Analysis of Rights Offerings - Financial Management

In addition to the sale of new common stock through underwriters, new equity capital can be raised using another option -based financing approach called a rights offering. In a rights offering, the firm’s existing stockholders are given an option to purchase a fraction of the new shares equal to the fraction they currently own, thereby maintaining their original ownership percentage.

Hence, rights offerings are used in equity financing by companies whose charters contain the preemptive right. In addition, rights offerings may be used as a means of selling common stock in companies in which preemptive rights do not exist. The number of rights offerings has gradually declined over the years.

The following example illustrates what a rights offering involves. The Miller Company has 10 million shares outstanding and plans to sell an additional 1 million shares via a rights offering. In this case, each right entitles the holder to purchase 0.1 share, and it takes 10 rights to purchase 1 share. (The rights themselves really are the documents describing the offer.

Each stockholder receives one right for each share currently held.) The company has to decide on a subscription price, which is the price the right holder will have to pay per new share. The subscription price has to be less than the market price, or right holders will have no incentive to subscribe to the new issue. As a general rule, subscription prices are 5 to 20 percent below market prices. If the Miller Company’s stock is selling at $40 per share, a reasonable subscription price might be $35 per share.

Valuation of Rights

Because a right represents an opportunity to purchase stock below its current market value, the right itself has a certain value, which is calculated under two sets of circumstances:

  • The rights-on case
  • The ex-rights case

A stock is said to “trade with rights-on” when the purchasers receive the rights along with the shares they purchase. In contrast, a stock is said to “trade ex-rights” when the stock purchasers no longer receive the rights.

For example, suppose the Miller Company announced on May 15 that shareholders of record as of Friday, June 20, will receive the rights. This means that anyone who purchased stock on or before Wednesday, June 18, will receive the rights, and anyone who purchased stock on or later than June 19 will not.9 The stock trades with rights-on up to and including June 18 and goes ex-rights on June 19, the ex-rights date. On that date, the stock’s market value falls by the value of the right, all other things being equal. The formula (or terminal) value of a right for the rights-on case can be calculated using the following equation:

valuation-of-rights

where R is the formula value for the right; Mo, the rights-on market price of the stock; S, the subscription price of the right; and N, the number of rights necessary to purchase one new share. In the Miller Company example, the right’s formula value is

valuation-of-rights

The formula value of a right when the stock is trading ex-rights can be calculated by using the following equation:

value of a rights

where Me is the ex-rights market price of the stock; S, the subscription price of the right; and N, the number of rights necessary to purchase one new share. If the Miller stock were trading ex-rights, the formula value of a right would be as follows:

value of a right

(Note that Me is lower than Mo by the amount of the right; that is, $40 versus $39.545.) Some shareholders may decide not to use their rights because of lack of funds or some other reason. These stockholders can sell their rights to other investors who wish to purchase them. Thus, a market exists for the rights, and a market price is established for them.

Generally, the market price is higher than the formula value until the time of expiration. The same factors discussed previously, which determine the value of a call option, also determine the value of a right, since a right is simply a short -term call option on the stock. As with call options, investors can earn a higher return by purchasing the rights than by purchasing the stock because of the leverage rights provide. In general, the premium of market value over formula value decreases as the rights expiration date approaches. A right is worthless after its expiration date.

One can demonstrate that there is no net gain or loss to shareholders either from exercising the right or from selling the right at the formula value.10 For example, suppose an investor owns 100 shares of the Miller Company common stock discussed earlier. The investor is entitled to purchase 10 (0.1*100) additional shares at $35 per share. Prior to the rights offering, the 100 shares of Miller Company are valued at $4,000 (100 shares*$40 per share). Exercise of the rights will give the investor 10 additional shares at a cost of $35 per share, or a total of $350.

These 110 shares will be valued at $4,350 (110*$39.545). Deducting the cost of these additional shares ($350) from the total value of the shares ($4,350), one obtains the same value ($4,000) as before the rights offering. Sale of the rights will yield $45.50 (100*$0.455) to the investor. Combining this value with the $3,954.50 (100*$39.545) value of the 100 shares still owned, one also obtains the same value ($4,000) as before the rights offering.


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