The Horner Pie Company

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The company considers 2 alternatives -

- Do nothing

- 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:

- 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.

Probability is equal to min(1, 3/p), where p is the stock price –

Probability is 3/10 = 30%.

With the price of $10 and a premium of 40%, the price expected to pay will be $10 * 1.4 = $14

Total wealth created 0.3*1,00,000*14 = $4,200,000

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

Given that the tender price is $15, and that the current stock price is $10, the premium will be 0.5 or 50%.

Using the formula –

% AR = 0.6 × PREMIUM + 0.25 × 0.2 = 0.6 × PREMIUM + 5 % = 0.6*0.5 + 0.05

% AR = 0.35 or 35%

Market Price will be (1 + AR)*$10 = (1 + 0.35)*$10 = $13.5

- 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.

Probability is equal to min(1, 3/p), where p is the stock price –

The probability will be 3/13.5 = 0.222

With the price of $13.5 and a premium of 40%, the price expected to pay will be $13.5 * 1.4 = $18.9

Wealth = $2M + 13.5*2,000,000 = $4.7M

Management Wealth = $4,700,000 * (1-0.222) + $4,200,000 * 0.222 = $4.59M

- 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?

Shares outstanding – 800,000 (20% was taken away to the fixed price offer)

Total Firm Value = $7,000,000

Share Price = $7,000,000/800,000 = $8.75

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

I would recommend (b).