Hop-In Foods Stores has historically been able to rely on internal financing and long term debt in order to continue its growth. The continued growth is attributed to acquisitions of already established stores. Hop-In management has predominantly stayed away from starting up new stores from scratch due to high start up costs. They had found out that it was easier and more cost effective to buy up smaller stores in good locations. As of 1976 all of Hop-In’s expansion was financed by long term debt or equity shed out by upper management.
Prior to 1976, Hop-In had had common shares outstanding, but was primarily traded only in Virginia. In order to continue the growth and expansion that management wanted they had to come up with additional funds. Equity financing was the answer to the Hop-In Food Stores need for the additional monies needed to cover growth costs. One of the main risks of IPO offerings is the risk of underpricing. This can be costly to both Hop-In and the investment bank. If the market decides that Hop-In’s value is worth more than initially offered stock prices with rise, leaving additional money that could have been raised by the company.
This money “left on the table” could have been used to finance other investments or pay down any outstanding debts. The investment bank takes on the risk from the standpoint that they did not properly value the stock price. The underpricing of stock means that they did not maximize the money Hop-In could have raised. The reputation of not properly valuing IPO prices can lead to lost future business. In order to determine Hop-In’s new issue price, Mr. Merriman must first forecast the next five years of free cash flows.
He should first create pro forma balance sheets and income statements. Once the financial have been forecasted the next step is to figure out what free cash flows are. This can be by multiplying EBIT*(1-tax), adding back depreciation, subtracting the change in capital expenditures, and also subtracting the change in net working capital. This will give you free cash flows for the year. These numbers need to be determined on a yearly basis of at least 5 years into the future. The next step is then to find out the WACC, aka r, of the company.
This can be found by the equation, rd(1-tax)(D/V)+re(E/V). Once WACC is found all of the free cash flows need to be discounted back to present values. Another factor that must be found is growth. This can be discovered by doing a industry analysis to determine what the growth rate is expected to be. The growth rate is used to find the terminal value of Hop-In at its horizon date (5 years out). This terminal value is then discounted back to present value. The summation of all PV cash flows plus PV of the terminal value give you the value of the firm.
The last step is to subtract the debt of the firm to land at the current equity value of the company. This equity value can then be divided by the number of shares outstanding or planning on being offered to come up with the IPO share price. Mr. Merriman has a difficult decision deciding what the final offering price will be. He has guaranteed a low value of $10 per share. He obviously wants it to close at a price higher than this because his firm will take a substantial loss since they will purchase all the shares from Hop-In Foods.
Investment banks usually give a range of possible prices instead of a single definite stock price. This range will consist of the low value of $10, plus 6% in fees, giving a final low value of $10. 60. The high value is calculated by redoing the firm value analysis; taking away all debt and making it an entirely equity financing company. Doing the same before mentioned process will give you a high value. In the end Mr. Merriman should pick a final offering price right in the middle of the low and high value.