Question 14.4: You are the CFO of a company that has a market capitalizatio...
You are the CFO of a company that has a market capitalization of $1 billion. The firm has 100 million shares outstanding, so the shares are trading at $10 per share. You need to raise $200 million and have announced a rights issue. Each existing shareholder is sent one right for every share he or she owns. You have not decided how many rights you will require to purchase a share of new stock. You will require either four rights to purchase one share at a price of $8 per share, or five rights to purchase two new shares at a price of $5 per share. Which approach will raise more money?
PLAN
In order to know how much money will be raised, we need to compute how many total shares would be purchased if everyone exercises their rights. Then we can multiply it by the price per share to calculate the total amount of capital raised.
EXECUTE
There are 100 million shares, each with one right attached. In the first case, four rights will be needed to purchase a new share, so 100 million/4 = 25 million new shares will be purchased. At a price of $8 per share, that would raise $8 × 25 million = $200 million.
In the second case, for every five rights, two new shares can be purchased, so there will be 2 × (100 million/5) = 40 million new shares. At a price of $5 per share, that would also raise $200 million. If all shareholders exercise their rights, both approaches will raise the same amount of money.
EVALUATE
In both cases, the value of the firm after the issue is $1.2 billion. In the first case, there are 125 million shares outstanding after the issue, so the price per share after the issue is $1.2 billion/125 million = $9.60. This price exceeds the issue price of $8, so the shareholders will exercise their rights. Because exercising will yield a profit of ($9.60 – $8.00 )/4 = $0.40 per right, the total value per share to each shareholder is $9.60 + 0.40 = $10.00. In the second case, the number of shares outstanding will grow to 140 million, resulting in a post-issue stock price of $1.2 billion/140 million shares = $8.57 per share (also higher than the Issue price). Again, the shareholders will exercise their rights, and receive a total value per share of $8.57 + (2 × ($8.57 – $5.00 )/5 ) = $10.00. Thus, in both cases the same amount of money is raised and shareholders are equally well off.