Final exam revision Flashcards
(97 cards)
1
Q
What are the forecasting-based valuation models?
A
Direct approach: Direct estimate of the value of shareholder’s equity
- Dividend discount model (DDM)
-Residual earnings (RE) model?
Indirect approach: Indirect estimate of value of the company and deduct the value of debt
- DCF model
-Residual op. income (REOI) model
2
Q
Relative valuation?
A
Valuation based on multiples
3
Q
What are some advatages and disadvantages of the DCF model?
A
Advantages:
- Easy concept (CFs are real and easy to comprehend + Familiar PV techniques)
Disadvantages:
-Fails to recognize value generated that does not involve cash flows
-Firms can increase FCF by cutting back on investments, causing investments to be treated as a loss of value
4
Q
What is the REOI model?
A
Value of firm = Net operating assets (NOA) + premium generated from residual operating income.
REOI = OI -WACC x NOA
5
Q
What does beta L equal to?
A
BL = Bu(1+(1-Tc)(D/E))
6
Q
What is WACC and what is its formula?
A
7
Q
How do you value a private firm?
A
- Estimate the discount rates - We assume that investors of publicly-listed firms are completely diversified. Not the case for private. Obtain B for private firm:
1a) Obtain a list of publicly-listed similar companies
1b) Regress historical stock returns of similar companies against market returns to obtain beta.
1c) Infer total b for private companies we divide by the r^2 value. eg - 1.24/sqroot(0.25) = 2.48
1d) Calculate re using rf, market risk premium and beta.
8
Q
What is an option to delay and what are the inputs?
A
A bad project today (neg. NPV) may become a good project in the future as the expected cash flows and discount rates change over time.
When a firm has exclusive rights to a project or product for a specific period it can delay taking this project or product until a later date. Thus a project that does not pass today, does not mean this project is not valuable.
Inputs:
1. Value of underlying asset > PV of expected cash flows from initiating project now
- Variance in the value of asset
>Var. in ash flows of similar assets or firms
>Var. in PV from capital budgeting simulation - Exercise price option
>A delay option is exercised when the firm owning the rights to the project decides to invest
>Cost of this decision is the exercise price of the option - Expiration of option
>Life of patent/license; relinquish period; time to exhaust inventory - Cost of delay (div. yield)
>Each year of delay translates into one less year of value-creating cash flows
>Annual cost of delay: 1/n
9
Q
Please provide the formula for the call option used in option to delay
A
10
Q
Please value the option to delay as well as the firm
A
11
Q
Please describe the option to expand
A
Taking a project today may allow a firm to consider taking another valuable project in the future
Thus, even though a project may have a neg. NPV, it may be a project worth taking if the option to expand provides the firm a large enough value to compensate for the initial loss
12
Q
What is the formula for the call option in option to expand?
A
C = S x N(d1) - Ke^-rt x N(d2)
13
Q
A
14
Q
Implications of valuing options to expand
A
The option to expand is implicitly used by firms to rationalize taking negative NPV investments, but provide significant opportunities to tap into new markets or sell new products.
15
Q
Option to abandon:
A
A company has the option to abandon a project at a certain stage in the life of the project, when its cash flows do not measure up to the expectations.
If abandoning the project allows the firm to save itself from further losses, this option can make a project more valuable
16
Q
Option to abandon formula
A
17
Q
A
18
Q
A
19
Q
Define corporate governance
A
Measures in place to align the interests of owners and managers
20
Q
What is the agency problem?
A
Agency problem refers to difficulties that financiers have in assuring that their funds are not expropriated or wasted on unattractive projects (Shleifer and Vishny, 1997)
21
Q
Two types of agency behavior
A
Managerial risk aversion: Risk-averse CEOs forego risky but high NPV projects > Need governance mechnaisms to motivate these CEOs to work harder
Managerial unethical behavior: Reckless & Fraudulent CEOs
>Need governance mechanisms to punish these CEOs for bad behavior
22
Q
Level 1 thinking of pay
A
Pay levels do not affect incentives
De Ree et al. (2018) Indonesia doubles teacher pay at experimented schools to encourage effort. Outcomes? - They remained equally lazy, but happier.
23
Q
Level 2 thinking of pay and the pros/cons
A
Sensitivity of pay
Make the CEO’s pay sensitive to firm performance
Pay with stock/options rather than cash
Pros:
CEOs will work harder to increase share prices to gain higher compensation.
Pay-performance sensitivity is a powerful way to cut CEO slack.
Cons:
Edmans, Fang, and Lewellen (RFS 2017): CEOs reduce investments (R&D, CAPEX) to inflate stock prices when they need to redeem their shares
Burns & Kedia (JFE 2008): Sensitive pay is linked to accounting misconduct
24
Q
Level 3 pay thinking
A
Level 3 thinking: Pay structure (pay duration & pay ratio)
Pay duration (period): whether number of shares that a CEO receives is based on short- or long-term. Powerful way to align the CEO with short-or long-term value.
25
Level 3 thinking academic references
Firms with a greater CEO-worker pay ratio perform better (Mueller, Ouimet, & Simintzi, 2017).
von Wachter (2017): Larger pay gap is linked to (1)higher employee productivity, & (2) riskier firm policies, for (3) innovative & complex firms
Kale et al. (2009): Larger pay gap between CEO and other executives contributes to better firm performance in US (Tournament effect) Kini and Williams (2012): Higher tournament incentives lead to greater risk taking
26
Key CEO pay takeaway
It is not how much you pay, but how you pay it.
27
Who found that there is a negative relationship between firm performance and likelihood of CEO turnover
Jensen & Murphy (1990)
28
What are the three to four committees that make up the board?
* Nominating: Hire & fire CEOs
* Compensation: Pay CEOs
* Audit: Accounting & Auditing policies
* Risk(optional)
29
What is board independence and who wrote about the benefits of it?
Beasley, M.S., 1996, An Empirical Analysis of the Relation between the Board of Director Composition and Financial Statement Fraud, The Accounting Review
30
How can large institutional shareholders be involved in the day-to-day operations of a firm?
(Voice) Forcefully replace the CEO or the board of directors
(Exit) Threaten to sell the firm’s shares
31
Distracted shareholders & corporate actions
Kempf, Manconi, & Spalt, RFS 2017
When large shareholders of a firm are distracted: CEOs of that firm are 53% more likely to engage in “pointless” mergers to build up his empire. These mergers destroy an average of $1.67 billion of firm value.
In addition, these CEOs are 1) less likely to be fired for having poor performance, 2) more likely to cut dividends & 3) more likely to grant themselves options rewards.
* Implications:
Large shareholders are important governance mechanism
When the cats away, the mice will eat your money!
32
How is the threat of being taken over a governance mechanism?
If the CEO does not efficiently utilise the firm’s resources to generate shareholder wealth, some other companies will try to forcefully buy it via a hostile takeover & try to replace the CEO.
Thus CEO will work towards preventing this
33
What happens when CEOs are insulated from takeovers, and who wrote a paper on this?
When CEOs are insulated from takeovers (Bertrand & Mullainathan, 2003 JPE)
Worker wages (especially those of white-collar workers) rise
Overall productivity and profitability decline
Less creation of new plants
Less destruction of old plants
34
What do Modigliani & Miller argue about capital structure?
That in perfect capital markets, the capital structure does not matter.
They reasoned that the start up's total cash flows still equal the cash flows of the project and therefore the same PV
35
Suppose the entrepreneur borrows $700 when financing the project. According to Modigliani and Miller, what should the value of the equity be? What is the expected return? (Strong econ: 1400, weak econ: 900)
Initial equity = 300
Rf = 5%
Do the table.
Return on levered equity = 38.33%
36
What are the conditions for perfect capital markets?
No taxes
No transaction costs
Investment cash flows are independent of financing choices. Assets generate the same cash flows independent of how they are financed.
Symmetric information
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MM proposition I
In a perfect capital market, the total value of a firm is equal to the market of the total cash flows generated by its assets and is not affected by its choice of capital strcuture
VL = VU
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MM Proposition II + formula
The cost of capital of levered equity is equal to the cost of capital of unlevered plus a premium that is proportional to the market value of debt - equity ratio.
39
Suppose the entrepreneur in Example 1 borrows $700 when financing the project.
Recall, the expected return on unlevered equity is 15% and the risk-free rate is 5%.
Use MM proposition 2.
Re = 0.15 + 700/300(0.15-0.05)
Re = 0.3833
40
MM proposition I with taxes + formula
41
Explain this graph
42
Provide the formula for the PV of the tax shield assuming that the tax rate is constant with permanent debt
PV(Interest Tax Shield) = PV(Tc × Future Interest Payments)
= Tc × PV(Future Interest Payments)
= Tc × D
43
Suppose a project financed via an issue of debt requires five annual interest payments of $18 million each year. If the tax rate is 35% and the cost of debt is 7%, and that the interest tax shields have the same risk as the loan, what is the value of the interest rate tax shield?
PV(Int. tax shield) = Tc x PV(Future int. payments)
PV(Fut. int. Payments) = 18/1.07 + 18/10.7^2 ... = 73.8
PV(Tax shield) = 0.35 x 73.8 = 25.83
44
Debt tax shield in a year
DTS in a year = Interest Income x Corporate taxes
– Perpetuity discounted at rD: PV(DTS)=D x Tc
45
What is CFD?
Cost of Financial Distress
Indirect costs (losses from anticipated future distress) large
– Loss of customers, suppliers, contract renegotiations…
– Risk shifting, Debt overhang…
46
Tradeoff theory + formula
Balancing gaining the benefits of DTS against the costs of CFD
The total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings
from debt, less the present value of financial distress costs.
47
Milton Industries expects free cash flow of $5 million each year. Milton’s corporate tax rate is 35%, and its unlevered cost of capital is 15%. The firm also has outstanding debt of $19.05 million, and it expects to maintain this level of debt permanently.
* What is the value of Milton Industries without leverage?
* What is the value of Milton Industries with leverage?
Vu = 5m/0.15 = 33.33m
Vl = Vu + DTS
DTS = 19.05 * 0.35 = 6.6675
Vl = 40.08m
48
Please describe the FCF problem
When firms have too much FCF, managers can start to empire build or use funds in their own best interest rather than the shareholders'
49
Please describe risk shifting with an example
Risk shifting, also known as the asset substitution problem is a classic conflict of interest between equity holders and debt holders in a company, especially when the firm is highly leveraged.
It occurs when equity holders have an incentive to take on excessively risky projects, even if those projects:
Have a negative expected value overall, and hurt debtholders more than they benefit shareholders.
A firm close to default might:
Reject a safe investment with a modest return
Accept a high-risk, high-variance project with a low expected return
Because even a small chance of success benefits equity holders more than the safe path.
Impact on the firm:
Increases cost of debt (lenders demand a premium)
Leads to underinvestment in safer, value-creating projects
May trigger restrictive covenants or monitoring costs
* Example: Savings and Loan (S&L) crisis in the 1980s
* S&Ls are banks with primarily mortgage loans as assets and primarily deposits as liabilities
* Early 1980s saw a combination of bad conditions for these banks
* Many S&Ls took on risky loans that would destroy capital if they went badly, but would save the firm if they paid off
50
Debt overhang
* If a firm’s existing debt is underwater in some states, then it may not be able to finance positive NPV projects with equity
* New investors reluctant to invest because some of the returns will go to pay existing creditors
* Debt overhang leads to underinvestment
Lesson: debt introduces distortions that might make it hard to raise additional equity financing in the future
* Even when projects are profitable!
* This partly explains why growth companies don’t use debt
51
What is management entrenchment? Please provide a real-world example as well as a paper discussing it and solutions
* A situation arising as a result of the separation of ownership and control in which managers may make decisions that benefit themselves at investors’ expenses
* Entrenchment may allow managers to run the firm in their own best interests, rather than in the best interests of the shareholders.
Shleifer, Andrei & Vishny, Robert W. (1989).
"Management Entrenchment: The Case of Manager-Specific Investments."
Published in: Journal of Financial Economics
Managers invest in projects that make them more valuable to the firm, but not necessarily maximize firm value.
These investments can deter takeovers and solidify managerial control.
Leverage, concentrated ownership, and monitoring can act as disciplining mechanisms. (Leverage because it restraints FCF and wasteful investment)
52
What is the value of the levered firm when incorporating agency costs and trade-off theory?
53
What paper discusses the free cash flow problem?
54
What is the MM irrelevance proposition? And what is a 'perfect world'?
In a world with perfect capital markets the payout policy is irrelevant. Dividend vs. Share Repurchases are irrelevant.
* The value of a firm is independent of its corporate payout policy
* Perfect world =
* No transaction costs (and no entry barriers).
* No tax advantage to dividends versus capital gains.
* Managers act in shareholders’ best interest.
* No information asymmetry.
* Investment is held constant.
55
What are the three equivalent ways in which dividends are reported?
Dividend Per Share (DPS): dollar amount per share.
Dividend Yield: DPS divided by share price.
Payout Ratio: DPS divided by EPS.
56
How with asymmetric information dividend decisions are often viewed as a signal?
Investors regard dividends as a signaling device:
healthier firms can afford to pay higher dividends
57
Without taxes and market imperfections, why does it not matter how the firm distributes cash?
Modigliani-Miller Dividend Irrelevance Theorem:
Investors can create their own "dividends" by selling shares if they want cash.
Or reinvest dividends if they prefer capital gains.
Therefore, the firm’s dividend policy (cash vs. reinvestment) has no effect on firm value.
The value of the firm depends only on its investment decisions, not how it splits profits between dividends and retained earnings.
Whether the firm pays out cash or reinvests, as long as it earns the same return, shareholder wealth is unaffected.
58
* Genron has $20 million in excess cash and no debt.
* The firm expects to generate additional free cash flows of
$48 million per year in subsequent years.
* If Genron’s unlevered cost of capital is 12%, then the enterprise value is:
* Genron’s board is meeting to decide how to pay out its $20
million in excess cash to shareholders
* The board is considering three options:
1. Use the $20 million to pay a $2 cash dividend for each of Genron’s 10 million outstanding shares
2. Repurchase shares instead of paying a dividend
59
When taxes are interoduced, which distribution policy tends to be preferred?
Capital gains tends to be taxed lower than income - hence share repurchase if preferable
60
Q: The JRN Corporation will pay a constant dividend of $3 per share, per year, in perpetuity. Assume that all investors pay a 20% tax on dividends and that there is no capital gains tax.
The cost of capital for investing in JRN stock is 12%.
Q: Assume that management makes a surprise announcement that JRN will no longer pay dividends but will use the cash to repurchase stock instead.
What is the price of a share of JRN's stock ?
3/0.12 = 25
61
What is the clientele effect?
62
What are the advantages and disadvantages of retaining
excess cash?
* With Perfect Capital Markets: MM Payout Irrelevance
* Buying and selling securities is a zero-NPV transaction, so it should not affect firm value
* Shareholders can make any investment a firm makes on their own if the firm pays out the cash
* The retention versus payout decision is irrelevant
* With Imperfect Capital Markets
* Taxes paid by investors and corporations may be different
* Issuance vs distress costs
63
Barston Mining has $100,000 in excess cash. Barston is considering investing the cash in one-year Treasury bills
paying 2% interest, and then using the cash to pay a dividend next year.
Alternatively, the firm can pay a dividend immediately and shareholders can invest the cash on their own.
Assume Barton must pay corporate taxes at 35%. Would pension-fund investors prefer an immediate dividend or dividend next year.
Given that pension funds are tax-exempt they would prefer the immediate payout.
Pension fund can buy T-bills themselves and get 2% rather than:
100k x 0.02 x 0.65 = 1300
Keeping cash is a negative tax shield
64
What did Lintner (1956) paper discover?
65
BRAV ET AL (2005)
66
How can private companies raise capital?
67
What is an underwriter?
Underwriters provide services to companies trying to make a public securities offer
* They act as intermediary between the company selling the securities and the public
* First, helps choose method to sell the securities
* Second, helps price the new securities
* Last, helps sell the securities
* Most cash offers will involve an underwriter… this is big business for investment banks
68
How are underwriters paid?
* Typically buy all the securities at an agreed upon price less
than the offering price
* Gross spread = difference between the underwriter’s buying price and offering price
* They bear risk of not being able to sell them!
* So, usually create a syndicate (group of underwriters) to share the risk and help sell them
69
What are the three IPO methods?
70
What is IPO underpricing and what are the theories as to why it exists?
On average, between 1960 and 2016, the price in the U.S. aftermarket was 17% higher at the end of the first day of
trading
* Explanation #1 – It is necessary to attract investors to compensate investors for the risk
* Remember; there is risk you are buying a lemon!
* Evidence: underpricing greater for younger firms, which may reasonably be seen as more risky
Explanation #2 – Underpricing is necessary to compensate investors for the ‘winner’s curse’
* Underpriced IPOs will be oversubscribed & rationed… i.e. you
won’t get any. Instead, you are more likely to get shares when it is overpriced, and you take a huge loss!
Explanation #3 – Agency conflict between underwriter & issuer
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* Firm has 2,000 existing shares, and the true market value of these shares is $124 per share
* IPO offers 1,000 new shares at $100 each
* Capital raised by IPO will fund NPV = 0 projects [i.e., post-IPO value of equity will equal original value plus cash raised as part of IPO]
* What will share price be after the IPO?
* How much money is “left on-the-table”?
* How much value do the pre-IPO shareholders lose from the underpricing?
Share price after IPO: $116
Money left on the table: $24,000
Loss to pre-IPO shareholders: $16,000
72
What are the direct costs of issuing stock?
Two types of direct costs
* Underwriting fee = direct fee you pay to the underwriting syndicate through gross spread
* Other expenses = Filing fees, legal fees, taxes
* These costs are significant!
* About 10% of the amount you successfully raise will be absorbed by these direct costs!
73
What are indirect costs of issuing stock?
Indirect expenses = time spent by management getting ready for the issuance
Underpricing implies you sell the stock below value (and this is implicitly a cost). This cost alone can be larger than the direct costs!
74
What are hot and cold IPO markets?
“Hot” and “Cold” IPO Markets
* It appears that the number of IPOs is not solely driven by the demand for capital
* Sometimes firms and investors seem to favor IPOs; at other times firms appear to rely on alternative sources of capital
-As exemplified by now where startups seem to prefer private capital. Low IPO activity
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High cost of issuing IPOs
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Poor Post-IPO Long-Run Stock Performance
Newly listed firms appear to perform relatively poorly over the following three to five years after their IPOs
* That underperformance might not result from the issue of equity itself, but rather from the conditions that motivated the equity issuance in the first place
77
What is a merger?
In a merger, two (or
more) corporations come
together to combine and
share their resources to
achieve common
objectives.
78
Acquisition
In an acquisition
(takeover), one firm
purchases the assets or
shares of another.
* The target firm’s
shareholders cease to be
owners of that firm.
* The target firm becomes
the subsidiary of the
acquirer.
79
Please distinguish between, horizontal, vertical and conglomerate merger
Horizontal merger:
Target and acquirer are in the same industry
Vertical merger:
Target’s industry buys from or sells to acquirer’s industry
Conglomerate merger:
Target and acquirer operate in unrelated industries
80
What is the acquisition premium?
Paid by an acquirer in a takeover, it is the percentage difference between the acquisition price and the pre-merger price of a target firm.
81
Average premium paid over pre-merger price as well as announcement price reaction for acquirer and target
43% premium
Price reaction acquirer = 1%
Price reaction target = 15%
82
Who wrote that it was better to lose a bidding war than win one?
83
Given the potential synergies, why do most M&As fail? (Also list the papers stating the various reasons)
* Increased power/control: increased firm’s size gives CEO more control over the board
* Increased compensation : remuneration + bonus for a successful takeover (Grinstein & Hribar 2004)
* Illusion of control: Most CEOs (and boards) believe the markets under-price their firms’ (and their abilities).
* Jealous CEOs: You want to follow your peers to do M&As (Goel & Thakor 2010)
* Excitement of the merger process (“deal heat”)
84
What are the motives for mergers? (8 motives)
**Synergies:**
Large synergies are by far the most common justification that bidders give for the premium they pay for a target.
Such synergies usually fall into two categories: cost reductions and revenue enhancements.
**Economies of scale and scope:**
The savings a large company can enjoy from producing goods in high volume that are not available to a small company.
Savings large companies can realize that come from combining the marketing and distribution of different types of related products
**Vertical Integration**
Refers to the merger of two companies in the same industry that make products required at different stages of the production cycle: A major benefit of vertical integration is coordination.
For example, Apple Computers makes both the operating system and the hardware.
**Expertise**
Firms often need expertise in particular areas to compete more efficiently.
Particularly with new technologies, hiring experienced workers directly may be difficult.
It may be more efficient to purchase the talent as an already functioning unit by acquiring an existing firm.
**Monopoly gains**
It is often argued that merging with or acquiring a major rival enables a firm to substantially reduce competition within the industry and thereby increase profits.
Most countries have antitrust laws that limit such activity.
**Efficiency gains**
Another justification acquirers cite for paying a premium for a target is efficiency gains, which are often achieved through an elimination of duplication.
* Acquirers often argue that they can run the target organization more efficiently than existing management could.
* Although identifying poorly performing corporations is relatively easy, fixing them is another matter entirely.
**Diversification**
Risk Reduction + Debt capacity and borrowing costs + liquidity
**Earnings growth**
It is possible to combine two companies with the result that the earnings per share of the merged company exceed the pre-merger earnings per share of either company, even when the merger itself creates no economic value.
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86
You know...
87
Managerial motives to merge
**Conflicts of interest**
Managers may prefer to run a larger company due to additional pay and prestige.
**Overconfidence**
Roll’s (1986) “hubris hypothesis” maintains that overconfident CEOs pursue mergers that have low chance of creating value because they believe their ability to manage is great enough to succeed.
Under the conflict of interest explanation, managers know they are destroying shareholder value but personally gain from doing so.
Under the hubris hypothesis, managers believe they are doing the right thing for shareholders.
88
Exchange ratio
The number of bidder shares received for the target share
89
Why might target shareholders prefer stock rather than cash transaction?
Because cash transaction triggers immediate capital gains taxes - the diff. between what they paid for the stock and the acquisition price paid.
90
Please outline the signalling of modes of acquisition as well as the perception of the synergies post acquisition
1. Mode of Financing as a Signal About Bidder Value
If the acquirer's shares are overvalued:
They are more likely to use stock as currency.
Why? Because they can “buy more” with their inflated stock.
🧠 Signal: The acquirer might not be as strong as it appears.
If shares are undervalued:
Acquirer prefers to use cash to avoid diluting value.
Signal: The acquirer is confident about its intrinsic value.
Investor takeaway:
Investors interpret the payment method as information about the acquirer.
A cash offer is often seen as good news for the bidder.
A stock offer may be seen as bad news, raising suspicion about overvaluation.
2. Signal of Expected Synergies in the Target
If the acquirer expects high synergies and wants to keep them:
It pays in cash — doesn’t want to share gains with target shareholders.
If synergies are uncertain or low:
It uses stock — shares both risk and reward with target shareholders.
Target shareholders are forced to share in the “pain” if things go badly.
91
Who found that equity financed deals had significant, negative performance over the long-term?
Mitchell & Stafford (2000)
92
What is the free-rider problem?
Often times the target firm is poorly managed, resulting in a low share price. If the corporate raider can take control of the firm and replace management, the value of the firm (and the raider’s wealth) will increase.
Assume the current price of the target firm is $45 per share and the potential price if the firm is taken over is $75 per share.
* If the corporate raider makes a tender offer of $60 per share,
tendering shareholders gain $15 per share.
* $60 – $45 = $15
But non-tendering shareholders can “free ride.”
* By not tendering, these shareholders will receive the $75 per share or a gain of $30 per share.
* However, if all the shareholders feel that the potential price is $75, they will not tender their shares and the deal will not go through.
* The only way to persuade shareholders to tender their shares is to offer them at least $75 per share, which removes any profit opportunity for the corporate raider.
The problem is that existing shareholders do not have to invest time and effort but still participate in all the gains from the takeover that the corporate raider generates, hence the term “free rider problem.”
* The corporate raider is forced to give up substantial profits and thus will likely choose not to bother at all.
93
What is a toehold in the context of acquisitions?
94
What is a two-tiered acquisition?
A two-tiered offer occurs when a bidder:
Offers a high price (e.g. $56) for shares initially tendered.
Once they gain control, they offer a lower price (e.g. $53) or less favorable terms for the remaining shareholders.
It pressures shareholders to tender early or risk being worse off later.
Current price = $50
Acquirer offers $56 in a tender offer
If enough shareholders tender, the bid succeeds, and:
Tendering shareholders get $56
Non-tendering shareholders get $53 (forced sale at "fair" value)
If the bid fails, price remains at $50 for everyone
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Outline an LBO
Assume a corporate raider announces a tender offer for half the outstanding shares of a firm.
Instead of using his own cash to pay for these shares, he borrows the money and pledges the shares themselves as collateral on the loan.
Because the only time he will need the money is if the tender offer succeeds, the banks lending the money can be certain that he will have control of the collateral.
If the tender offer succeeds, the corporate raider now has control of the company.
The law allows the corporate raider to attach the loans directly to the corporation—that is, it is as if the corporation, and not the corporate raider, borrowed the money.
At the end of this process the corporate raider still owns half the shares, but the corporation is responsible for repaying the loan.
The corporate raider has effectively gotten half the shares without paying for them!
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97
What is a seminal paper on who gets value from mergers and acquisitions as well as the free rider problem?
Grossman & Hart (1980)
"Takeover Bids, the Free-Rider Problem, and the Theory of the Corporation"
Published in: The Bell Journal of Economics
