Thursday, December 22, 2005

What price will you pay?

Company A and B are in the same business, with company A having a 2 time market share than company B. The nature of the industry is such that there are only two firms, A and B.

Company A's stock is currently trading at twice the price as that company B. Company B is currently on a new product project, which if successful - would mean Company B's stock going up by 100%, i.e. doubling. If the project is unsuccessful, company B's share price will halve as a huge amount of resources have been put on the same and losses will be considerable.

Also as a result of a "successful" new product project, company A's market share will reduce from a 2:1 share over company B to a 1:1 market.

Company A is valuing the business of company B for quite sometime. Now on Dec 19th 2005, we have the following information. The project has be "________". This information (success / unsuccessful) is only available to company B executives which they wil not tell company A until the deal is signed. What should company A do?

Some questions you may want to answer -
a) Should company A acquire company B?
b) If yes, at what price?
c) Best ways of dealing with company B to reduce risks/maximize profits?

3 Comments:

Blogger Aditya Ramachandran said...

Assuming that:
a. A and B have the same number of shares
b. valuation is linked to market share

1. Yes, A should acquire B. assuming 50% chance of B's success, the loss of market share due to B's success is greater than (possible) gain due to B's failure. if A is trading at 10 and B at 5, the overall valuation of the market is A+B=15. No matter how the market share changes, the total valuation of A+B will remain 15.

B's success will drop the A's price to 7.5. If B fails, A's price might increase to 12.5 (IF B manages to lose 1/2 its market share due to the experiment). A 25% loss is greater than a 25% gain since (from 7.5) A needs to gain 33.3% to get back to where it started.

2. B's value after failure is 2.5 and B's value after success is 7.5. so the price to pay ought to be (success.prob * 7.5 + failure.prob * 2.5). If success probability is 50%, the answer works out to 5.

3. i'm guessing a 2:1 stock swap ( MAX of one share of A for every two shares of B).

total valuation of market = 10 * Ashares + 5 * B.shares = 15* Ashares
current valuation = post-merger valuation = 1.5 * (A+B)shares
stock price of merged entity = 10.

No fall in share price, diluted shares compensated by increased market share and no cash spent!
No risk because, If B has succeeded or failed, the merged entity will still have 100% share and
a stock price of 10.

now, how do i find out if i'm right...?

3:18 PM  
Blogger Shankar said...

No idea, mate. I got bamboozld on this one. I tried to use Game Theory and stuff ... no avail. Will consult my prof for the same.

Warm regards
Shankar

12:31 AM  
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4:51 PM  

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