1 CHRYSLERS WARRANTS: SEPTEMBER 1983 (Written Analysis of Case) I.

Statement of the Problem With Chryslers rapid recovery, exceeding profit expectations and increasing negative market factor resiliency, is the request to return its warrants held by government at no cost valid and justifiable? II. Objectives 1. Value the Chrysler warrants held by the government. 2. Determine the factors that affected the value of warrants over time. 3. Determine if the governments guarantee is overpriced or underpriced. 4. Determine Chryslers bid price taking into account all the risks the government had run. 5. State a well-defined, reasonable, and accurate justification to support Chryslers claim. III. Areas of Consideration 1. The governments warrant of Chrysler saved the company from a financial tragedy. 2. The impact on the federal budget of a Chrysler failure would be greater than the cost of assistance. 3. A Chrysler failure would disproportionately affect a city and a region that already had substantial economic problems. 4. Failure of Chrysler would lead to either greater monopoly power by surviving US firms, or worsening balance of payments as foreign producers captured increase US market share. 5. In the long term forecast, Chrysler actually has an increasing demand. 6. Common Stock Warrants 7. Chrysler requested from the government to surrender the warrants at little or no cost. 8. Lee Iacocca, CEO of Chrysler, stated that the governments money was never at risk in the first place when the warrants were issued. IV. Alternative Courses of Action 1. Chrysler will no longer request for return of its warrants at no cost Pros: The company will not anymore concern itself on reclaiming its warrants for the time being; instead it will focus on realigning with its existing strategies to increase market share and profitability. Cash will be used in more profitable activities Feud between the government and company will be avoided. Bad press image will also be avoided.

2 Cons:

Shareholders confidence with the company will be questioned because of its inability to bargain with the government The company forfeits its rights to claim what is rightfully theirs The company will be faced with a greater risk of claiming its warrants if it value will appreciate and the profitability weakens. It could leave the company open to a hostile takeover

2. Chrysler will continue to pay for annual interest of its outstanding debts until maturity before it can reclaim its warrants Pros: The company will be able to allocate its finances and service its long term liabilities without having to face resistance with government and other stakeholders. There will be assurance of claiming the warrants after the term has lapsed and all credit obligations have been paid. If Chrysler will be able to buy back stocks, the company could gain voting control. There will be no company takeover from other brands Cons: There will be waste of cash in paying interest instead of using it in operational expenditures to help the company. There is the probability that the company will face another downturn and will have no more assets to be used as security. 3. Chrysler to participate on the bidding and offer whatever price it takes to repurchase its stocks. Pros: The company will end its feud with the government and other third parties. The company will be able to regain all the assets that the government has liens and encumbrances Cons: The company might exhaust all its valuable cash reserves to get its warrants back and none will be left for capital and operational expenditures

3 V. Analysis & Solution It is important to determine timeline values of Chryslers warrants held by the government to determine if the proposal of the company is relevant TIMELINE: 1. First date of loan guarantee bill with equity kicker drawn up at treasury Sept. 14, 1979: $5.016 2. President signs the loan guarantee bill with no equity kicker January 7, 1980: $5.748 3. Chrysler and the Treasury negotiate, warrants proposed April 8, 1980: $4.070 4. Government signs guarantee including warrants May 12, 1980: $6.256 5. Date bids for the governments Chrysler warrants were due September 1, 1983: $23.442

Number of shares Number of warrants Risk-free rate Time (t) Stock Price Adjusted Stock Price Strike Price Historic (30 day) Volatility d1 d2 N(d1) N(d2) Call Value-Historic Volatility Dilution factor Warrant value-Historic Volatility Implied Volatility Warrant value-Implied Volatility Total warrant value-Historic Total warrant value-Implied

9/14/1979 1/7/1980 4/8/1980 5/12/1980 9/1/1983 Assumptions behind inputs 87,106,000 87,106,000 87,106,000 87,106,000 87,106,000 Assume all 13.3M bank warrants, 5M other warrants & 320k option 14,400,000 14,400,000 14,400,000 14,400,000 14,400,000 Given on case page 1 9.3% 10.6% 11.0% 10.5% 11.9% 10-year T-bonds except for 1983 (7-year bond) 10.307 9.992 9.740 9.647 6.340 Assume warrants expire on 1/1/1990 7.875 7.500 6.625 7.500 28.375 Given in case exhibits 8.704 8.450 7.298 8.534 32.250 =Stock price+(# warrants/# shares)*Warrant value(historic) 13.000 13.000 13.000 13.000 13.000 Given on case page 1 47.5% 66.8% 47.4% 82.6% 59.4% 1.126 1.354 1.075 1.515 1.861 =(LN(Adj stock price/strike price)+t*(RFR+(Volatility^2/2)))/(Volatilit -0.398 -0.756 -0.403 -1.052 0.365 =d1-Volatility*t^.5 0.870 0.912 0.859 0.935 0.969 =normsdist(d1) 0.345 0.225 0.344 0.146 0.643 =normsdist(d2) 5.845 6.698 4.743 7.290 27.318 =Ad stock price*N(d1)-Strike price*N(d2)*EXP(-RFR*t) 85.8% 85.8% 85.8% 85.8% 85.8% =Number of warrants/(Number of shares+warrants) 5.016 5.748 4.070 6.256 23.442 =Call value(historic)*Dilution Factor 39.2% 40.8% 57.5% 59.9% 134.4% 4.519 4.471 4.551 5.340 27.196 =Call value(implied)*Dilution Factor 72,230,825 82,764,499 58,603,892 90,089,256 337,570,746 =Warrant value(historic)*Number of warrants 65,072,767 64,377,093 65,537,770 76,889,607 391,628,173 =Warrant value(implied)*Number of warrants

450,000,000 400,000,000 350,000,000 300,000,000 250,000,000 200,000,000 150,000,000 100,000,000 50,000,000 0 9/14/1979 1/7/1980 4/8/1980 5/12/1980 9/1/1983 Total warrant value-Historic Total warrant value-Implied

Chryslers warrant value has changed over time primarily because of changes in the stock price. Other factors are changes in the estimate of volatility, risk free rate and time remaining on the warrant.

4 It is to determine the value of the governments loan guarantee as of May 12, 1980 since it amounts to a put option, which allows the banks to put their risky Chrysler loans to the government. Exhibit 11 was used to estimate the volatility of returns on Chrysler debt. Determining the value of loan guarantees using two methods: 1) Treating the guarantee as a put option. Answer: $372.5MM (Method 1 Put Option)
B 4 5 6 7 8 9 10 11 12 13 14 15 16 17 C D E

Risk-Free Rate Time (t) Guaranteed Bond Price Bond Coupon Rate Strike Price Volatility d1 d2 N(d1) N(d2) B-S Call Value Put Value Total Put Value

$500M Bond 10.52% 9.5918 $100.000 10.4% $100.000 86.93% 1.352 -1.340 0.912 0.090 $30.505 $29.905 $149,526,226

$300M Bond $400M Bond 10.52% 10.52% 9.5096 8.9205 $100.000 $100.000 11.4% 14.9% $100.000 $100.000 86.93% 86.93% 1.309 1.148 -1.372 -1.449 0.905 0.874 0.085 0.074 $27.471 $20.263 $30.423 $32.917 $91,269,183 $131,668,346 $372,463,756 Total

Assumptions behind inputs 10-Year T-Bond rate at 5/12/1980 - closest date to bond issues Assume that bonds mature on 1/1/1990 Assume that government guarantee is default-free, freezes price at 100% Assume that government fully guarantees the face value =(0.002999*252)^0.5; daily deviation from Exhibit 11 =(LN(E7/E9)+E6*(E5-E8+(E10^2/2)))/(E10*E6^0.5) =E11-E10*E6^0.5 =NORMSDIST(E11) =NORMSDIST(E12) =(EXP((0-E8)*E6))*E7*E13-E9*(EXP((0-E5)*E6))*E14 =E15-E7*EXP((-E8)*E6)+E9*(EXP((-E5)*E6)) =E17*400000000 =C17*500000000+D17*300000000+E17*400000000

2) Estimating the present value of interest savings Chrysler is getting from the guarantee. Answer: Estimate of $360.3MM Alternate approach comparing the above total put value to the interest savings from a lower debt cost due to the government guarantee, discounted at Chryslers market debt rate: (Method 2 Interest Savings)
Check of Interest Savings vs Put Valuation of Guarantee Interest savings w/ $500M portion Interest savings w/ $300M portion Interest savings w/ $400M portion Total interest savings Less 10% prepayment risk Versus: Total put value 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

$205,951,830 33,263,014 57,000,000 57,000,000 57,000,000 57,000,000 57,000,000 57,000,000 57,000,000 57,000,000 57,000,000 $110,093,406 15,567,534 31,050,000 31,050,000 31,050,000 31,050,000 31,050,000 31,050,000 31,050,000 31,050,000 31,050,000 $84,247,696 $400,292,933 $360,263,640 $372,463,756 24,997,808 27,400,000 27,400,000 27,400,000 27,400,000 27,400,000 27,400,000 27,400,000 27,400,000

The prospective internal rate of return to the government on the loan guarantee as of May 12, 1980, taking into account the expected fees and current value of the warrants:

Ex-Ante Cost of Gurantee Value of Warrant Fee Net CF IRR -282374500 -15% 372463756 90089256 10,800,000 10800000 10,800,000 10800000 10,800,000 10800000 10,800,000 10800000 10,800,000 10800000 10,800,000 10800000 10,800,000 10800000 10,800,000 10800000 10,800,000 10800000 10,800,000 10800000

Answer: IRR to be -15%. Explanation: Value of Guarantee: $372.5 MM Value of Warrant on May 12, 1980 = $90.1MM Fee: 1% of outstanding principal, assuming 10% prepayment risk and 10 year maturity. Market rate for Chrysler-type risk is in the +20% range. Government IRR is -15%, therefore government is heavily subsidizing Chrysler. Price that Chrysler should bid for its warrants in September 1983: Shearson/Amex offered $20.1. Estimating the value of call option in Sep 1983 to be $23.44. A price point between these two numbers makes sense $21.5. Total bid = $21.5*14.4MM = $309.6MM. Based on your bid price, what was the IRR on the governments liability after the fact: After the fact IRR = -3% Ex-Post Cost of Guarantee Value of Warrant Fee Net CF IRR

372525983 0

309,600,000 11,000,000 320,600,000

-372525983 -3%

11,000,000 11,000,000 11,000,000 11,000,000

Value to Chrysler = PV of Guarantee = ~$372MM Cost to Chrysler = PV_Fee + PV_Warrant on May 12, 1980 = $44+$90.08 = ~$134MM. Government guarantee was under-priced by ~$240MM When warrants became much more valuable, pay-off to Government was lower than the value of guarantee by ~$30MM

6 VI. Conclusion Iacoccas argument is not sound. Chrysler actually got a good deal, based on analysis. While Government did not get the full price from Chrysler commensurate with the benefit Chrysler got from this deal, Government guarantee can still be justified based on positive externalities (such as saved jobs, tax revenue impacts, impacts on suppliers etc.) because the guarantee enabled Chrysler to continue as a going concern. VII. Recommendation When deciding what appropriate action to consider in order to maximize company potentials and ensure continuous success from its turnaround, Chrysler might consider the following variables: Current purchase price of warrants. The purchase price of the warrants that they will reacquire plan to acquire should be reasonable enough. Paying a premium of on top of the current market value is generally considered reasonable as long as there will be enough cash to be used that will not hamper operations. And if Chrysler has to pay a premium which is relatively higher than that, then they are not being very sensible as the synergy would need to be huge to make the deal worthwhile. Value adding investments. The company should consider acquiring an investment when it contributes to its value chain so that it can be utilized in processing or delivering its products. Risk. Risk an important factor in determining what decision to take in business. Taking into consideration the recent events in the political and economy of US before they decide on what to decision to take. Also, accounting for the risk reduction when diversifying products in order to achieve a stable profit. Emphasis on quality of products. The company should consider the worth or the need of the products they produce in order to be in line with what they already have. Goodwill. Since the company aims to achieve a customer loyalty image, it should consider the image or the value of the business they will acquire as perceived by the customer.

7 VII. Potential Problem Analysis Substantial financial investments required to implement the purchasing of warrants. Diversion of managements time and resources to focus on implementing the strategy and managing a broader scope of businesses and risks inherent in making new acquisitions and investments. Growth through realigning strategies might involve business risks, including unforeseen contingent risks, latent business liabilities and other challenges that may only become apparent after the companys warrants has been brought back or remained with creditors In addition, there is no assurance that Chrysler will achieve the anticipated benefits, expected returns, strategic benefits or synergies from reclaiming its warrants prematurely Problems may develop among private and public partners which may result to disruption to these businesses. Regulatory decisions and changes in the legal and regulatory environment across various industries could increase Chryslers operating costs and adversely affect its business, results of operations and financial condition.