Question

company currently has 150k shares outstanding, selling at $64 per share. The firm intends to raise $565k through a rights offering. Management suggests that a discount cannot fall below 11% as outlined in the previous issue, to which existing shareholders did not respond with much enthusiasm. They believe that a 37% discount offer is more appropriate. Also, the CEO is rejecting calls for raising capital through debt or preferred stock.
Net earnings after taxes (EAT) are $649k. Furthermore, a recent corruption scandal involving a number of senior figures in the firm has come to light in the press; soon after the rights offering was announced – in other words, it was already too late. Among the immediate consequences were a fall in stock price by 17.09% and increased capital requirements by 62%. Required: In percentage terms, determine by how much did the dollar value of one right change before and after the consequences described above, together with the 37% discount offer which was simultaneously taking place. Answer

Answer 1

We can calculate the desired result as follows

Market Price of Share = $ 64

Capital Requirement = $ 565,000

Discount rate = 37%

Right issue price = Market Price * (1 - Discount rate)

= 64 * ( 1 - 37% )

= 64 * 0.63

= $ 40.32

Initial Value of right before the corruption scandal is $ 40.32.

No of Right Shares Issue to raise the 565k Capital will be

= Capital Requirement / Value of Right

= 565,000 / 40.32

= 14,013 Right Shares

Situation after the Corruption Scandal came into light lead to

Decrease in Share Market Price = Original Price * (1-Decrease in Share price)

= 64 * ( 1 - 17.09% )

= 64 * 0.8291

= $ 53.06

Increase in Capital Requirement = $ 565,000 * (1+62%)

= 565,000 * 1.62

= $ 915,300

Discount rate = 37%

Right issue price = Market Price * (1 - Discount rate)

= 53.06 * ( 1 - 37% )

= 53.06 * 0.63

= $ 33.43

Percentage Change in Dollar Value of a Right

= (Right Issue Price before Scandal - Right Issue Price before Scandal) / Right Issue Price before Scandal

= ( 40.32 - 33.43 ) / 33.43

= 6.89 / 33.43

= 0.2061 or 20.61%

There is a 20.61% decrease in dollar value of one right.