Download Rights Offerings of Common Stock

Rights Offerings of Common Stock
When publicly traded firms issue new common stock, they have the following
options:
a) General Public Offering: stock is sold to any interested investor
b) Private Placement: stock is placed with large investors, typically institutions.
c) Rights Offering: existing shareholders are given the first right to buy the new
shares.
Mechanics of a Rights Offering
Let us say that a firm has 5 million shares outstanding, and the price per share is
$40. The firm seeks to raise $30 million. It decides to go for a rights offering, with a
subscription price of $30. In order to raise $30 million, the firm needs to sell 1 million
new shares. Under a rights offering, the existing shareholders have the first rights to buy
these shares. Each share registered with the firm as of the record date receives a right;
thus, there will be 5 million rights issued. In order to purchases 1 new share, a
shareholder will need to send in $30 and 5 rights before the offer expiration date. If a
shareholder is not inclined to buy new shares, she can sell the rights in the market. The
rights offering will succeed as long as the subscription price is below the market price,
since under this condition the shareholder will lose if they do not participate in the rights
offering.
Impact of a rights offering on shareholders’ wealth
What is the impact on existing shareholders of selling new shares at $30? Should
they be dismayed that shares are being sold below the market value of $40, or should
they be glad to get an opportunity to buy shares below market price?
Let us consider the share price after the issue under perfect capital markets, where
the issue of equity does not convey any news (information) about the firm.
Market value of equity after issue = Pre-issue market value + cash raised through offer
= $200 m + $30 m = $230 m.
Number of shares after issue = 5 m old shares + 1 m new shares = 6 m shares.
Price after issue = ($230m)/6 m = $38.3333.
What is the position of a shareholder who had 100 shares to start with and who
participated in the right offer by paying $600 for 20 shares ($30 each).
Wealth pre-offer = 100 shares * $40/share + $600 in cash = $4600.
Wealth post-offer = 120 shares *$38.3333 = $4600.
Thus, there is no impact on the shareholder. Recall that shareholders are selling stock to
themselves. Since they are both the buyers and sellers, they can neither gain nor lose.
This important fact should be grasped firmly. This is true regardless of the extent of the
discount in the subscription price compared to the market price.
Value of one right
What is the market value of 1 right? Five rights have a value of $8.3333, since they
allow an investor to buy a share that is going to be worth $38.3333 for $30. Hence the
value of 1 right is $8.3333/5 = $1.6667. Even if a shareholder did not participate in the
rights offering, their wealth will be unaffected as long as they sell the rights they receive.
Negative stock price reaction to rights offerings
In the real world, there is a negative stock price reaction to rights offerings. We
understand from the above discussion that the discount in the subscription price neither
benefits nor hurts shareholders. So why should stock prices fall at the time of the
announcement of the rights offering?
In the real world, there is information asymmetry between managers and
investors. Investors recognize that managers have superior information about the future
prospects of the firm. Thus, they look to managerial actions to discern manager’s
information about future prospects. This idea helps us to understand managerial behavior
and the market’s reaction to many different financial decisions. We will apply it to the
case of rights offerings below.
The negative stock price reaction is attributable to the bad news conveyed by the
rights offering. The fact that the firm has to seek external funding may signal to the
market that the manager does not expect the firm to earn as much as previously expected.
Furthermore, recall that the rights offering will succeed as long as the market price at
offer expiration exceeds the subscription price. (If the market price is less than the
subscription price, investors are better off acquiring shares in the market.) A manager
who is nervous about the future stock price will set the subscription price lower to ensure
success. A more confident manager will set the subscription price closer to the current
market price. Thus the extent of the discount in the subscription price will reveal the
manager’s concerns about the future stock price. Thus, there will be a stronger negative
reaction to larger discounts due to indications of greater managerial pessimism about the
stock price.
Question for mulling over
What are the relevant lessons that can be transferred from rights offerings to
tender offer stock repurchases by firms?