On October 1, 1997, WorldCom Inc. offered to acquire MCI Communications Corp.,

with payment to MCI shareholders in the form of WorldCom shares. If WorldComs offer were accepted, the acquisition was expected to be completed in the middle of March 1998 (subject to regulatory, antitrust and shareholder approvals). At that time, MCI shareholders would receive payment according to the following schedule (In the below table, SW refers to the price of one share of WorldCom stock at the time of exchange of stock):

WorldCom Share Price Payment to MCI shareholders (per 1 share of MCI)

SW

$34 = SW = $40 $41.50

$40

a. Graph this potential payoff to an MCI shareholder holding one share of MCI. Be sure to clearly indicate the slope of each part of the payoff diagram.

b. An investor can construct this payoff by forming a portfolio of some Worldcom stock plus some European put options on WorldCom stock (with strike prices of 34 and 40). Identify all components of this portfolio, i.e. identify how many shares (long or short) of WorldCom stock and how many units (long or short) of each put option one should hold to get the payoff expected from the WorldCom acquisition of MCI. Justify your answer without the aid of diagrams.

c. Here is some data for October 15, 1997.

Risk-free rate=6%

Volatility of Worldcom stock=40%

Price of Worldcom (WCOM) stock=35.4375

Price of MCI (MCIC) stock=36.875

Time to acquisition=5 months

Using your answer to b. above, and the Black-Scholes-Merton model, value the MCI share as the value of a package of WorldCom stock and put options. Based on your valuation of the package, would you say MCI stock is underpriced, overpriced or correctly priced on October 15, 1997? Support your answer with calculations.

Background: On October 1, 1997, WorldCom Inc. offered to acquire MCI Communications Corp., with payment to MCl shareholders in the form of WorldCom shares. If WorldCom's offer were accepted, the acquisition was expected to be completed in the middle of March 1998 (subject to regulatory, antitrust and shareholder approvals). At that time, MCl shareholders would receive payment according to the following schedule (In the below table, Sw refers to the price of one share of WorldCom stock at the time of exchange of stock): a. Graph this potential payoff to an MCl shareholder holding one share of MCl. Be sure to clearly indicate the slope of each part of the payoff diagram. b. An investor can construct this payoff by forming a portfolio of some Worldcom stock plus some European put options on WorldCom stock (with strike prices of 34 and 40 ). Identify all components of this portfolio, i.e. Identify how many shares (long or short) of Worldcom stock