Question

ABC stock price is $5. Briefly discuss why the price of the new right shares are unlikely to be priced at $4.70.

 

(b) XYZ Company is making a 1-for-2 rights issue, i.e. an investor who holds 2 shares will be entitled to buy 1 new share. The new rights share will be priced at $3. If XYZ shares traded at $4 the day before the stock went ex-rights. 

Calculate the theoretical ex-rights price the next day.

 

(c) Briefly discuss one  advantage of a value-weighted stock index compared to a price-weighted stock index.

 

(d) Describe two possible reasons for an investor buying an ETF instead of a mutual fund.

Answer 1

(a) The new right shares are unlikely to be priced at $4.70 because the market price of ABC stock is currently $5, indicating that investors are willing to buy and sell ABC shares at that price. If the new right shares were priced at $4.70, investors could buy them at a discount and immediately sell them on the market for a profit, which would create upward pressure on the stock price. As a result, the underwriters are likely to set the new right shares' price at a premium to the current market price to prevent immediate selling pressure.

(b) The theoretical ex-rights price is calculated by taking the current market value of the shares and subtracting the value of the subscription rights that the shareholder did not exercise, divided by the number of outstanding shares after the rights issue. In this case, if an investor holds 2 shares, they will be entitled to buy 1 new share at a price of $3. Therefore, the total cost to purchase 3 shares will be $2 x 2 + $3 = $7. Theoretical ex-rights price = (2/3) x $4 + (1/3) x $7 = $2.67.

(c) One advantage of a value-weighted stock index compared to a price-weighted stock index is that it reflects the actual market capitalization of each company in the index, rather than just its share price. In a value-weighted index, the companies with a higher market capitalization will have a larger weighting in the index, which better represents their influence on the overall market. In contrast, a price-weighted index gives higher weighting to companies with a higher share price, regardless of their actual market capitalization. This can result in an inaccurate representation of the market if companies with lower market capitalization have a higher share price.

(d) One reason an investor may prefer an ETF over a mutual fund is that ETFs often have lower expense ratios than mutual funds, making them a more cost-effective investment option. Additionally, ETFs can be traded throughout the day like individual stocks, while mutual funds are priced at the end of each trading day, which can be a disadvantage for investors who want to quickly respond to market changes. Finally, ETFs can be more tax-efficient than mutual funds because they typically have lower capital gains distributions, resulting in fewer taxable events for investors.