Managerial Economics & Business Strategy 8th Edition by Michael Baye,Jeff Prince

Exercise 25

Recently, PeopleSoft announced that its second-quarter net income was down by nearly 70 percent. The company's CEO attributes 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, are 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 decision-maker 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.