3Com Corporation was a digital electronics manufacturer that sold computer network systems and services. At the end of 1999, 3Com decided to carve out Palm, one of its subsidies that developed a handheld computer known as the Palm Pilot. 3Com issued 5% of the shares of Palm in an initial public offering (IPO) on March 2, 2000. 3Com further announced its intention to spin off the remaining 95% of the Palm shares to its stockholders within 9 months, at which time it would distribute 1.5 shares of Palm for each 3Com share. After the IPO, 3Coms non-Palm businesses also were generating $750 million in annual profits.

The newly issued shares of Palm closed at $95.06 on March 2, 2000. 3Com stock traded at $81.81 per share that day. On July 27, 2000, 3Com investors received 1.5 shares of Palm for each share of 3Com they owned. 3Com and Palm, respectively, traded at $64.56 per share and $35.56 per share on July 27, 2000.

Question 1. Calculate the negative stub value per share of 3Com on the IPO day. Explain why the phenomenon of a negative stub value violated the law of one price.

Question 2. How would you exploit this arbitrage opportunity, assuming a 40% margin for both buying and selling short a stock? In answering this question, please show 1) the amount of money you would invest in the long/short portfolio on March 2, 2000, and 2) the amount of profit and the percentage return that you would realize on July 27, 2000, assuming you bought and held the long/short portfolio until July 27, 2000.

Question 3. Figure 1 shows that the phenomenon of negative stub values persisted for months after Palms IPO. Use the knowledge on limits to arbitrage that we discussed in class to explain the possible reasons for the prolonged mispricing.