Problem 3 (Real Options, Part #3): A Challenge Problem. You are advising an all-equity financed technology company (let's call it the seller) which has become an acquisition target for a large multinational corporation (let's call it the "buyer"). The seller currently pays no dividends, has a market value of $10 billion, and a volatility of 50% (expressed as a continuously compounded annual rate) The buyer offers the following initial) merger contract to the seller. It offers to pay $11 billion in cash for the firm but maintains the right to back out of this purchasing transaction on or before the closing date of the merger (which occurs in exactly 6 months). However, if it exercises this buyer termination option", the buyer commits to paying the seller a $500 million termination fee. This merger contract also prohibits the seller from paying dividends to its owners prior to the closing date of the merger. (a) From the perspective of the buyer, why is it important for the merger contract to restrict divi dend payments by the seller prior to the closing date of the merger? (b) Is the buyer rational in making this initial offer? In other words, would this transaction be positive NPV for the buyer? In answering this problem and others below, assume that: (i) the seller's value would always increase by 10% if it were owned by the buyer due to synergies relative to the seller's "no merger" value), (i) the current market price for the seller reflects no anticipation of a possible merger, (iii) the riskless rate equals 7% (expressed as a continuously compounded annual rate), (iv) the assumptions of the Black-Scholes model hold, and (v) the merger contract never gets renegotiated. Furthermore, for this problem and others below, you may want to use the following fact: under the assumptions of the Black-Scholes model, the formula for the price of a cash-or-nothing binary call is given by: Price = exp{---T) Nda) where d, is the same as in the Black-Scholes formula and N.) is the cumulative distribution for a stan dard normal distribution found in the Black-Scholes formula as well (c) Show that you should advise your client, the seller, to reject this initial merger offer. The seller plans to follow your advice and reject the initial merger offer. However, it also wants to make a counter-offer that is acceptable from its own perspective. In order to sweeten the terms of the deal (for itself), it will add a seller termination option to the original contract ie, all other elements of the original contract will remain the same). This option will allow the seller to beck out of the selling transaction on or before the closing date of the merger subject to a fee (the values of the buyer and seller termination fees can, and will be different (d) What seller termination fee leaves the seller indifferent between signing the merger contract and not signing it? If the merger contract's seller termination fee is set at this level, would the buyer accept this merger contract as well? Explain. (e) In this simple setting, should regulators allow buyers and sellers to include termination options in merger contracts? Would your answer change if merger contracts were easily renegotiated? Problem 3 (Real Options, Part #3): A Challenge Problem. You are advising an all-equity financed technology company (let's call it the seller) which has become an acquisition target for a large multinational corporation (let's call it the "buyer"). The seller currently pays no dividends, has a market value of $10 billion, and a volatility of 50% (expressed as a continuously compounded annual rate) The buyer offers the following initial) merger contract to the seller. It offers to pay $11 billion in cash for the firm but maintains the right to back out of this purchasing transaction on or before the closing date of the merger (which occurs in exactly 6 months). However, if it exercises this buyer termination option", the buyer commits to paying the seller a $500 million termination fee. This merger contract also prohibits the seller from paying dividends to its owners prior to the closing date of the merger. (a) From the perspective of the buyer, why is it important for the merger contract to restrict divi dend payments by the seller prior to the closing date of the merger? (b) Is the buyer rational in making this initial offer? In other words, would this transaction be positive NPV for the buyer? In answering this problem and others below, assume that: (i) the seller's value would always increase by 10% if it were owned by the buyer due to synergies relative to the seller's "no merger" value), (i) the current market price for the seller reflects no anticipation of a possible merger, (iii) the riskless rate equals 7% (expressed as a continuously compounded annual rate), (iv) the assumptions of the Black-Scholes model hold, and (v) the merger contract never gets renegotiated. Furthermore, for this problem and others below, you may want to use the following fact: under the assumptions of the Black-Scholes model, the formula for the price of a cash-or-nothing binary call is given by: Price = exp{---T) Nda) where d, is the same as in the Black-Scholes formula and N.) is the cumulative distribution for a stan dard normal distribution found in the Black-Scholes formula as well (c) Show that you should advise your client, the seller, to reject this initial merger offer. The seller plans to follow your advice and reject the initial merger offer. However, it also wants to make a counter-offer that is acceptable from its own perspective. In order to sweeten the terms of the deal (for itself), it will add a seller termination option to the original contract ie, all other elements of the original contract will remain the same). This option will allow the seller to beck out of the selling transaction on or before the closing date of the merger subject to a fee (the values of the buyer and seller termination fees can, and will be different (d) What seller termination fee leaves the seller indifferent between signing the merger contract and not signing it? If the merger contract's seller termination fee is set at this level, would the buyer accept this merger contract as well? Explain. (e) In this simple setting, should regulators allow buyers and sellers to include termination options in merger contracts? Would your answer change if merger contracts were easily renegotiated