The Right to Purchase New Shares
In addition to a claim to residual income and the right to vote for directors, the common stockholders may also enjoy a privileged position in the offering of new securities. If the corporate charter contains a preemptive right provision, holders of common stock must be given the first option to purchase new shares. While only two states specifically require the use of preemptive rights, most other states allow for the inclusion of a rights offering in the corporation charter.
The preemptive right provision ensures that management cannot subvert the position of present stockholders by selling shares to outside interests without first offering them to current shareholders. If such protection were not afforded, a 20 percent stockholder might find his or her interest reduced to 10 percent through the distribution of new shares to outsiders. Not only would voting rights be diluted, but proportionate claims to earnings per share would be reduced.
The Use of Rights in Financing
Many corporations also engage in a preemptive rights offering to tap a built-in market for new securities—the current investors. Rights offerings are not only used by many U.S. companies, but are especially popular as a fund-raising method in Europe. It is quite common in European markets for companies to ask their existing shareholders to help finance expansion.
For example, Telephon A.B. Ericsson, a Swedish company, had a $3 billion rights offering in August 2002 to raise new funds. The collapse of the Internet bubble in 2000 caused a huge decline in sales and earnings, and Ericsson was in need of new capital. What better place to look for equity capital than the existing stockholders. If they already believe in the company and own shares, they might be willing to ante up more money to keep the company alive. This also happened in 2009 in the banking crisis. Many banks were short of their required capital requirements and needed new infusions of equity capital. The American banks relied mostly on secondary offerings available to anyone while the European banks relied on rights offerings. In Table 17-2, we feature three European banks that raised a total of $56.7 billion of new equity through rights offerings. Also included are smaller rights offerings from Sweden, Singapore, Spain, and the United States.
Most rights offerings are successful in getting shareholders to exercise their rights to buy new shares. When all the shares are not exercised by shareholders, the investment banker in charge of the offering exercises the rest and sells them in the open market. Additionally, the number of shares a shareholder can buy is conditional on the number of shares he or she owns, and there is a ratio of new shares to shares already owned. This is shown in the table in the fourth column of Table 17-2, and one can see that there is no standard ratio. In the Royal Bank of Scotland rights offering, for every 18 shares a stockholder owned, he or she could buy 11 new shares, while for Banco Popular Español SA, a shareholder could buy 1 new share for every 3 shares owned.
Usually the investment banker in charge of the rights offering will price the new shares at a discount to the price of the existing shares. The price of the new shares is stated on the announcement day, and the underpricing is expressed as the offering price of the new shares compared to the market price of the shares traded on the market on the day of the announcement. The more the shares are underpriced, the more likely it is that the rights will be exercised. The underpricing is shown in column five.
To illustrate the use of rights, let’s take a look at a hypothetical company, Watson Corporation, which has 9 million shares outstanding and a current market price of $40 per share (the total market value is $360 million). Watson needs to raise $30 million for new plant and equipment and will sell 1 million new shares at $30 per share.2 As part of the process, it will use a rights offering in which each old shareholder receives a first option to participate in the purchase of new shares.
Table 17-2 Rights offerings big and small
Sources: Bloomberg, Globe Newswire, PR Newswire, 123Jump.com, Morningstar, Standard & Poor’s, and corporate websites.
Each old shareholder will receive one right for each share of stock owned and may combine a specified number of rights plus $30 cash to buy a new share of stock. Let us consider these questions:
1. How many rights should be necessary to purchase one new share of stock?
2. What is the monetary value of these rights?
Rights Required Since 9 million shares are currently outstanding and 1 million new shares will be issued, the ratio of old to new shares is 9 to 1. On this basis, the old stockholder may combine nine rights plus $30 cash to purchase one new share of stock.
A stockholder with 90 shares of stock would receive an equivalent number of rights, which could be applied to the purchase of 10 shares of stock at $30 per share. As indicated later in the discussion, stockholders may choose to sell their rights, rather than exercise them in the purchase of new shares.
Monetary Value of a Right Anything that contributes toward the privilege of purchasing a considerably higher priced stock for $30 per share must have some market value. Consider the following two-step analysis.
Nine old shares sold at $40 per share, or for $360; now one new share will be introduced for $30. Thus we have a total market value of $390 spread over 10 shares. After the rights offering has been completed, the average value of a share is theoretically equal to $39.3
|Nine old shares sold at $40 per share||$360|
|One new share will sell at $30 per share||30|
|Total value of 10 shares||$390|
|Average value of one share||$ 39|
The rights offering thus entitles the holder to buy a stock that should carry a value of $39 (after the transactions have been completed) for $30. With a differential between the anticipated price and the subscription price of $9 ($39 − $30) and nine rights required to participate in the purchase of one share, the value of a right in this case is $1.
|Average value of one share||$39|
|Rights required to buy one share||9|
|Value of a right||$ 1|
Formulas have been developed to determine the value of a right under any circumstance. Before they are presented, let us examine two new terms that will be part of the calculations—rights-on and ex-rights. When a rights offering is announced, a stock initially trades rights-on; that is, if you buy the stock, you will also acquire a right toward a future purchase of the stock. After a certain period (say four weeks), the stock goes ex-rights—when you buy the stock, you no longer get a right toward the future purchase of stock. Consider the following:
Once the ex-rights period is reached, the stock will go down by the theoretical value of the right. The remaining value ($39) is the ex-rights value. Though there is a time period remaining between the ex-rights date (April 1) and the end of the subscription period (April 30), the market assumes the dilution has already occurred. Thus the ex-rights value reflects the same value as can be expected when the new, underpriced $30 stock issue is sold. In effect, it projects the future impact of the cheaper shares on the stock price.
The formula for the value of the right when the stock is trading rights-on is:
|M0 =||Market value—rights-on, $40|
|S =||Subscription price, $30|
|N =||Number of rights required to purchase a new share of stock; in this case, 9|
Using Formula 17-3 we determined that the value of a right in the Watson Corporation offering was $1. An alternative formula giving precisely the same answer is:
The only new term is Me, the market value of the stock when the shares are trading ex-rights. It is $39. We show:
These are all theoretical relationships, which may be altered somewhat in reality. If there is great enthusiasm for the new issue, the market value of the right may exceed the initial theoretical value (perhaps the right will trade for 1.375).
Effect of Rights on Stockholder’s Position
At first glance, a rights offering appears to bring great benefits to stockholders. But is this really the case? Does a shareholder really benefit from being able to buy a stock that is initially $40 (and later $39) for $30? Don’t answer too quickly!
Think of it this way: Assume 100 people own shares of stock in a corporation and one day decide to sell new shares to themselves at 25 percent below current value. They cannot really enhance their wealth by selling their own stock more cheaply to themselves. What is gained by purchasing inexpensive new shares is lost by diluting existing outstanding shares.
Take the case of Stockholder A, who owns nine shares before the rights offering and also has $30 in cash. His holdings would appear as follows:
|Nine old shares at $40||$360|
If he receives and exercises nine rights to buy one new share at $30, his portfolio will contain:
|Ten shares at $39 (diluted value)||$390|
Clearly he is no better off. A second alternative would be for him to sell his rights in the market and stay with his position of owning only nine shares and holding cash. The outcome is:
|Nine shares at $39 (diluted value)||$351|
|Proceeds from sale of nine rights||9|
As indicated previously, whether he chooses to exercise his rights or not, the stock will still go down to a lower value (others are still diluting). Once again, his overall value remains constant. The total value received for the rights ($9) exactly equals the extent of dilution in the value of the original nine shares.
The only foolish action would be for the stockholder to regard the rights as worthless securities. He would then suffer the pains of dilution without the offset from the sale of the rights.
|Nine shares at $39 (diluted value)||$351|
Empirical evidence indicates this careless activity occurs 2 to 3 percent of the time.