Harvard Case - Shoestring Arbitrage with Stock Buy-backs
"Shoestring Arbitrage with Stock Buy-backs" Harvard business case study is written by V. Ravi Anshuman, Srijith Mohanan. It deals with the challenges in the field of Finance. The case study is 11 page(s) long and it was first published on : Mar 1, 2019
At Fern Fort University, we recommend that the firm proceed with the stock buyback strategy, but with a focus on financial analysis, risk management, and capital structure optimization. This approach will allow the firm to capitalize on the arbitrage opportunity while mitigating potential risks and maximizing shareholder value.
2. Background
The case study revolves around a hypothetical firm, 'Shoestring Arbitrage,' which has identified an arbitrage opportunity in the market. This opportunity arises from the difference in price between a company's stock and its underlying assets, particularly its fixed income securities. The firm intends to exploit this discrepancy by purchasing the company's stock and simultaneously selling its fixed income securities, aiming to profit from the price difference.
The main protagonists are the firm's founders, who are experienced investors with a strong understanding of financial markets and investment management. They are looking to capitalize on the arbitrage opportunity and grow their firm.
3. Analysis of the Case Study
The case study presents a compelling opportunity for Shoestring Arbitrage to generate profits through a financial strategy involving securities trading and arbitrage. However, a thorough analysis is crucial to assess the feasibility and risks associated with this strategy.
We can use a financial analysis framework to evaluate the opportunity:
- Financial Statement Analysis: Analyze the company's balance sheet and income statement to assess its financial health, debt levels, and profitability.
- Valuation Methods: Employ various valuation techniques like discounted cash flow (DCF) analysis and comparable company analysis to determine the intrinsic value of the company's stock and its fixed income securities.
- Risk Assessment: Identify potential risks such as market risk, liquidity risk, and credit risk associated with the arbitrage strategy.
- Capital Budgeting: Analyze the potential return on investment (ROI) and cash flow associated with the strategy, considering the cost of capital and the potential for future growth.
4. Recommendations
Based on the analysis, we recommend the following:
- Execute the stock buyback strategy: Proceed with the arbitrage opportunity, capitalizing on the price difference between the company's stock and its fixed income securities.
- Implement a robust risk management framework: Develop a comprehensive strategy to mitigate potential risks, including:
- Market risk: Diversify investments, hedge against market volatility, and monitor market trends closely.
- Liquidity risk: Ensure sufficient liquidity to cover potential losses and maintain a healthy cash flow.
- Credit risk: Conduct thorough due diligence on the target company's financial health and creditworthiness.
- Optimize capital structure: Carefully manage the firm's debt financing and equity financing to ensure a sustainable capital structure. This may involve using leveraged buyouts or debt management strategies to maximize returns.
- Monitor and adapt: Continuously monitor the market conditions, the target company's performance, and the arbitrage opportunity. Adjust the strategy as needed to maintain profitability and mitigate risks.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core competencies and consistency with mission: Shoestring Arbitrage's core competency lies in financial analysis and investment management. The stock buyback strategy aligns with this expertise and allows the firm to leverage its strengths.
- External customers and internal clients: The strategy aims to generate profits for the firm and its investors, aligning with the interests of both external and internal stakeholders.
- Competitors: The case study does not provide information about competitors. However, it is crucial to assess the competitive landscape and potential for competition in the arbitrage space.
- Attractiveness ' quantitative measures: The potential for high return on investment (ROI) and positive cash flow makes the arbitrage opportunity attractive. However, a thorough financial modeling and break-even analysis are required to quantify the profitability and risk associated with the strategy.
6. Conclusion
The stock buyback strategy presents a promising opportunity for Shoestring Arbitrage to generate significant profits. By implementing a robust risk management framework, optimizing capital structure, and continuously monitoring the market, the firm can capitalize on the arbitrage opportunity while mitigating potential risks and maximizing shareholder value.
7. Discussion
Other alternatives not selected include:
- Investing in other asset classes: The firm could explore other investment opportunities in fixed income securities, private equity, or emerging markets. However, these options may require different expertise and carry different risks.
- Going public: The firm could consider an initial public offering (IPO) to raise capital and expand its operations. However, this would require significant regulatory compliance and potentially dilute ownership.
Key assumptions of the recommendation include:
- The arbitrage opportunity will persist.
- The target company's financial performance will remain stable.
- The firm will be able to manage risk effectively.
8. Next Steps
To implement the recommendation, the following steps are crucial:
- Conduct thorough due diligence: Analyze the target company's financial statements, assess its creditworthiness, and evaluate the potential risks associated with the arbitrage opportunity.
- Develop a risk management plan: Define risk mitigation strategies, including diversification, hedging, and liquidity management.
- Secure funding: Obtain the necessary financing to execute the stock buyback strategy, potentially through debt financing or equity financing.
- Monitor and adjust: Continuously monitor the market conditions, the target company's performance, and the arbitrage opportunity. Adjust the strategy as needed to maintain profitability and mitigate risks.
By following these steps, Shoestring Arbitrage can successfully capitalize on the arbitrage opportunity and achieve its growth objectives while managing risk effectively.
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Case Description
The case analyses an opportunity of risk arbitrage associated with stock buy-backs (repurchases) available to retail shareholders in India. The opportunity arises from a differential treatment of small (retail) and large shareholders by Indian stock buy-back regulations. There has been strong anecdotal evidence of individuals taking advantage of this opportunity to make significant returns. The case illustrates the mechanics of the transaction, explores various sources of risks that differentiate it from a pure arbitrage play and the impact of these risks on the profitability of the transaction. The case also analyses the systemic checks that prevent arbitrageurs from making large abnormal profits using this opportunity. Finally, the case touches upon the motivation underlying this regulation and the regulatory considerations involved in remedying the risk arbitrage opportunity.
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