Question

For short-answer questions, provide your answers and explanations. For numerical questions, it is important to show your work.

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

Right Issue Subscription Price = $10

Right Issue Ratio = 1:3

Number of outstanding shares before right issue = 12,000,000 shares @ $15 share each

Number of right shares issued = 12,000,000/3= 4,000,000

(1) Total amount of new money raised = New shares x Issue Price

= 4,000,000 x $10

= $40,000,000

Total amount of new money raised $40,000,000

(2) Ex-right Price  = (New Shares × Issue Price + Old Shares × Market Price)/ (Old Shares +New Shares)

= (4,000,000 x $10 + 12,000,000 x $15)/ (4,000,000 + 12,000,000)

= (220,000,000)/16,000,000

= $13.75 per share

Ex-right Price $13.75 per share

Right issue is a method to raise finance by the company. In right offerings, the company offers the existing shareholder the right to purchase equity shares at discounted price to that prevailing in the market. When right shares are issued it leads to dilution as the company's earnings as now the earnings are to be distributed over larger number of shareholders leading to reduced EPS and consequently reduced Market Value

Right issue provides shareholders with value in order to compensate for the loss due to fall in the stock prices.

For Example: When Issue price = $10

Value of right = (Ex-right price-issue Price)

= (13.75-10)

= 3.75 or 1.25 per share

(3) Assuming Right Issue Subscription Price = $8

Total amount of new money raised = $40,000,000

Number of Shares required to raise the given amount of money =  $40,000,000/$8 = 5,000,000 shares

Ex-right Price  = (New Shares × Issue Price + Old Shares × Market Price)/ (Old Shares +New Shares)

= (5,000,000 x $8 + 12,000,000 x $15)/ (5,000,000 + 12,000,000)

= (220,000,000)/17,000,000

= $12.94 per share

Ex-right Price $12.94 per share

Now lets assume a shareholder holds 120 shares, Lets calculate the impact of right issue on the wealth of this shareholder:

When Issue price = $10, Nos of Shares after right issue = 120+120/3=160

Value of shares after right issue (160*13.75) = $2200

Less: Amount paid to acquire right shares (40*10) = $400

Wealth = $1800

When Issue price = $10, Nos of Shares after right issue = 120+120*5/12=170

Value of shares after right issue (170*12.94) = $2200

Less: Amount paid to acquire right shares (50*8) = $400

Wealth = $1800

Thus , We can conclude that whether the issue price is $10 or $8 there will be no change in the wealth of shareholder