Question

Question 2

In March 2020, Snow Fun, Inc., made a rights issue at a subscription price of $10 a share. One new share can be purchased for every 3 shares held. Before the issue, there were 12 million shares outstanding, and the share price was $15.

(1) What is the total amount of new money raised?

(2) What is the expected stock price after the rights are issued? Why is the stock price expected to fall after the right issue?

(3) Suppose that the company had decided to issue the new stock at $8 instead of $10 a share, how many new shares would it have needed to raise the same sum of money? Show that Snow Fun’s shareholders are just as well off if it issues the shares at $8 a share rather than $10.

Answer 1

(1) Total amount of shares offered for the right share = 12 * 1/3 million shares = 4 million shares

Total amount of new money raised = No. of right shares * Subscription Price = 4 million* $10 = $40 million

(2) Total Market Capitalization before the rights are issued = 12 million shares * $15 = $180 million

Total Market Capitalization after the rights are issued = $180 million + $40 million = $220 million

Total Shares after the rights are issued = 12 million + 4 million = 16 million shares

Expected Stock Price after the rights are issued = Total Market Capitalization after the rights are issued/ Total Shares after the rights are issued = 220/16 = $13.75

The Earnings Per Share decrease because there are additional number of shares whereas there is the same amount of earnings available to the shareholders. Since, the number of shares increase, the market needs to adjust it and therefore, the stock price is expected to fall after the rights issue. Also, the capital raised by the company has not been utilised immediately and the benefits will only arise in a few years.

(3) If the company had raised capital at $8 a share, the total amount of new money raised = No. of right shares * Subscription Price = 4 million* $8 = $32 million

The deficit amount needed to raise the same capital = $40 -$32 = $8 million

No. of shares additionally required to raise the deficit= $8million/$8 = 1 million shares

Expected Stock Price after the rights are issued = Total Market Capitalization after the rights are issued/ Total Shares after the rights are issued = 220/17 = $12.94

Shareholder's Perspective

In the earlier scenario, the expected stock price becomes $ 13.75 while the shareholders were given 1 share for every 3 shares held by them but in the next scenario the expected stock price becomes $ 12.94 while the shareholders will be given 5 share for every 12 shares held by them. In total, the net value of the shareholder remains the same.