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 manageme nt’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 announceme nt 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 me rger 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
improveme nt 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 manageme nt
headed by Marvin Davis might have better managed the combined company than the
Time Warner manageme nt 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
manageme nt is to blame . In light
of Time Warner’s subsequent
performance, the fact that such an attractive Paramount
offer was turned down by Time manageme nt 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
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Decision Alternatives
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States of Nature
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60% Participation
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80% Participation
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100% Participation
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Market Purchase
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$90
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$90
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$90
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RightsOffering Participation
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$63
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$84
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$105
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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, some time s
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
announceme nt 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 manageme nt 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
manageme nt 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 investme nt
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.