Effects on Shareholders

Shareholders can exercise their rights or sell them. In either case, the stockholder will neither win nor lose because of the rights offering. The hypothetical holder of two shares of National Power has a portfolio worth $40. If the shareholder exercises the rights, they end up with three shares worth a total of $50. In other words, with an expenditure of $10, the investor's holding increases in value by $10, which means that the shareholder is neither better nor worse off.

On the other hand, if the shareholder sells the two rights for $3.33 each, he or she would obtain $3.33 X 2 = $6.67 and end up with two shares worth $16.67 and the cash from selling the right:

The new $33.33 market value plus $6.67 in cash is exactly the same as the original holding of $40. Thus, stockholders cannot lose or gain by exercising or selling rights.

It is obvious that after the rights offering, the new market price of the firm's stock will be lower than the price before the rights offering. As we have seen, however, stockholders have suffered no loss because of the rights offering. Thus, the stock price

Total

Ross et al.: Fundamentals I VI. Cost of Capital and I 16. Raising Capital I I © The McGraw-Hill of Corporate Finance, Sixth Long-Term Financial Companies, 2002

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CHAPTER 16 Raising Capital 553

decline is very much like that in a stock split, a device that is described in Chapter 18. The lower the subscription price, the greater is the price decline resulting from a rights offering. It is important to emphasize that because shareholders receive rights equal in value to the price drop, the rights offering does not hurt stockholders.

There is one last issue. How do we set the subscription price in a rights offering? If you think about it, you will see that the subscription price really does not matter. It has to be below the market price of the stock in order for the rights to have value, but, beyond this, the price is arbitrary. In principle, it could be as low as we cared to make it as long as it was not zero. In other words, it is impossible to underprice a rights offer.

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