4. Explain the rationale behind the idea that equity is a call option on a firm\

Question

4. Explain the rationale behind the idea that equity is a call option on a firm's assets. In other words, explain why equity ownership of a firm is equivalent to owning a call option on the firm’s assets. Next, explain what it would mean for shareholders to allow this call option to expire, and under what circumstances shareholderswould do so. (20 points)

5. Defensive merger tactics are designed to thwart takeovers and mergers. Briefly describe a few examples of such tactics. Do such activities work to the advantage of shareholders all of the time? Who do you think benefits the most from these activities? Are these types of activities ethical? Briefly discuss the above questions. (20 points)

Explanation / Answer

Question 4

The equity in a firm is a residual claim, i.e., equity holders lay claim to all cashflows left over after other financial claim-holders (debt, preferred stock etc.) have been satisfied.

If a firm is liquidated, the same principle applies, with equity investors receiving whatever is left over in the firm after all outstanding debts and other financial claims are paid off.

The principle of limited liability, however, protects equity investors in publicly traded firms if the value of the firm is less than the value of the outstanding debt, and they cannot lose more than their investment in the firm.

So Payoff to equity on liquidation

= V - D if V > D

= 0 if V

where,

V = Value of the firm

D = Face Value of the outstanding debt and other external claims

Payoff on exercise = S - K if S > K

= 0 if S

So the shareholders can let equity expire if the firms value is more than its debt liabilities.

Question 5

The below mentioned are some of the merger tactics designed to thwart takeovers and mergers & their impact on share holders.

Shareholders Rights Plan

The most common form of takeover defense is the shareholders' rights plans, which activates at the moment a potential acquirer announces its intentions. Under such plans, shareholders can purchase additional company stock at an attractively discounted price, making it far more difficult for the corporate raider to take control. But it is more beneficial to elite upper echelon of corporate executives, rather than the company or its investors.

Greenmail

A company may also pursue the greenmail option by buying back its recently acquired stock from the putative raider at a higher price in order to avoid a takeover. Because the shares must be purchased at a premium over the takeover price, this "payout" strategy is a prime example of how shareholders can lose out even while avoiding a hostile takeover. The practice was effectively curtailed in the U.S. by an amendment to the U.S. Internal Revenue Code, which applied a punishing 50% tax on greenmail profits.

White Knight

If a determined hostile bidder thwarts all defenses, a possible solution is a white knight, a strategic partner that merges with the target company to add value and increase market capitalization. Such a merger can not only deter the raider, but can also benefit shareholders in the short term, if the terms are favorable, as well as in the long term if the merger is a good strategic fit. Although a white knight defense is generally considered beneficial to shareholders, this is not always the case when the merger price is low or when the synergies and efficiencies of the combined entities do not materialize.

Triggered Option Vesting

A triggered stock option vesting strategy for large stakeholders in a company can be used as a defense, but it rarely benefits anyone involved because it often results in massive talent migration. Generally, the share price drops when the clause is added to the charter as executives sell off the stock and leave the company.

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