Fall

08

Ubid, an Internet auction firm and subsidiary of Creative Computers, a catalog distributor
of computer and computer peripherals released its IPO recently. Creative Computers plans to
expand its distribution network by opening retail outlets. However, the direct pressure on profits
margins in the computer business forces the firm to sell Ubid. SCM, a hedge fund which looking
forward to putting the fund and to get positive return, closely monitors and researches the IPO
price of Ubid.
On December 9, 1998, Creative Computers was trading at $22.75 and Ubid was trading
at $35.6875. At that time, Creative Computers had 10,238,703 shares outstanding and Ubid had
9,146,883 shares outstanding. Since stock Valuation equals to stock price times outstanding
shares, the stock valuation of Creative Computer equals to 22.75*10,238,703=232,930,493.3 and
Stock Valuation of Ubid is 35.6875*9,146,833= 326,429,387.1.
After the IPO of Ubid, Creative Computer holds approximately 80% of Ubids security.
Add an account Security in the left side of the balance sheet to reflect the market value of
Creative Computers stake in Ubid. ((9146883-1817000)*35.6875=261,585 thousands of
dollars).
On the right side, calculate the market value of Creative Computers stock by timing $22.75 with
10,238,703 shares to get 232,930 thousands of dollars.
Assets

Consolidated Balance Sheet of Creative Computer

(thousands of
Liability & Equity

Cash and Equilvalent

Accounts Receivable
Inventory
Other Current Assets
PPE
Securities (Ubid)

dollars)
15,528
40,564
44,958
12,428
15,040
261585

Accounts Payable
Short-term Debt
Other Current Liabilities
Capital leases
Notes Payable

75,877
2,969
15,336
29
154

Other Long-term

14,313

Stock holders equity

232,930

Assets
Total Asset

404,416

Total Liability & Stockholders

327,295

equity
According to the adjusted balance sheet gotten above, equity value of Creative Computer
is smaller than its asset value. It can be concluded that the stock price of Creative Computer is
relatively undervalued; therefore, the stock price of Ubid is relatively overvalued. To achieve the
spread of the prices of two stocks, hedge fund should long Creative Computer and short Ubid.
Now the ratio of long and short should be determined. In its IPO, Ubid sold 1,817,000 shares,
which means Creative Computer now holds 7,329,883 shares of Ubid in its asset. (9,146,883
-1,817,000=7,329,883 shares). In this case, each shareholder of Creative Computer will get
0.7159 shares of Ubid in the spin-off. (7,329,883/10,238,703=0.7159). The ratio should goes by
long one share of Creative Computer and short 0.7159 shares of Ubid at the same time.
As discussed before, Creative Computer is undervalued and Ubid is relatively
overvalued. In this specific spin-off case, the one share value of Creative Computer is $22.75 and
0.7159 share value of Ubid is $25.55. So there is an arbitrage opportunity. By longing one share
of Creative Computer and shorting 0.7159 share of Ubid at the same time, this strategy can get
riskless profit of $2.8 per share of Creative Computer. When the spin-off happens in six months,
the hedge fund will get the exact amount of Ubid shares as a Creative Computer shareholder to
repay the stock borrowed when short selling.
The difference between the underwriting price received by the issuing company and the
actual price offered to the investing public should be covered by the gross spread. The gross
spread received by the hedge fund should be calculated by subtracting $22.75 from $25.55.
Basically, the net spread should be different from net spread because the net spread including

subtracting margin interest, adding short debate, and adjusting dividends. In this case, there is no
dividend paid or received. Net spread could be obtained by operating the following formula:
$2.8-22.75/2*5%*(1/2)+25.55*4%*(1/2)=$3.03.

Total

capital

employed

calculated

by

22.75/2+25.55/2=$24.15. After calculating all of these data, now the return on investment is
available. ROI equals to Net spread divided by Capital employed. When plug the numbers in the
formula, ROI goes by 3.03/(22.75/2+25.55/2)=12.5%. Annualized ROI is easily to be got based
on the potential ROI. Annualized ROI equals to 25% through 0.125 times 2.

Gross spread
Net spread

=$25.55-22.75=$2.8
=$2.8-

Total capital employed

ROI
Annualized ROI

22.75/2*5%*(1/2)+25.55*4%*(1/2)=$3.03
=22.75/2+25.55/2=$24.15
=3.03/(22.75/2+25.55/2)=12.5%
=0.125*2=25%