Question

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 Shares Issue Price = $10

Right Issue Ratio = 1:3 (1 share will be will be issued for every 3 shares held)

Number of outstanding shares before right issue = 12,000,000 shares

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

(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 one of the popular methods used by the companies to raise finance. In right offerings, the company Invites the existing shareholder to purchase equity shares at discounted price. The issue price is at a discount to the market price to makes the offer attractive to shareholders. However, it can be noticed when after right issue is made the market price of the share tends to fall. The same can be noticed in our case where Ex- Right Market Price of the share falls to $13.75 from $15 This happens because when right shares are issued it leads to dilution in the company's earnings. The earnings of the company will now be distributed over larger number of shareholders leading to reduced earnings per share (EPS) and which will further lead to fall in the Market Value.

But even though there is decline in Market Price of the share 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. Therefore, even though the Market Price has decline by $1.25 per share (-$15 - $13.75) Value of equal amount is compensated to the shareholder due to discount on Issue Price.  

(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

In this case Value of Right = (Ex-right price-issue Price)= (12.94-8)= 4.94 or 2.06 per share and difference between Market Price - Ex-right Price = $ 15- $12.94 = 2.06. Therefore, this means that the loss in value of market price is compensated by the value of right issue which means that even if Issue price is $8 rather than $10 the shareholders in both the case will be equally well off. This can also be explained as follows:

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)	$2,200
Less: Amount paid to acquire right shares (40*10)	$400
Value to shareholder (or Shareholders Wealth)	$1,800

When Issue price = $8, Nos of Shares after right issue = 120+120*5/12=170

Value of shares after right issue (170*12.94)	$2,200
Less: Amount paid to acquire right shares (50*8)	$400
Value to shareholder (or Shareholders Wealth)	$1,800

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