ABC is all equity financed, has 1 million shares outstanding and a current stock price of $10. Although management believes the stock is fairly valued, they came across some obscure research on share buybacks that shows that companies announcing repurchase tender offers see their stock prices increase significantly. In particular, if the company makes a fixed price tender offer at a premium (PREMIUM) above the market price for 20 % of the shares, the short-term percentage abnormal return to the non-tendering shareholders after the announcement of a tender offer can be estimated as

% AR = 0.6 PREMIUM + 0.25 0.2 = 0.6 PREMIUM + 5 %

The management is concerned about the stock price as Joe Raider is on the prowl and may make a hostile bid for the company during the next month. The management is particularly concerned as Joe wants to eliminate their perks ($2 million worth (in present value) of spending on corporate jets, plush offices, executive courses on the Bahamas).Management owns 20 % of the shares and cannot participate in a tender offer. It is advised by Bill Slick who points out that the probability of a takeover bid is inversely related to the stock price. Specifically, the probability is equal to min(1, 3/p), where p is the stock price. Bill Slick also mentions that he expects Joe Raider to offer a 40% premium to the market price. If the company decides to make a buyback tender offer, the "market price" will be the post-expiration price. In other words, Joe Raider will only make his bid after the buyback tender offer is over.

The company considers 2 alternatives

1) Do nothing

2) Make a fixed price tender offer for 20 % of the shares at a tender price of $15.

If the goal of the management is to maximize their own wealth (stock ownership plus expected perks), what action do you recommend? To build up your reasoning towards a recommendation, please answer the following questions:

a) Assuming management does nothing, calculate the probability of a hostile bid, the price that Joe Raider is expected to pay in a bid, as well as the resulting wealth of management.

b) If management chooses the fixed price tender offer, what is the market price you expect after announcement of the tender offer?

c) Given your answer to (b), calculate the probability of a hostile bid and the price that Joe Raider is expected to pay in a bid that occurs after the fixed price tender offer.

d) What is the long-run stock price that you expect ABC to trade at in the absence of a hostile bid by Joe Raider if management chooses the fixed price tender offer?

e) Based on your calculations, what action do you recommend to management?