Advanced Corporate Finance Problem Set 2

Team Members: Ryan See, Ziwei Xiang, Yingyu Zhang, Langxuan Zhou

Takeovers: Consider a company with a stand-alone value normalized to 0. Ownership is dispersed among
many small shareholders, each of which has only a negligible effect on the aggregate success of a control
transfer (takeover). Formally, the company has a continuum of shares of measure 1 outstanding. Each
shareholder holds one share. There is an outside bidder B who can take over and restructure the firm.
Restructuring requires control, i.e., B must have the majority (i.e., at least ) of the shares outstanding.
Restructuring increases firm value to V > 0. B can obtain control by a conditional tender offer p at which
she offers to acquire shares. The offer is conditional in that if fewer than half of the shares are tendered,
the tender offer becomes void. Given the tender offer p, target shareholders individually decide whether
to sell their share. Assume that if shareholders are indifferent between selling and not selling, they sell.
1. (1 point) Suppose B obtains private benefits b > 0 if she obtains control (i.e., if the takeover is
successful). What is the equilibrium tender offer and bidder profit? Explain the intuition underlying the
tender offer p.
𝑉, 𝑖𝑓 𝑡𝑎𝑘𝑒𝑜𝑣𝑒𝑟
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = ,
0, 𝑖𝑓 𝑛𝑜 𝑡𝑎𝑘𝑒𝑜𝑣𝑒𝑟
No single shareholder can impact the aggregate outcome of the entire firm on an individual basis. The
best scenario would be, other shareholders choose to sell their shares, so that the takeover can
successfully happen. Those who did not sell their own shares will end up benefiting. Thus no shareholder
will sell at P < V.

As long as B offers p ³ V, small shareholders will choose to accept.

However B will only do this if his private benefits, b > V
Thus assuming, b > V, Equilibrium Offer is p = V, Bidder Profit = b (private profit) +V (value creation)–
V (offer price) = b

2. (1 point) Suppose now the private benefit b is the result of extraction and assume that V = 1. In
particular, once in control B can extract a percentage e ∈ [0, 1] of the firm value to generate private
benefits. However, extraction is inefficient in the sense that reducing firm value by e only yields private
benefits of b = e . Given some post-takeover stake α ∈ [ , 1] owned by B, what amount does B
optimally extract? Also compute the exact values of extraction at α = 0.5 and at α = 1.
B will extract to maximise his total value,which is his share of the firm, 𝛼(𝑉 − 𝑒), plus the private
!
benefit that he will get 𝑒 " , where V=1 here.
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𝐵 𝑣𝑎𝑙𝑢𝑒 = 𝛼(1 − 𝑒) + 𝑒 "
!
𝑀𝑎𝑥 𝛼(1 − 𝑒) + 𝑒 " , 𝑤𝑟𝑡
1 !
𝐹𝑂𝐶: − 𝛼 + 𝑒 #" = 0
2

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 1
𝐵$ 𝑠 𝑣𝑎𝑙𝑢𝑒 𝑤𝑖𝑙𝑙 𝑚𝑎𝑥𝑖𝑚𝑖𝑧𝑒 𝑎𝑡: 𝑒 =
4𝛼 "
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𝐹𝑜𝑟 𝛼 = 0.5, 𝑒 = %∗'.)" = 1, in this case, B’s value will equals 1 at optimal
! !
𝐹𝑜𝑟 𝛼 = 1, 𝑒 = %∗!" = %, B’s value will equal to 1-0.25+0.5 = 1.25 at the optimal point

3. (1 point) Given some extraction level e* , what is lowest tender offer p that allows B to obtain control,
i.e., induces small shareholders to sell?
Since firm value is reduced by 𝑒 ∗ , the firm value after takeover is 𝑉(1 − 𝑒 ∗ ).
Small shareholder will only accept the tender offer if 𝑃 ≥ 𝑉(1 − 𝑒 ∗ ).
Therefore, the lowest tender offer 𝑃 = 𝑉(1 − 𝑒 ∗ ), in which small shareholder will gain the same from
selling with holding the shares.
! !
Acquirer will issue the tender offer only if 𝛼𝑉(1 − 𝑒) + 𝑒 " − 𝑃 ≥ 0, as 𝑒 " ≥ 0, 𝑃 = 𝑉(1 − 𝑒), the payoff
of takeover for acquirer is larger than 0. Therefore, acquirer can provide this tender offer (𝑃 = 𝑉(1 − 𝑒 ∗ ),
the takeover transaction will happen.

4. (1 point) Suppose now B can restrict her offer by specifying a maximal amount r ∈ [ , 1] of shares she
is willing to acquire in the tender offer. That is, if B selects r = 0.6 and all shareholders sell, then B only
acquires 60% of the shares. What is the restriction r B would like to set?
If B can set r, it means that B can restrict how much he has to offer. B only needs to offer rV to obtain
private benefits of b, he will thus choose the minimum r to obtain control.
The restriction r = 0.5. When p = 0.5V, the target shareholders are indifferent between selling and not
selling, thus the shares will be sold and B can obtain control at a minimum price.

5. (1 point) Would the target shareholders like to forbid restrictions ex-ante?

Yes. Target shareholders would like to forbid restrictions as these restrictions reduce the tender offer that
B can offer. Without restrictions, target shareholders are able to get a higher tender offer and thus extract
more of the profit from th bidder. With restrictions, the amount they can extract will be strictly less.

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Shareholder Activism: Suppose there is an activist A. The activist can improve firm value from V to V +
∆ with V > 0 and ∆ > 0 with a hidden action a ∈ {0, 1}. The action is unobservable to everyone except A.
Exerting effort (a = 1) is costly: A incurs privately . A knows her effort cost privately whereas everyone
else just knows that is distributed according to some cdf F[0, ∞). After spending voice effort or not, A
can trade. Simultaenously, liquidity traders sell ϕ ∈ (0,α) shares, don’t trade, or buy ϕ ∈ (0,α) shares each
with probability . The market is cleared by a competitive market maker who only observes the total
order flow Q but not the individual orders. Conjecture the following equilibrium: There is > 0 so that A
exerts effort if c ≤ . If c > , A does not exert effort. If A exerts effort (a = 1), she buys ϕ shares. If she
does not exert effort (a = 0), she sells ϕ shares.

1. (1 point) What are the potential total order flows Q and what are the associated posterior probabilities
that the market assigns to A having spend effort? Denote this posterior probability by β(Q).
There are five possible realizations of the total order flows Q:
1) Q = −2ϕ: This happens if both A and liquidity traders sell ϕ shares
2) Q = −ϕ: This happens if A sells ϕ shares and liquidity traders do not trade
3) Q = 0: This happens if A and liquidity traders’ actions offset each other
(one buys ϕ shares and the other sells ϕ shares)
4) Q = ϕ: This happens if A buys ϕ shares and liquidity traders do not trade
5) Q = 2ϕ: This happens if both A and liquidity traders buy ϕ shares

Associated posterior probabilities: β(Q) =

1) 0, if Q = −2ϕ, -ϕ
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*(,̂) ∗
2) !
#
! = 𝐹(𝑐̂ ), if Q = 0
*(,̂ ) ∗ 0 1! # *(,̂ )2 ∗
# #

3) 1, if Q = 2ϕ, ϕ

2. (1 point) What are the share prices for each potential total order flow Q?
1) Share Price P(-2ϕ) = P(-ϕ) = V (Firm Value stays the same if the activist chose not to exert effort)

2) Share Price P(0) = 𝐹(𝑐̂ ) ∗ (𝑉 + Δ) + O1 − 𝐹(𝑐̂)P ∗ 𝑉 = 𝑉 + 𝐹(𝑐̂) ∗ Δ

3) Share Price P(2ϕ) = P(ϕ) = V + Δ (Δ Valued is added if the activist chose to exert effort)

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3. (1 point) Show that, given some equilibrium conjecture , it is actually optimal for A to buy after voice
and to sell if she did not engage in voice

Given some equilibrium conjecture 𝑐̂ , we can separately calculate the payoff of buying shares if there’s a
voice and selling shares if there’s no voice. Then we can compare each payoff with the payoff under the
corresponding scenario without trading to show the optimality.

1) If A voices, then the payoff of buying shares is:

2 1
(α + 𝜙) ∗ (𝑉 + Δ) − 𝑐̂ − ∗ 𝜙 ∗ (𝑉 + Δ) − ∗ 𝜙 ∗ (𝑉 + 𝐹(𝑐̂) ∗ Δ)
3 3
1
= α ∗ (𝑉 + Δ) + ∗ 𝜙 ∗ O1 − 𝐹(𝑐̂ )P ∗ Δ − 𝑐̂
3

If A doesn’t buy shares, the payoff is:

α ∗ (𝑉 + Δ) − 𝑐̂

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The payoff of buying shares is larger than not buying share by 3 ∗ 𝜙 ∗ O1 − 𝐹(𝑐̂ )P ∗ Δ

2) If A doesn’t voice, then the payoff of selling shares is:

2 1 1
(α − 𝜙) ∗ 𝑉 + ∗ 𝜙 ∗ 𝑉 + ∗ 𝜙 ∗ (𝑉 + 𝐹(𝑐̂ ) ∗ Δ) = α ∗ 𝑉 + ∗ 𝜙 ∗ 𝐹(𝑐̂ ) ∗ Δ
3 3 3

If A doesn’t sell shares, the payoff is:

α∗𝑉

!
The payoff of selling shares is larger than not selling by 3 ∗ 𝜙 ∗ 𝐹(𝑐̂ ) ∗ Δ

• If c ≤ 𝑐̂ , A exerts effort because the expected benefit from the increase in firm value (+Δ) minus the
cost of effort 𝑐̃ exceeds the expected value from not exerting effort. Buying shares (a=1) maximizes
A's gains from the effort-induced increase in firm value.
• If c > 𝑐̂ , A does not exert effort, as the cost outweighs the benefits. Selling shares (a=0) allows A to
avoid potential losses from a decrease in share price once the market updates its beliefs based on the
total order flow Q.

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4. (1 point) Determine the equilibrium value of 𝑐̂ . Hint: at 𝑐̂ , A has to be indifferent between voice &
buying and no-voice & selling.
Being indifferent between voice & buying and no-voice & selling means:

1 1
α ∗ (𝑉 + Δ) + ∗ 𝜙 ∗ O1 − 𝐹(𝑐̂ )P ∗ Δ − 𝑐̂ = α ∗ 𝑉 + ∗ 𝜙 ∗ 𝐹(𝑐̂ ) ∗ Δ
3 3

1 2
𝑐̂ = α ∗ Δ + ∗ 𝜙 ∗ Δ − ∗ 𝜙 ∗ 𝐹(𝑐̂) ∗ Δ
3 3

5. (1 point) Does possibility for A to trade increase or decrease voice incentives as measured by 𝑐̂ ? You
may first need to determine the voice cutoff if there is no possibility to trade.
If there’s no possibility to trade, the payoff of voice is:

α ∗ (𝑉 + Δ) − 𝑐

The payoff of no-voice is:

α∗𝑉

The voice cutoff under this scenario is:

cV = α ∗ Δ

1 2 1
𝑐̂ − cV = ∗ 𝜙 ∗ Δ − ∗ 𝜙 ∗ 𝐹(𝑐̂ ) ∗ Δ = ∗ 𝜙 ∗ Δ ∗ (1 − 2 ∗ 𝐹(𝑐̂))
3 3 3

To assess the change of voice incentives, we need to have specific value of 𝐹(𝑐̂ ).

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1) If 𝐹(𝑐̂ ) < ", then 𝑐̂ > cV, and the voice incentives become higher with the possibility of trading
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2) If 𝐹(𝑐̂ ) = ", then 𝑐̂ = cV, and the voice incentives stay the same
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3) If 𝐹(𝑐̂ ) > ", then 𝑐̂ < cV, and the voice incentives become lower with the possibility of trading