Question

Target Corp has a current share price of $30. Analysts forecast annual earnings of $2.50 per share for the foreseeable future and a cost of equity of 10%. There are rumours that Target may be taken over by a large retail company, which if true, would expect to increase the share price to $40.

What is the market’s current perception of the likelihood of the merger?

(2 mark) What should a market maker set her ask price at if she believes there is a 2% chance that she will face an informed trader?

(2 mark) How should she set her bid price?

Answer 1

price after one year = 30 * (1+10%) + 2.5 . = 35.5

a)

likelihood of perception is extremely positive as price of share post merger is 40 which is greater than current price per share

b)

Market maker is that person who is always ready to sell and buy a stock.

Ask price is that price at which the market maker is always ready to sell the shares, so in this case as there is 2% chance that she will face an informed investor, she will set her ask price in such a way to make maximum profits or in other words more than the bid price.

c)

She will set her bid price to be lower than ask price so she will always make some profit. Since bid price is that price at which she is ready to buy the share from any investor whether informed or un-informed.