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

Part (1)

Before the issue, there were 12 million shares. One new share can be purchased for every 3 shares held.

Hence, number of new shares issued under rights, N = 12 / 3 = 4 million

Issue price, P = $ 10 / share

Hence,  the total amount of new money raised = P x N = 10 x 4 = $ 40 million

Part (2)

Market cap before the rights issue = Number of shares outstanding before issue x Per share price before issue = 12 million x 15 = $ 180 million

Market cap after rights issue = market cap before issue + funds raised during rights issue = 180 + 40 = $ 220 million

Number of shares outstanding after rights issue = Number of shares outstanding before issue + N = 12 + 4 = 16 million

Hence, the expected stock price after the rights are issued = Market cap after rights issue / Number of shares outstanding after rights issue = 220 / 16 = $ 13.75 / share

The stock price expected to fall after the right issue, because stocks have been issued at discount to the prevailing market price, under the right issue. Since the issue price is lower than the market price, the stock price is expected to fall after the right issue.

Part (3)

If P = $ 8

then N = $ 40 million / 8 = 5 million new shares to be issued to raise the same sum of money.

Share price after right issue = 220 / (12 + 5) = $ 12.94 per share

4 million new shares for 12 million exisiting shares, means 4/12 new share for every 1 share held. Hence, the wealth of a shareholder who was having 1 share prior to right issue will be equal to = new price x new shares held = 13.75 x (1 + 4/12) = $ 18.33

5 million new shares for 12 million exisiting shares, means 5/12 new share for every 1 share held. Hence, the wealth of a shareholder who was having 1 share prior to right issue will be equal to = new price x new shares held = 12.94 x (1 + 5/12) = $ 18.33

Hence,  the Snow Fun’s shareholders are just as well off if it issues the shares at $8 a share rather than $10