Free Rider Problem
When a bidder makes an offer for a firm, the target shareholders can benefit by keeping their shares and letting other shareholders sell at a low price.
However, because all shareholders have the incentive to keep their shares, no one will sell. This scenario is known as the free rider problem.
To overcome this problem, bidders can acquire a toehold in the target, attempt a leveraged buyout, or, in the case when the acquirer is a corporation, offer a freezeout merger
Freezeout Merger
A situation in which the laws on tender offers allow an acquiring company to freeze existing shareholders out of the gains from merging by forcing non-tendering shareholders to sell their shares for the tender offer price
Advantage of Freezeout vs. LBO
The freezeout tender offer is better than a leveraged buyout because the acquiring corporation can use its own stock instead of cash to buy the target's shares. Shareholders can exchange their target stock for the acquirer's stock at a fair value set by the exchange rate, without legal recourse for non-tendering shareholders.
Toehold
An initial ownership stake in a firm that a corporate raider can use to initiate a takeover attempt.
• Once an investor has a toehold, they must make their intentions public by informing investors of their large stake.
Real estate purchases are often financed with at least 80% debt. Most corporations, however, have less than 50% debt financing. Provide an explanation for this difference using the tradeoff theory.
According to trade-off theory, tax shield adds value while financial distress costs reduce a firm’s value.
The financial distress costs for a real estate investment are likely to be low, because the property can generally be easily resold for its full market value.
In contrast, corporations generally face much higher costs of financial distress. As a result, corporations choose to have lower leverage.
Although the major benefit of debt financing is easy to observe—the tax shield—many of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs.
Overinvestment: Investing in negative NPV projects
underinvestment: Not investing in positive NPV projects
cashing out: paying out dividends instead of investing in positive NPV projects
employee job security: highly leveraged firms run the risk of bankruptcy and so cannot write long-term employment contracts and offer job security.
Difference of Dividends and Share Repurchases (Signaling Theory)
Managers are less committed to share repurchases than to dividends
Share Repurchases are not smoothed over time such as dividends
Cost of Share Repurchase depends on current market value - if manager believes that the stock is overpriced, the investment has negative NPV
Dividend Capture
When the tax rate on dividends exceeds the tax rate on capital gains, shareholders will pay lower taxes if a firm uses share repruchases for all payouts rather than dividends.
Optimal dividend policy when Td > Tg is to pay no dividend at all
The effective tax disadvantage of retaining cash
Merger Waves
Peaks of heavy M&A activity followed by quiet troughs.
1960s: Conglomerate Wave
1980s: Hostile Takeovers
1990s: Strategic and global deals
2000s: Conslidation plays by PE
Reasons to Acquire
Synergies
Economies of Scale
Economies of Scope
Vertical Integration
Expertise
Monopoly Gains
Efficieny Gains
Diversification
Earnings Growth
Conflicts of Interest
Overconfidence
Merger Arbitrage
Once a tender offer is annoucned, the uncertainty about whether the takeover will succeed adds volatility to the stock price.
This uncertainty creates an opportunity for investors to speculate on the outcome of the deal.
Hostile Takeover
A situtation in which an individual or organization purchases a large fraction of a target and in doing so gets enough board votes to replace target board and directors, who were against the merger
Proxy Fight
In a hostile takeover, the acquirer attempts to convince the target’s shareholders to unseat
the target’s board by using their proxy votes to support the acquirers’ candidates for
election to the target’s board.
Poison Pill
It is a rights offering that gives the target shareholders the right to buy shares in
the target at a deeply discounted price.
Staggered Board
In many public companies, a board of directors whose three-year terms are
staggered so that only one-third of the directors are up for election each year.
Further defenses
Type of Directors
Inside Directors: Members of board that are employees, former employees or family members of employees
Gray Directors: Members of board who are not directly connected to the firm but have existing or potential business relationships with the firm
Independent Directors: Any other member - have the role of “watchdogs” but have less incentive to closely monitor the firm as they are likely to be less sensitive to performance
A board is captured if monitoring duties are compromised due to conncecitons or percieved loyalty to management
Tunneling
A conflict of interest that arises when a shareholder who has a controlling interest in multiple firms moves profits away from companies in which he has relaticely less cash flow toward firms in which he has relatively more cash flow rights
Backdating options
Choosing the grant date of a stock option retroactively, so that the date would coincide with a date when the stock price was lower than its price actually was - thus they receive options that are already in the money
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