Time Warner, Inc., Is Playing Games with Stockholders (Case Study)


A.               Was Paramount’s above-market offer for Time, Inc. consistent with the notion that the prevailing market price for common stock is an accurate reflection of the discounted net present value of future cash flows?  Was management’s rejection of Paramount’s above-market offer for Time, Inc. consistent with the value-maximization concept?



B.               Assume that a Time Warner shareholder could buy additional shares at a market price of $90 or participate in the company’s rights offering.  Construct the payoff the matrix that corresponds to a $90 per share purchase decision versus a decision to participate in the rights offering with subsequent 100%, 80%, and 60% participation by all Time Warner shareholders.

C.               Describe the secure game theory strategy for Time Warner shareholders.  Was there a dominant strategy?

D.               Explain why the price of Time Warner common stock fell following the announcement of the company’s controversial rights offering.  Is such an offering in the best interests of shareholders?


CASE STUDY SOLUTION


A.               These are, of course, controversial questions designed to spur debate on the issues of capital market efficiency and the convergence or divergence between shareholder and managerial interests.  Paramount’s 1989 above-market offer for Time, Inc. is consistent with the notion that the prevailing market price for common stock is an accurate reflection of the discounted net present value of future cash flows to the extent that such a merger promised significant synergistic benefits.  As a separate entity, the stock market estimated the discounted net present value of Time, Inc. at $125 per share.  It is possible that advantages from combining Paramount and Time might have led to such a dramatic improvement in cash flows that a $200 versus $125 market price per share could be justified.  However, subsequent events may call this interpretation into question.  Paramount and Warner have many similarities, and Time Warner’s failure to generate such synergies makes the magnitude of such benefits questionable.  Still, one might argue that Paramount management headed by Marvin Davis might have better managed the combined company than the Time Warner management team headed by Stephen Ross.  On the other hand, if the 1989 offer of $200 per share was above the fair value of Time, Inc., then perhaps hubris on the part of Paramount management is to blame.  In light of Time Warner’s subsequent performance, the fact that such an attractive Paramount offer was turned down by Time management suggests that they neglected to fully consider shareholder interests.


B.               The payoff matrix that corresponds to a $90 per share purchase decision versus a decision to participate in the rights offering in light of 100%, 80%, and 60% participation by all Time Warner shareholders is:




Share Purchase Cost Payoff Matrix



Decision Alternatives

States of Nature                                                    



60% Participation

80% Participation

100% Participation

Market Purchase

$90

$90

$90

Rights Offering Participation

$63

$84

$105

Note that investors wish to minimize the cost of additional share purchases.  Therefore, a payoff is realized in terms of a lower share purchase price. 


C.               A secure strategy, sometimes called the maximin strategy, guarantees the best possible outcome given the worst possible scenario.  In this case, the worst possible scenario for current shareholders would occur if they chose to participate and all other shareholders also decided to participate in the rights offering.  In that case, everybody would pay $105 per share.  To avoid that outcome, the secure strategy for current shareholders is not to participate in the rights offering, and to instead buy additional shares in the marketplace for $90.  Because the best possible outcome cannot be assured without knowledge of the actions of other participating shareholders, there is no dominant strategy in this case.


D.               The price of Time Warner common stock fell subsequent to the announcement of the company’s controversial rights offering for a number of reasons.  The uncertain nature of the contingent rights offering increases the risk of Time Warner stock and, absent any offsetting increase in cash flows, thereby reduces the risk-adjusted net present value of future cash flows.  Thus, the contingent nature of the rights offering has the predictable effect of reducing the market price of Time Warner stock.  The simple fact that the company wanted to sell additional common stock at a market price of $105 per share also seems to suggest that management views this price as “high,” and indicates some lack of confidence in the company’s future prospects.  And finally, the cohesive nature of the offering might drive down the price of the company’s stock because it suggests an adversarial rather than cooperative relationship between management and stockholders.


Interestingly, in light of the furor caused by its contingent rights offering, Time Warner decided to withdraw the offer a few weeks after it had been announced.  In its place, the company decided to offer current shareholders the right to purchase up to 34.45 million new shares at a fixed price of $80 per share.  The company’s investment bankers also took a haircut on commissions, reducing their take to a total of 3% of the amount raised and agreed to purchase for their own account any unsold shares.  Obviously, the initial contingent rights offering was a bad idea.  Both large and small investors heralded the company’s change in the offering as a victory for shareholders.




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