Answer to Question #144353 in Financial Math for Eric

Question

3. The chairman of the company receives a call from an angry shareholder who own 3,000 shares. The shareholder argues that he will suffer a loss in his personal wealth due to this rights issue, because the new shares are being offered at a price lower than the current mark value. The chairman assures him that his wealth will not be reduced because of the rights issue, as long as the sharesholder takes appropriate action.
Required:
Prepare a statement showing the effects of the right issue on this particular shareholder’s wealth, assuming he exercises the rights and sells half of it.

Answer 1

Shares available to existing shareholders equal to their holdings which can be bought at a discounted price for a definite period of time.

Rights can be renounced either completely or partially

A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. This type of issue gives existing shareholders securities called rights. With the rights, the shareholder can purchase new shares at a discount to the market price on a stated future date. The company is giving shareholders a chance to increase their exposure to the stock at a discount price.

Until the date at which the new shares can be purchased, shareholders may trade the rights on the market the same way that they would trade ordinary shares. The rights issued to a shareholder have value, thus compensating current shareholders for the future dilution of their existing shares' value. Dilution occurs because a rights offering spreads a company’s net profit over a larger number of shares. Thus, the company’s earnings per share, or EPS, decreases as the allocated earnings result in share dilution.

In some cases, rights are not transferable. These are known as non-renounceable rights. But in most cases, your rights allow you to decide whether you want to take up the option to buy the shares or sell your rights to other investors or the underwriter. Rights that can be traded are called renounceable rights. After they have been traded, the rights are known as nil-paid rights.

To determine how much you may gain by selling the rights, you can to estimate value on the nil-paid rights ahead of time. Again, a precise number is difficult, but you can get a rough value by taking the value of the ex-rights price and subtracting the rights issue price. At the adjusted ex-rights price of $4.92 less $3, your nil-paid rights are worth $1.92 per share. Selling these rights will create a capital gain.