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February 14, 2005
Finance question of the week
Update: this is a "famous" experiment performed in 1985 by Samuelson and Bazerman. They gave this very problem to 69 MBAs at Northwestern and allowed them to bid repeatedly with monetary incentives to perform well. The results: most students lost money over time and only five picked up on the core problem. Here it is:
If Company A bids any amount - call it $X - and Company T accepts the bid, Company T must be worth less than $X. Why? "Management of Company T is aware of the results of the exploration" and thus knows the true value of the company.
So given any bid between $0 and $100 per share, if Company T accepts the bid, management of Company T must know that the company is worth less than the bid. Otherwise they would never accept it. The correct bid is $0. I wanted to break that choice out of the $0 - $25 range but thought it might give away the answer. Big ups to whomever chose $0 - $25.
My professors conclusion from the results: "learning is neither easy nor fast."
Read this paragraph closely:
In the following exercise, you will represent Company A (the acquirer) which is currently considering acquiring Company T (the target) by means of a tender offer. You plan to tender in cash for 100% of Company T's shares but are unsure how high a price to offer. The main complication is this: the value of the company depends directly on the outcome of a major oil exploration project it is currently undertaking.
The very viability of Company T depends on the exploration outcome. In the worst case (if the exploration fails completely), the company under current management will be worth nothing - $0 per share. In the best case (a complete success), the value under current management could be as high as $100 per share. Management of Company T is aware of the results of the exploration but you have no access to that information.
Given the range of exploration outcomes, all share values between $0 and $100 per share are considered equally likely. By all estimates the company will be worth considerably more in the hands of Company A than under current management. In fact, whatever the value under current management, the company will be worth 50 percent more under the management of Company A than under Company T.
The board of directors of Company A has asked you to determine the price they should offer for Company T's shares. The offer must be made now, before the outcome of the drilling project is known.
How much would you bid for Company A?
Posted by sam at 12:06 PM