Times Mirror Case Study

Times Mirror owns a substantial portion of Netscape common stock, just over 2.3% after the split. The common stock they purchased prior to Netscape's IPO has substantial unrealized gains but they are restricted by the SEC from selling the common stock in a public offering prior to holding the stock for two years. As a result, they are considering issuing PEPS to monetize their holding in Netscape which could also have a large tax advantage. Each PEPS will contain one share of common stock of Netscape. The issue date is March 19, 1996 and the maturity date for these securities is March 15, 2001 (without extensions or early redemption). Each of the securities issued will pay a 4.25% coupon annually. The accrued interest on each PEPS would be paid on the 15th of each quarter in a year. Upon redemption, cash equaling the market price of each share of Netscape stock would be paid, taking into consideration, the redemption ratio along with any unpaid, but accrued interest.

PEPS are a combination of a put option (right to sell) and common stock. In this case, the threshold appreciation price can be considered as the strike price and the market price as the spot price. Exhibit 1 (Payoff diagram) shows that when Netscape’s stock price is between zero and $39.25, the ratio between the stock and the PEP payoff is 1:1. However when the stock price is above $45.14, the ratio is 1:0:.8696. Another feature of this derivative instrument they created is that these options have to be compulsorily redeemed after December 20, 2000. Between December 20, 2000 and March 15, 2001, all these securities will be sold by the investors, back to the company. Since accrued interest in being paid to the investors, the securities function like bonds with coupons.

The pricing proposed by Morgan Stanley seems fair from the perspective of the potential investors. The Netscape stock prices were volatile and had gone down since the IPO. A price of $39.25 per share is low compared to the market prices at that time but the price also includes Morgan Stanley’s commission. Furthermore, the investors were guaranteed market price at the time of redemption. One of the key assumptions made here was that the technology was quite new and on the rise, chances of stock prices going below the issue price seemed less. Morgan Stanley introduced a hedge against downside risk for TMC by underwriting a threshold multiplier in the offering however they are still exposed to significant risk. For example, as seen in exhibit 1, if the stock price reaches $80 as it did in 1995 then TMC would lose $34.67 on each share of common stock redeemed.

As part of their restructuring program, TMC wanted to sell off their stake in Netscape. Since the shares had been acquired originally as part of a non-registered private