Question

According to Smith, C. W. (1977) 's hypothesis,  identify and discuss the reasons that have been put forward to explain the preference for underwritten offerings over rights issues.

Answer 1

Acc .to Smith,c.w.(1977)'s Hypothesis this are the reason which he have put forward regarding Underwritten Offering over Rights Issue.

- In a firm comrmtment underwrltten offermg, the underwrrtmg syndicate purchases the new shares from the firm at an agreed upon price, and offers the shares for sale to the puhl~c at the offer prrce If the shares cannot be sold at the offer price, the underwrltmg syndtcate breaks and the shares are sold for whatever prrce they will bring The underwriters bear the risk associated with adverse prrce movements, the proceeds to the firm are guaranteed Of course the dtfference betlleen the offer price and the proceeds to the firm are expected to compensate the underwriter for bearing thrs risk In a rights offerrng, each shareholder receives one Right for each share owned This right is an optron Issued by the firm to purchase new shares The right states the relevant terms of the option, specifyrng the number of rights requtred to purchase each new share, the price for each new share, and the expiration date of the optron Since issuing rights is costly, It in the firm’s Interest to Insure the success of the offering A lower subscription price for the rights provides thrs Insurance, a lower Subscription price raises the market value of the right and reduces the probability that at the expiration date of the rights offering the stock price will be below the subscrlptron price There is a corresponding fall in the market value of the stock, but this fall is like a stock split It does not affect the wealth of the owners of the firm.

If the shareholder does not exercise his rights, or does not sell hrs rights to someone who will exercise the rights, his wealth is reduced by the market value of the rights Thus the firm can make the probability of failure of the rights offerring small by setting the subscrrptron price low enough.

Thus, since rights offerings and undewritten offerings can be specified so that the amount of capital raised by each is  essentially equivalent, the decision as to which method to employ depends on the costs, the firm should employ that method which has lower net costs.