Rights Offerings

The third option available to seasoned issuers is a rights offering. In this case, instead of trying to sell new stock at the current market price to all investors, the existing investors in the firm are given the right to buy additional shares, in proportion to their current holdings, at a price much lower than the current market price.

A company that uses a rights offering generally issues one right for each outstanding common share, allowing each stockholder to use those rights to buy additional shares in the company at a subscription price, generally much lower than the market price. Rational stockholders will either exercise the right or sell it. Those investors who let a right expire without doing either will find that the market value of their remaining holding shrinks — the market price will almost certainly drop when the rights are exercised since the subscription price is set much lower than the market price. In general, the value of a right should be equal to the difference between the stock price with the rights attached — the rights-on price — and the stock price without the rights attached — the ex-rights price. The reasoning is simple. If this were not true, there would be opportunities for easy profits on the part of investors and the resulting price would not be stable. To illustrate, if the price of the right were greater than the difference between the rights-on price and the ex-rights price, every stockholder would be better off selling the right rather than exercising it. This, in turn, would push the price down toward the equilibrium price. If the price of the right were lower than the difference between the rights-on and the ex-right price, there would be an equally frenzied rush to buy the right and exercise it, which, in turn, would push the price up towards the equilibrium price. The value of a right can be estimated using the following equation -

Price of a right = (Rights-on Price - Subscription Price)/(n + 1) where n is the number of rights required for each new share.

Rights offerings are a much less expensive way of raising capital than public issues, for two reasons. First, the underwriting commissions are much lower, since a rights offering has little risk of not receiving subscriptions if the subscription price is set well below the market price. Second, the other transactions and administrative costs should also be lower because there is a far smaller need for marketing and distribution.

What is the drawback of making a rights issue? The primary reservation seems to be that it increases the number of shares outstanding far more than a general subscription at the existing stock price. To illustrate, a firm that makes a rights issue at $ 5 per share when the stock price is $ 10 will have to issue 10 million shares to raise $ 50 million. In contrast, the same firm would have had to issue only 5 million shares, if the issue had been at the existing stock price of $ 10. Some financial managers argue that this dilutes the share holding and lowers the market price. While this is true in a technical sense, the existing stockholders should not object since they are the only ones who receive the rights. In other words, the stock price will drop, but everyone will own proportionately more shares in the firm. In general, firms in the United States have been much more reluctant to use rights issues than European firms, in spite of the significant cost savings that could accrue from them. Part of this reluctance can be attributed to the fear of dilution.

Illustration 7.3: Valuing a Rights Offering — Tech Temp Inc.

Tech Temp Inc. has 10 million shares outstanding, trading at $ 25 per share. It needs to raise $ 25 million in new equity and decides to make a rights offering. Each stockholder is provided with one right for every share owned, and 5 rights can be used to buy an additional share in the company at $12.50 per share. The value of a right can be calculated as follows:

Before Rights Exercised After Rights Exercised

Number of Shares 10 million 12 million

Value of Equity $ 250 million $ 275 million

The rights-on price is $ 25.00 per share, and the ex-rights price is $ 22.92, leading to a per right value of $ 2.08. This can be confirmed by using the equation: Value per Right = (Rights-on Price - Subscription Price)/(n + 1) = ($25 - $ 12.50)/ (5 + 1) = $ 12.50 /6 = $ 2.08

If the rights price were greater than this value, investors would want to sell their rights. Alternatively, if the rights could be acquired for less than $ 2.08, there would be an opportunity to gain by acquiring the rights at the lower price and exercising them.

rightsxls: This spreadsheet allows you to estimate the ex-rights price and the value per right, in a rights issue.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

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