordinary shares to raise
250,000 of additional capital, net of issue costs amounting to 4% of the gross proceeds.
The company’s most recent summarized financial accounts are furnish Profit and loss account
Turnover 1,240,300
Operating costs 1,120,950
Net interest payable 33,850
Profit before taxation 85,500
Taxation 17,100
Profit attributable to ordinary shareholders 68,400
Ordinary dividends 28,000
Retained profit 40,400
BalancFixed assets
Land & building 260,000
Plant & machinery 105,000 365,000
Current assets
Inventory 120,000
Receivables 150,000
Cash 4,000
Other current assets 10,000 284,000
Total Assets 649,000
Current liabilities
Bank overdraft (110,000)
Trade payables (101,000)
Other current liabilities (20,000) 231,000
Bank term loan 75,000
Total Liabilities 306,000
Ordinary shares (par value 25 pence each) 270,000
Retained earnings 73,000
Total Equity 343,000
Total Liabilitiese sheBobs daughter, Barbara Byte, who writes the firms accounts, has estimated the market
value of land and building at 400,000, and that of plant and machinery at 125,000.
Current assets include 20,000 of obsolete stock which are saleable at 25% of book value.
Ten percent of book debts are considered doubtful.
The firm proposes to maintain its long-standing dividend policy of paying out
approximately 40% of its distributable earnings. Investment of the fresh capital raised is
expected to increase the company’s post-tax distributable earnings by 50,000 in the first
year, and enable the company to achieve an overall earnings growth rate of 9% per annum
for the next four years; thereafter the growth rate is expected to settle at a level of 6% per
annum for the foreseeable future The treasury bill yield of 2% per annum is expected to remain fairly stable for the
foreseeable future. The average market return is estimated at 10% per annum.
Nutec proposes to make the share issue on the basis of the appropriate market value
estimated using a standard business valuation technique. Barbara suggests a
straightforward assets valuation, but it has been suggested that the valuation ought to be
done by comparison with a similar quoted company in the same industry. It has also been
suggested that it is normal for initial public offerings to be underpriced, so whatever value
is estimated on the basis of a similar quoted company should be discounted by 30%. Bob
Byte accordingly favours a simple earnings valuation, using the next five years average
earnings, and an appropriate P/E ratio. But the firms financial advisers and underwriters
prefer to use a more complex dividend valuation. Relevant information on two listed companies engaged in the same line of activity as Nutec,
are furnished below:
Hitec plc Trutec plc
Distributable earnings 4.8m 1.65m
Earnings growth rate 10% 8%
Share price 400p 36p
Market capitalization 60m 9.9m
Equity beta 1.2 1.5
Gearing: Total debt (including
current liabilities) to net worth 30% 50%
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Added on 16.11.2015 15:31
on two listed companies engaged in the same line of activity as Nutec,
are furnished below:
Hitec plc Trutec plc
Distributable earnings 4.8m 1.65m
Earnings growth rate 10% 8%
Share price 400p 36p
Market capitalization 60m 9.9m
Equity beta 1.2 1.5
Gearing: Total debt (including
current liabilities) to net worth 30% 5%
Required:
A. Using the three proposed valuation techniques, estimate the approximate
market value of Nutec plc.
(circa 25 marks)
B. Critically discuss the advantages and disadvantages of the three valuation
methods used, and suggest which you think would be most appropriate in the
given case.
(circa 25 marks)
Using the method of valuation that you consider the most appropriate,
calculate the number of shares the company should issue to raise the required
capital, the issue price (to the nearest penny), and the estimated price
earnings ratio.
(circa 10 marks)
Discuss why the initial public offerings of small companies tend to be
under priced, and suggest ways to minimize such under pricing.
(circa 20 marks
E Discuss the particular problems in estimating a discount rate for valuing small
enterprises, and how you think they might be addressed. (circa 20 marks