Tuesday, February 16, 2010

Integrative Thinking: Dutch Auction - Tender Offer

What an interesting concept. We had briefly touched the idea of Dutch Auctions in microeconomics way back in Q1 which is a bidding strategy whose mechanics are based in the math of economics. Today, we applied this strategy towards share buy-backs in finance.

While it might be easy to pick up shares at the current market price, large orders by corporations to buy-back their shares is much more difficult because the market can't immediately absorb the change in liquidity from the huge jump in temporary demand.

So what to do? What mechanism will work where the company can get the best (a "fair") price for buying back its shares and shareholders can get the best (a "fair") price. The mechanism to use is a Dutch Auction.

Everyone announces their lowest acceptable price and number of shares for sale. The buyer (the company in the case of a buy-back) slowly adds up all the numbers of shares from lowest price to highest price until it accumulates all the stock it wants. It pays out all the share holders at the highest price of the group. This ensures that sellers get AT LEAST their minimum required amount and the buyer (the company) gets all the shares they need at the LOWEST possible price.

This actually happened in practice with Morgan Stanley's Dutch Auction system used for Google's IPO. They used a similar Dutch auction system which neutralized the effect of large companies purchasing stock and allowed smaller investors to also pick up shares.

Also, another lesson from class (something I was wondering about previously) Dividend policies don't really matter. Perhaps, like our capital structure lecture, this only occurs in "perfect" capital markets, but it is something to think about.

In summary: If a company gives out cash, it's beta goes up (because it's mix of "risky" assets has gone up, and it has given out cash which is a "safe" asset). However, on a net position your total holdings is the same. The risk gained / lost by giving out cash doesn't change your total net position.


Anonymous said...

On the dividend: i agree in theory. $1 of cash held by a company = $1 in your pocket. But if management can't be trusted to do something intelligent with that $1 then it might be less risky to have it in your pocket!

Joshua Wong said...

Well put. Actually, that's the exact point our professor made.

The assumption if the company holds the dollar is that they can reinvest in in the company at a better rate than you can find outside the company.

If the management team does something foolish with it, then it makes a HUGE difference who is holding the dollar, the investor or the management (through the company).

But if you disagree, technically you can sell some shares to get cash out and reinvest somewhere else. While not entirely true (due to tax reasons etc), this essentially renders dividend policies useless conceptually.