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In the mid-1980s, "Carbonic" Industries had revenues of $14 billion a year and was one of the largest corporations in the United States producing chemicals and plastics. It also had a small, but growing and highly regarded, consumer products division. Because the firm's management believed that chemicals and plastics were mature, highly competitive industries, management planned to pour the bulk of the business's free cash flow into investment in consumer products in the following decade. "Carbonics" had virtually no debt--it was an entirely equity-financed company, with 80 million shares outstanding and a total market valuation of $4.0 billion.
As of mid-1986, "Carbonics" paid a dividend of $5 a share per year. Analysts assessed the required rate of return of typical firms in its highly cyclically sensitive lines of business to be 13% per year, in a context in which the risk-free rate was 4% per year and the market rate 10% per year. Carbonics typically paid out two-thirds of after tax earnings, and there was no reason to expect the payout rate to change in the future. Carbonics also 40% of its pre-tax earnings in federal income tax, and if it stayed an all-equity company there was no reason to think that that tax rate would change.
On December 1 1986 GFA, a holding company led by Mel Zealous, announced that it intended to acquire Carbonic--a company ten times GFA's size--by offering to pay $68 a share in cash for 70% of the outstanding shares of Carbonic Industries. GFA had acquired four other companies--all larger than itself before the acquisitions--in the previous five years, paying shareholders of the target companies in a mix of stock in GFA and cash raised by selling high-yield bonds to Savings and Loans.
GFA had, before its announcement, quietly acquired a large chunk of Carbonics stock and held some 10% of Carbonics stock by the beginning of December. Largely fueled by rumors of a takeover, the price of Carbonics stock had risen from $50 a share in August to $63 a share by the beginning of December.
Carbonics' board of directors met with its investment bankers to discuss the offer in mid-December. They concluded that GFA's offer was too low--and that Carbonics should make a counteroffer. Carbonics offered to pay "$85" a share--$25 in cash and $60 in high-yield debt securities with a $60 face value. The high-yield securities contained covenants prohibiting Carbonics from selling any of its lines of business save its consumer products division.
In early January Carbonics sold off its consumer products division to Gamble and Proctor, an established consumer products company, for $1 billion. Carbonics used that $1 billion and virtually its entire liquid assets of $500 million and bought back 75% of its 80 million outstanding shares--including all of the 10% of the company owned by GFA.
1. What is the beta of Carbonics as a company? What is the beta of Carbonics common stock before the series of transactions outlined above?
2. The debt securities used by Carbonics as part of its buy-back of stock had a face value of $60. They were ten-year notes paying interest once a year calculated according to a complicated floating-rate formula. Outside analysts believed that the expected value of the interest payments was $5 per note for the first four years, $4 per note for the second four years, $3 per note in the ninth year, and $2.82 a note at the end of the tenth year, at which time the principal would be repaid. Since there was no market for these securities before their issue, the value of $60 a share was "speculative". After the issue, it became clear that the market valued these ten-year notes as if they had a beta of one. What did the market value (as opposed to the face value) of these ten-year notes turn out to be?
3. How much did Carbonic really pay for each of the shares that it bought back?
4. Assume that GFA bought half of its 10% stake at a price of $50 a share and half at a price of $63 a share. How much money did GFA make between August and January? What is the implied annual rate of return?
5. Is Mel Zealous happy?
6. After the sequence of transactions above is concluded, Carbonics' accountants announce that--because of the changed financial structure of the firm--the present value of all future tax liabilities are some $1.5 billion less than in August, 1996. If the consumer products division was sold for a fair price, and if the repurchase of shares and the reduction in expected tax liability are the only changes in the value of the business's assets between August and January, what is the total value of the firm as of the end of January?
7. What would you expect the stock price of Carbonics to be at the end of January--after this entire sequence of transations has been concluded--if the stock market in January is at the same level that it was at the beginning of the previous August?
8. Suppose that this series of transactions does not change the beta of Carbonics as a company. What would you expect the beta of Carbonics' common stock to be after this series of transactions?
9. Who really paid for the premium (over the market value at the start of August) paid to shareholders whose stock was bought back?
10. How happy are shareholders who bought Carbonics at the end of August in the hope of getting a takeover premium?
Do you think that Carbonics' board of directors fulfilled their fiduciary duty to look after the interests of such shareholders?
Do you think that Carbonics' board was fulfilling its fiduciary duty before GFA came along?
6. If markets are "perfect" how could AFG and Carbonic each offer to pay substantially more than market for Carbonic stock? Why would takeover rumors cause the stock price to rise?
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Associate Professor of Economics Brad De
Long, 601 Evans
University of California at Berkeley; Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax