Executive summary

Blue Arrow is a publicly held firm and the leading UK employment agency. The management is thinking about expanding further in to the US by buying the largest temporary help company in the world, Manpower. The bid was to be made by a cash tender offer funded by a fully underwritten rights issue of 837 million. In this report we calculate the value of one right and the value of the underwriter's put as of August 3 by using the Black-Scholes and put-call parity valuation approach. In addition we assess the sensitivity and validity regarding these calculations, and discuss the fee charged by the underwriter. The detailed assumptions regarding our calculations are: o The rights are issued on August 3; one right can be converted into 2.5 shares with an issue price of 1.66 per share. o The rights issue closes on September 28 o Everyone is fully informed about the issue and acquisition Assuming a successful acquisition price of $82.50 per share, or 51.56 per share, we end up with the following estimates for the value of one right and the underwriter's put.

In our calculation we have adjusted the market value of equity as of August 3 by subtracting total issuing fees. Since our calculations depend critically on the NPV of the Manpower acquisition, we also calculated different values assuming reasonable NPV for the acquisition. Our valuation technique, the Black-Scholes model, is furthermore sensitive to changes in volatility, time to maturity (or risky days), risk free rate and the issue price. All of these variables, except the volatility, are set and there is therefore little uncertainty connected with them.

The underwriting costs amounts to a total of 19.5 million assuming a successful acquisition. Our base case scenario (NPV = 0 and = 30.4%) gives us an estimate of these costs, or the value of the underwriter's put, of only 0.75 million. The underwriting costs of 19.5 million implies a volatility of 98.1%, which is more than three times our estimated volatility and may imply an overpricing of their services.

1. Valuing the rights and the "underwriter's put" Firstly we calculate the value of the rights and the "underwriter's put" as of August 3. In the valuation process we assume the following: o Acquisition is funded by a fully underwritten rights issue of 837 million. o The rights are issued on August 3; one right can be converted into 2.5 shares with an issue price of 1.66 per share. o Blue Arrow's price per share as of August 3 is 2.162 before the issue announcement is made. o The accepted bid for Manpower is $82.5 per outstanding share, resulting in a total bid of 831.8 million. The acquisition is conducted at this price. o The rights issue closes on September 28. o Everyone is fully informed about the issue and acquisition after the announcement is made.

a) Adjusting market cap Not all of the information needed is explicitly given in the case, and we therefore had to make "backward calculations" in order to estimate the different input variables.

After the rights issue was completed, CNW's Corporate Advisory Department was left with 35 million shares or 4.9993% of Blue Arrow's share capital, which implies a total number of shares after the issue of 35m/0.049993 = 700.1 million. The total amount raised from the issue was 837 million with an issue price of 1.66, which implies a total number of issued shares of 837m/1.66 = 504.2 million. This results in 700.1m - 504.2m = 195.9m number of shares outstanding in Blue Arrow before the rights issue and a total market cap of 195.9m x 2.162 = 423.5 million as of August 3. The fees related to the rights issue amounts to a total of 36.50 million, which includes underwriting, legal and advisory fees. Total underwriting costs are 19.50, since we assume the acquisition is conducted and successful. Since everyone is fully informed about these costs, we need to deduct the total costs from the market cap because these costs would reduce the current market value of equity following the announcement. Note that the dilution effect from the discount issue price will not have any (theoretical) effect on the share price on August 3 since the issue is not placed before September 28. Blue Arrow's bid on Manpower is 831.8 million, which is far above the company's market cap per August 3 of 629 million. This may imply that there are positive synergy effects to gain from the acquisition or possible that the company is actually undervalued. But since these possible NPVs would already be included in the acquisition price and the total amount raised from the issue, the NPV in our base case scenario is therefore assumed to be zero.

b) Estimating the risk free rate and volatility The risk free rate was obtained from the homepage of England's central bank; "Bank of England". The 3M Treasury bill, Sterling, as of 31 July 1987 was 8.49% per annum, resulting in an annualized risk free rate of 8.76%. The volatility of the equity (or share price) were estimated using the given daily historical share prices from January to July 1987 for the Blue Arrow share. A sample population of 152 resulted in an estimated daily standard deviation of 1.88%, which annualized gives

us an estimated future volatility of 1.88% x 261 = 30.4%. Note that 261 is the total number of trading days in 1987.

c) Valuating the rights and the "underwriter's put" Assuming that the underwriting agreement was signed on August 3 and that the rights issue ended on September 28, the total number of risk bearing days for the underwriter is 56 days. Since this is a fully underwritten rights issue, the underwriters would have to buy any unsubscribed shares at the agreed upon price of 1.66 per share. Since the rights issued are short dated warrants issued to shareholders, by using the Black-Scholes model and the put-call parity we can estimate the value of the rights and the "underwriter's put" using the input variables stated above. A right is furthermore a fraction of a call option on the equity of the firm, where the fraction () is the dilution factor resulting from the issue. Inserting the different inputs into the model gives us the following results.

Our basis scenario results in an value per right of 0.25, the value of the shareholders right to buy issued shares at a 1.66 subscription price. Blue Arrow has made an agreement of a fully underwritten rights issue, which means they have bought (long) a put option from the underwriters. However, the estimated value of 0.75 million is far below the actual underwriting costs of 19.50 million. We will discuss this further under section 4.

d) Manpower acquisition and NPV Our calculated values above critically depends on the NPV of the Manpower acquisition. In our basis scenario we assumed that the added NPV from the acquisition would already be reflected in the price, and hence would not affect our market cap as of August 3. However, it might also be possible that there are other NPVs that are not reflected (hidden) in the acquisition price, for example positive

synergy effects. It might also be possible that the price overcompensates for the assumed NPV, and hence that the total and accepted bid is too high relative to its true value. This might for example be the case if the current management only is concerned about growing (for personal reasons) at the expense of current shareholders, or more formally an agent problem. Since we are assuming that everyone is fully informed about the issue and the acquisition, a possible deviation from our basis of NPV = 0 would be reflected in the share price per August 3. By assuming different values for these unknown NPVs, and taking the terms of the rights issue as given, we end up with the following adjusted calculations.

The different assumptions regarding the NPVs will be adjusted in the share price, S, as of August 3. As the table shows, an increase in S (NPV > 0) gives an added value per right, but a reduced value for the underwriter's put. A decrease in S (NPV < 0) gives the opposite results, that is a decrease in the value per right and an increase in the underwriter's put value. The results stems both from the change in price per share, but also from the change in the probabilities associated with the issue price. For example, a decrease in "today's" price would reduce the probability that a stochastic future price would be above the issue price and hence that the rights will be exercised.

2. Sensitivity analysis The calculated values of the rights and underwriter's put are also sensitive to other changes then the share price, S. Moreover they depend on time to maturity (or risk days), the risk free rate, the issue price and volatility. However, since both the time to maturity (risk days) and the issue price is given in the prospectus (therefore small uncertainty), we only perform a sensitivity analysis with respect to the risk free rate and the volatility.

As the sensitivity analysis show, the value per right and the "underwriter's put" are more sensitive to changes in the volatility than in changes of the risk free rate. Moreover, since the risk free rate is observed in the market there is relatively little uncertainty regarding this variable. When the volatility increases, the value of the rights and underwriter's put increases rapidly . In our case the underwriter's put is far-out-of-the-money and therefore extremely sensitive to increases in volatility. Since the value per right is already deep-in-the-money, an increase in volatility would have a relatively small positive effect on the value.

3. Is the Black-Scholes valuation valid in this case? The Black-Scholes model is only valid under certain assumptions, moreover assumptions regarding the share price and the economy. Share price: o Share price is a stochastic variable where the returns are normally distributed and independent over time. o Volatility is known and constant o Future dividends are known The economic environment: o Risk-free rate is known and constant o There are no transaction costs or taxes, and it's possible to shortsell without any costs and to borrow at the risk free rate. In our case, and in most other cases, these assumptions will most likely be broken. Perhaps the most crude assumption is the volatility. Volatility is evolving over time, and to assume that is constant is not

consistent with the real world. As the case with Blue Arrow, we estimated the future volatility by using historical volatility. This approach neglects the possibility of future outcome. In our case the market crash in October 1987 highlights that future volatility is hard to estimate when only looking at historical data. Another aspect of this case is that the rights issue announced per August 3 is supposed to be used for an acquisition, where the issue is only conditionally underwritten and that the acquisition price was not final. Hence, any changes in the negotiations after the announcement would most likely have changed the valuations at August 3. Moreover, the fraud attempted by the investment bankers in this case might also have resulted in changes in our assumptions. Since the underwriter's were offered success geared structure fees, their incentive for taking on more risk increased. The Black-Scholes model is a simplification of the real world, but empirical evidence suggest that the model gives us good estimates close to the market prices of options and therefore assumed to be valid in this case. 4. Underwriting costs - a fair price? As we mentioned briefly under section 1, the underwriter is fully guaranteeing that the offered shares are subscribed for. The underwriter is therefore selling (short) a put option to the company. If the share price in the market falls below the issue price, the shareholders/investors will not exercise their rights and Blue Arrow will use their option to sell the offered shares to the underwriter. In section 1 we also estimated the underwriter's put, or the fair price of the underwriting costs, to be approximately 0.75 million. This estimate is far below the actual underwriting costs of 19.50 million. Assuming that the actual underwriting costs (the put) is the fair price of their service, this implies a volatility of 98.1% (using "goal seek" function in excel) on Blue Arrow's equity/share price holding every other variable constant. Furthermore, this is more than three times our estimated volatility of 30.4%. These calculations may imply that the costs charged by the underwriter are severely overpriced. Of course, there might be other reasons for the big deviation. The

underwriter may have significant information about Blue Arrow's financial and operating risks, or their calculations regarding volatility may be slightly different. However, the big deviation is more likely to be an overpricing, at least from our analytical point of view.

Side note: If we calculate the actual volatility over the period by using daily data from August to September, we find an annualized volatility of 56.4% which is far less than the implied volatility of 98.1%. However, with hindsight one could also argue that the underwriting costs was clearly too small given that the rights issue flopped!

Appendix

Valuing warrant/right and dilution factor

Black and Scholes model

Put-Call parity