Times Mirror PEPS
In April 1995, Times Mirror Co. purchased 1.8m shares of Netscape in a private
placement. The price (adjusted for subsequent share splits) was $2/share. As is typical
with private placements, the stock was restricted and could not be resold publicly for
2 years even if Netscape were to go public. In order to sell the stock, Times Mirror
would have to find a qualified buyer (basically a wealthy or professional investor) and
sell the shares in a private placement. In August 1995, Netscape issued shares
publicly. In March 1996, Times Mirror wished to sell its position in Netscape.
Following the IPO, Netscape's stock price rose as high as $80/share. In early 1996 the
price was in the 50s.
Times Mirror had approximately $85 million in capital gains on the stock. If the
shares were to be sold on the open market the tax liability would be approximately
0.35 x $85m = $29.75 million. Trying to offset or defer capital gains taxes is a
standard problem in tax planning. Any sale of shares would trigger the capital gains
tax. Thus, the question was whether there was a way for Times Mirror to hedge its
holdings of Netscape without triggering immediate taxation of gains. See the note on
Revlon below for some background on the tax issues.
Times Mirror wanted to sell its Netscape shares in early 1996. The tax environment
described in the Revlon note suggested that the U.S. Treasury department would
scrutinize tax deferral strategies. At the time Congress had not ruled definitively on a
change in capital gains tax rules, but the IRS can always challenge a transaction that
appears to have no motive other than reducing taxes. Hence, Times Mirror had to be
sensitive to the possibility that the IRS might challenge a transaction intended to defer
capital gains.
Times Mirror considered option strategies that might effectively liquidate their
Netscape position without immediately triggering capital gains taxes. A sufficiently
wide “collar” seemed likely to avoid challenge by the IRS. A collar is the purchase of a
put and the sale of a call with identical expirations dates but with the call having a
higher strike price. (Draw a hypothetical payoff diagram to see why this would
approximately hedge the underlying shares)
There were still problems, however. Times Mirror's Netscape stake amounted to about a
quarter of Netscape's publicly available shares. The required collar position would have
been too large to undertake with exchange-traded options. An over-the-counter deal
would have left an investment bank with a difficult hedging problem.
Instead of entering the collar directly, Times Mirror issued a 5-year equity-linked note
or Premium Equity Participating Security (PEPS) at $39.25 with a 4.25% (annual)
coupon. At maturity of the note, the PEPS-holders’ payment depended upon the price
of Netscape stock (S N) as follows:
If SN < $39.25,
PEPS-holders receive S N;
If $39.25 < SN < $45.14,
PEPS-holders receive $39.25;
If $45.14 < S N,
PEPS-holders receive $39.25 + 0.8696(S N - $45.14).
Assume that at the PEPS issuance, Netscape traded at $39.25 with a five-year
volatility estimated at 40% per annum and no expectation of dividends on the horizon.
Also assume that the Treasury yield curve is flat at 7% out to five years.

Draw a payoff diagram for the PEPS holder and for Times Mirror assuming
that the coupon payments are held in escrow (earning the risk-free rate of
interest) and paid out as a lump sum on the maturity date.

Determine the theoretical value of the PEPS at issuance assuming that PEPS holders receive coupons annually as stipulated in the contract.

Offer a rationale for the 0.8696 multiplier.

Explain how (well) the PEPS satisfies Times Mirror’s objective.