Chapter 3 - Auctions in Corporate Finance

Abstract

This chapter reviews the applications of auction theory to corporate finance with a focus on applications to corporate finance. Auctions, viewed broadly, are economic mechanisms that transfer control of an asset and simultaneously determine a price for the transaction. The chapter begins with a review of the main auction theory frameworks and the major results. Following this, it discusses how auction theory can be applied, in the context of the market for corporate control, not only to “inform” a company's board or regulators, but also to understand some of the observed empirical evidence on target and bidder returns. It then considers the role of preemptive bidding, stock versus cash offers, the effect of toeholds on bidding behavior, the effect of bidder heterogeneity and discrimination in auctions, merger waves, bankruptcy auctions, share repurchases and “Dutch” auctions, IPO auctions, and the role of debt in auctions. Many key insights can be developed from this simplest model—the basic pricing result that an auction's expected price equals the expected second-highest value; general solution methodology; effects of more bidders' risk aversion, reserve prices; revenue equivalence of the different auction forms; revenue enhancement from ex-post means-of-payment; and the solution of auction models via the Revelation Principle. Finally, the chapter presents a discussion of the econometrics of auction data.