Question

1. Firm A has 10 million shares outstanding, currently trading at $5/share. They are worried about possible hostile acquisitions, so they adopt a poison pill that consists of call options that allow shareholders to purchase 1 additional share per share owned. The poison pill options will allow the shareholders to purchase their new share at a price of $2/share if a hostile bidder purchases 20% of the equity of Firm A. (Assume all options are exercised)

Show the impact of this poison pill if a bidder buys 20% of Firm A:

Answer 1

We are told that Firm A has 10 million Shares outstanding, Currently trading at $ 5/share.

They adopt Poison pill to avoid possible Hostile Acquisitions.

What then is poison pill?

Poison Pill: Poison Pill technique is used to avoid the acquisitions which may take place due to the hostile takeovers. This is a defensive mechanism used by the target company to prevent the bidders from takeover. At that time it allows the shareholders to buy more shares at a discount , if one shareholders purchase the 20% of the shares.

Here, the posison pill allows the shareholders to purchase additional share per share owned. This allows the shareholders to purchase their new shares at a price of $2/sahre if a hostile bidder purchases 20% of the equity of firm.

If a bidder buys 20% of Firm A, this allows the other share holders to buy the shares at discount which would dilute the bidders interest and increase the cost of the bid.This makes the bidder to withdraw from the decision to takeover. He has to negotiate with board inorder to revoke the plan. The Board of Directors revokes the plan by attaching option or warrant to the existing shares.

So, the Bidder may withdraw the plan to takeover due to increase in the cost of the bid due to the purchases made by the othershareholders at discount.

Step-by-step explanation: