The Derivation of Theoretical Value of Right and the Logic Behind It

Disclaimer: This is going to be a lengthy read and of a very technical nature.

Before we get to the real stuff, lets have a background check.
We all know that Atty. Valix's Financial Accounting Book is the most used book here
in the Philippines by Accountancy students because of its simplicity and its
comprehensive coverage. Valix's style in writing and technique at reinforcing topics
are nothing short of impressive. He is the reason why I'm enrolled at CPARs May October review session. However, derivation of formulas used/involved in certain
problems and the logic behind it are clearly not given (when it needs to be IMO)
much room and attention in the book. And one of them is the formula used to arrive
at the Theoretical Value of a Stock Right.
Let us begin
At Page 650 of Financial Accounting 1 (2011) by Atty. Valix a new formula is
introduced.
It shows:

Market Value of share on

Number of rights
minus subscription price one share plus 1

Theoretical Value of one

To fully understand this formula we need to have clear-cut definition of terms.

First off, the stock right.
According to Atty. Valix:
A stock right is a legal right allowing shareholders of record to subscribe with
priority every time a corporation issues new and additional shares. Not only that,
the exercise price is normally at a lower price than the current market value of the
corporation's shares. As a shareholder, not only are you buying shares at a discount,
youre also preserving your equity interest in the corporation. (Stock rights can be
traded as well. )
Example:
Assume a PLDT share is selling @P15 right-on and par value P5.
Yes, you got it. If you have 1 right and PLDT issues new shares, then you can buy
em shares at a discounted price of P5, that's around 66% discount! Due to its
advantages, proper valuation should be observed concerning stock rights.

Using above example (P15 right-on and subscription/exercise price of P5), if there is
no available fair value for a stock right, how much should one right cost, assuming 1
right to buy 1 share and all else equal - no gains/losses?
.
.
If you guessed P10, you're wrong. (Well get back to this later.)
Next two, market value of shares right-on and market value of shares ex-right
Exactly what it says. Market value of shares right-on means the price of one share
with a right.
Market value of shares ex-right the price of one share without a right.
Now reread the definition.
You should logically come up with the conclusion by now that the Theoretical
Value of a Right is the difference between those two. Now you see why P10 is
wrong?
Lastly, the theoretical value of a right is an assumed value or price where an
investor would be indifferent between buying shares with rights, exercising them
and buying the same number of shares without rights. Such a price would assure
that most stockholders would either exercise or sell their rights rather than just
letting them expire (this will be explained later).
Now we got the terms down, lets consult the formula:
Market value of share right-on = P15
Subscription Price = P10
Number of rights to purchase one share = 1

Market Value of share on

Number of rights
minus subscription price one share plus 1

Value of one

155
=P 5
1+1

Why? It would only seem logical that the difference between market price and
exercise price of a share would be the stock right price assuming there are no gains
and losses involved in it.
Perspective #1:
One should need to take note of what Theoretical Relationships mean on this
context. As stated above, the theoretical value of a right is an assumed value or

price where an investor would be indifferent between buying shares with

rights, exercising them and buying the same number of shares without
rights.
Lets take the statement apart by phrase.
buying shares with rights, and exercising those rights
Using the previous example again, lets assume we bought one share of PLDT at
P15 right-on. Since it is right-on, we also got a stock right with it and immediately
exercised the same at P5.
Total shares bought = 2
Total cash out = P15 + 5 = P20
Now hold that thought for a moment.
Lets take a look at the next phrase:
buying the same number of shares-without-rights (or buying shares ex-right)
To be indifferent, the cash out and number of shares bought should be the same =
P20 for 2 shares
Therefore, for theoretical relationships to hold, market value of shares ex-right =
20/2 = P10
You guessed it right.

Market Valueof Shares RightOnMarket Valueof Shares ExRight=Theoretical Value of

P15-P10 = P5 = Theoretical Value of Right
Use any other value, the theoretical relationships will not hold.
I see youre still not convinced why 10 is wrong.
Alright, lets take a different perspective.
#2:
Continuing on the previous example, suppose you plan to buy additional shares.
Shares right-on are still selling @P15 You found a secondary market for your share
that is indeed trading @P10. You also heard that PLDT is planning to issue new and
additional shares. PLDT computed the fair value of the rights approximate its
theoretical value. At what exercise price should management issue new shares
right-on in a way that such a price would assure that you would either exercise or
sell (indifferent) their rights rather than just letting them expire yet a careless
failure to use the rights would not impose too severe a hardship on anyone?
Case 1: If management issues the share right-on with P5 exercise price instead,
will the theoretical relationships hold?
Answer: Yes. Because you would be indifferent in selling or exercising the right.
Selling the right @P5 (theoretical value) and buying another one at the secondary
market ex-right @P10 would result into a net cash out of P5 for one share. The cash
out is the same if you instead exercised the right @P5.

Case 2: If management issues the share right-on with P8 exercise price instead,
will the theoretical relationships hold?
Answer: No. Because you would absolutely favor selling the right. Selling the right
@P5 (theoretical value) and buying another one at the secondary market ex-right
@P10 would result into a net cash out of only P5 for one share. If you instead simply
exercised the right @P8 you lose P3.
Case 3: If management issues the share right-on with P3 exercise price instead,
will the theoretical relationships hold?
Answer: No. You would now exercise the right. Cash out would only be P3, compared
to selling the right and buying shares ex-right @P10 with net cash out of P5 - you
lose P2.
Case 4: If management issues the share right-on with P5 exercise price but the
rights are trading @P10, will the theoretical relationships hold?
Answer: No. You would sell the right. Selling the right @P10 (fair value) and buying
another one at the secondary market ex-right @P10 would not result into any cash
out for one share. You get a new share for free. Talk about the perfect arbitrage
opportunity. If you instead simply exercised the right @P5 you lose P5.

Therefore, any exercise price higher than the original of P5 will result into the stock
right holder selling the right and any lower would result into an exercise of the right,
letting them expire will result into an opportunity cost for the holder every time and
any value of the stock right other than P5 will distort the relationships.
So now we are convinced that the P15-P10-P5 price combination will hold
theoretical relationships only when the value of the right is P5. Can you now see
why P10 is wrong?

The explanation of the logic ends here. Now hold on to your seats, here comes some
technical sh*t.
On to derivation
.
.
.
.
For simplicity purposes, lets assign variables for our techy terms.

x=Market Valueof Share On

y=number of rights buy 1 share

z=subscription price/exercise price

Using above example: x = 15; y =1; z = 5

xy + z
=Market Value of Share Ex
y +1
Numerical proof:

15 x 1+5 20
= =10
1+1
2
Numerator: We bought enough shares (xy) to get enough rights to buy one
additional share at price (z)
Denominator: The total number of shares bought (including the share bought with
the exercise of rights)
We arrive at the market value of share ex-right (see numerical proof)
Restating our formula:

Market Valueof Shares RightOnMarket Valueof Shares ExRight =Theoretical Value of

--->

xy + z
=Theoretical Value of
y+1
x ( y +1) xy + z

y +1
y +1

--->

xy + xxy z
y +1

--->

xz
y +1

Substituting our variables back to real terms:

Market Value of share on

Number of rights
minus subscription price one share plus 1

Value of one

The accountancy program is plagued with formulas like the one above and were left
with very little (if any) explanation. The reason is that the logic behind every
formula is very complex and is impractical to explain in class. It should be left with
the mathematicians to solve and explain. Mathematicians derive and explain, we
accountants simply use/apply them.