Question

Household International (acquired by HSBC in 2003 and now known as HSBC Finance Corporation) is one of the largest U.S. lenders to consumers with poor credit histories, carrying receivables for auto loans, Mastercardand Visa credit card debt, and a significant amount of private non credit card debt. In September 2002, Household issued 18.7 million shares, raising about $400 million. The issue, combined with a decision to sell $7.5 billion of receivables and deposits, was cheered by analysts concerned about the subprime lender's liquidity and credit rating.

However, closer inspection revealed that Household International might have to use the cash raised for purposes other than bolstering its reserves. While the firm issued shares at a price of $21.40 per share, about the same time it also repurchased 2.1 million shares at anaverage price of $53.88 under forward purchase agreements when the market price of the shares was $27.

a. What was the loss to shareholders from the repurchase of shares under the forward purchase agreements?

b. At the end of its third quarter for 2002, when the stock price stood at $28.31, there were outstanding contracts to repurchase 4.9 million shares at a weighted-average price of $52.99 per share. Make a rough calculation of the option overhang that shareholders were facing?

c. Why does issuing shares at one price and using the proceeds to repurchase shares at a higher price lose value for shareholders?

Answer 1

a.) Loss under forward purchase agreements

b.) Information about options and the total number of shares outstanding is required which is not given in the question.

c.) Take an example of issuing 1 share at $20 and repurchasing 1 share at $50. Thus, after this the number of shares outstanding remains same whereas company is short $30. Thus cash in effect assets reduce while liabilities of the company remain the same. What is asset-liabilities - Equity or Shareholder's net worth. So if assets reduce while liabilities stay same, hence shareholder's net worth reduces when issuing shares at one price and using proceeds to repurchase shares at a higher price.