(Capital structure, IPOs, risk, firm value, principles of financial management, bonds)

The owners of Logging (Pty) Ltd want to list on the Namibian Stock Exchange (NSE) with the intent of diversifying the business away from its forestry operations that are sometimes affected by drought. The company currently has N$5 000 000 debt and N$20 000 000 in equity. The plan is to raise an additional N$20 000 000 to enable the company to move into greenhouse farming, as it expects this would be countercyclical. At the moment, the company is not growing and it delivers a constant free cash flow (FCF) of N$3 000 000 per year with a WACC of 15%.

If the company were to list, the company would pay a dividend of N$5 per share at the end of next year, with 1 000 000 shares outstanding, and the company would grow at a constant rate of 2% for the foreseeable future. It is expected that a required return on equity of 18% would be associated with the company in this scenario. If the company does list, it would follow the route of an offer for subscription, as the current owners would not want to sell their own shares but rather raise external capital. The owners of the company think that they require about N$20 000 000 in new capital and they are planning to price their shares to obtain this amount. On top of this, they would need to pay some fees to the bank that has advised them on the listing, leading to the company netting only 90% of the issuing price. They decide to list the shares in such a way that they can receive exactly the amount that is required after these costs. They expect a fully subscribed issue.

Another feasible option is the issue of corporate bonds instead of listing. The preparation process of listing has led to the company undergoing formal auditing procedures, which allows them access to the bond market. Companies with a similar rating and risk profile can issue bonds at 10%. The company expects to be able to raise all the funds it requires by issuing bonds. If the company takes this route, it expects the FCF to double due to the new operations and still to reap a growth rate of 2%. If the company follows this route, it is expected that its WACC will stay at 15%.

REQUIRED

Draw up a brief report on the current firm value (also referred to as the value of operations) using the FCF model (otherwise called the cash flows to the firm approach) for all valuations of the company. Indicate the expected value of the company if it goes along with an initial public offering (IPO) and if it decides on issuing bonds. Also, include the issue price in your report if the company decides to take the IPO route.

Advise the company on the possible benefits and drawbacks of each of the two proposed plans to obtain funds to expand, taking into account that the company may wish to expand further in the future.

Structure your analysis and report in the following manner:

Current value

Issue price versus expected share price, according to the dividend discount model

Value, if an IPO is carried out

Value, if bonds are issued

Discussion (benefits and drawbacks)