Question

A few years ago PeopleSoft announced that its second-quarter net income was down by nearly 70 percent. The company's CEO attributed the poor performance to an ongoing hostile takeover battle against its rival, Oracle (PeopleSoft has reportedly spent over 10.5\( million to defend itself). Analysts, however, were quick to note that PeopleSoft's revenue estimates were adjusted downward from approximately 680\) million to 660\( million. Suppose that Oracle perceives that there is a 70 percent probability that PeopleSoft's decline in net income is merely the transitory result of efforts to fight the takeover. In this case, the present value of PeopleSoft's stream of profits is 10\) billion. However, Oracle perceives that there is a 30 percent chance that PeopleSoft's lower net income figures stem from long-term structural changes in the demand for PeopleSoft's services, and that the present value of its profit stream is only 2\( billion. You are a decisionmaker at Oracle and know that your current takeover bid is 7\) billion. You have just learned that a rival bidder-SAP - perceives that there is an 80 percent probability that the present value of PeopleSoft's stream of profits is 10\( billion and a 20 percent probability of being only 2\) billion. Based on this information, should you increase your bid or hold firm to your 7$ billion offer? Explain carefully.

Short answer

Oracle should increase the bid.

Step-by-step solution

Information given

PeopleSoft's financial condition and performance has been compromised by its efforts against rival Oracle where PeopleSoft has reportedly spent over $10.5 million to defend itself.

Finding probabilities of the outcomes and expected value

As representatives of Oracle, a competitor to Oracle, we have made the decision to establish a maximum offer of $7 billion. However, through the expected value equation, we can estimate with the corresponding probabilities of the outcome and the expected value of the income the expected value in PeopleSoft's earnings stream.

$\mathrm{E}\left(\mathrm{x}\right)={\mathrm{q}}_1{\mathrm{x}}_1+{\mathrm{q}}_2{\mathrm{x}}_2+\dots +{\mathrm{q}}_{\mathrm{n}}{\mathrm{x}}_{\mathrm{n}}$

Where,

q: are the probabilities of the outcomes.

: the expected value.

Explaining the first scenario

In this first scenario, Oracle management estimates a 70% probability that the present value of PeopleSoft stream of profits is 10$ billion and a remaining 30% that the present value of its profit stream is only 2$ billion. These values can be substituted: in equation (1). Thus,

$\begin{array}{c}\text{E(x)}=\left(70\%\times \$10\right)+\left(30\%\times \$2\right)\\ \text{E(x)}=\$7+\$0.6\\ =\$7.6\end{array}$

With this result, it can be seen that the offer we will make for $7.6 billion.

Sap’s valuation

Based on the information obtained, the management has made the correct decision to keep its offer at 7$ billion and when its estimate the income of the company is above ($7.6 billion), however, the competitor Sap has a higher estimate of the company ($8.4 billion), for which we assume that the bid of this company will be much greater than 7$ billion.

Therefore, Oracle may seek to increase its bid up to the level of Sap's valuation, as we assume that both bidders are risk neutral.