Purpose of Exchange Offer:
The exchange offer represented a plan to gradually decrease the total dividend payout from Avon. With PERCS in place, only up to 18 million PERCS holders would continue to receive a dividend of $2 per year. The remaining common shareholders would receive dividends of not more than $1.50 a share per year unless the PERCS were redeemed. Hence, Avon would be able to decrease its dividend payout per common shareholder by at least 50 cents a share for the next 3 years.
Motivation of PERCS:
Using PERCS allows Avon to offer a choice of investments to its potential investors and shareholders. PERCS would appeal to investors who want an equity that pays a high and steady stream of dividend but with a limited upside on the stock value. In this case, PERCS holders were restricted to a maximum value of $31.50 at the expiration date. On the other hand, investors who prefer to take on more risk upfront and less dividends would hold on to Avon’s common shares. In the same time, Avon also hoped that PERCS would cushion the impact of a dividend reduction.
Net Impact on Stock Price:
We would still expect Avon’s common share price to decrease once the announcement was made. This is due to several reasons. Firstly, Avon would be announcing the divestment of two businesses at a loss. This negative news would no doubt put downward pressure on its stock price. Secondly, Avon would be reducing dividend payments for common shares. This reduction would again be viewed as the stock generating a lower return to investment. Hence, this would also put downward pressure on its price. Finally, although the introduction of PERCS offered the same dividend payout as before, it would expire in 3 years and present a capped upside on the underlying stock. Hence, taking into account these factors, Avon’s share price was expected to decrease.
Fair value of PERCS:
To find the fair price of PERCS, we first replicate the payoff of PERCS with a set of simpler...
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