Chapter 13

Corporate Financing and Market Efficiency

1. Can Financing Decisions Create Value?
2. A Description of Efficient Capital Markets
3. The Different Types of Efficiency
4. The Evidence
5. Implications for Corporate Finance

Can Financing Decisions Create Value?

Example: Suppose Jays Electronics is thinking about
relocating its plant to Mexico where labor costs are
lower. In the hope that it can stay in Ontario, the
company has submitted an application to the province to
guarantee a five-year bank term loan for $2 million. With
a provincial guarantee, a chartered bank has offered to
make the loan (interest payments are paid at the end of
each year) at an interest rate of 5 percent. This is an
attractive rate because the normal cost of debt capital for
Jays Electronics is 10%. What it the NPV of this potential
financing transaction?

What Sort of Financing Decisions?

Typical financing decisions include:
How much debt and equity to sell
When (or if) to pay dividends
When to sell debt and equity
Just as we can use NPV criteria to evaluate
investment decisions, we can use NPV to
evaluate financing decisions.

How to Create Value through Financing

1. Fool Investors
Empirical evidence suggests that it is hard to fool
investors consistently.
2. Reduce Costs or Increase Subsidies
Certain forms of financing have tax advantages or
carry other subsidies.
3. Create a New Security
Sometimes a firm can find a previously-unsatisfied
clientele and issue new securities at favorable prices.
In the long-run, this value creation is relatively small,
however.
4

A Description of Efficient Capital Markets

An efficient capital market is one in which stock
prices fully reflect available information.
The EMH has implications for investors and firms.
Since information is reflected in security prices
quickly, knowing information when it is
released does an investor no good.
Firms should expect to receive the fair value
for securities that they sell. Firms cannot profit
from fooling investors in an efficient market.
5

Ex: How Does an Efficient Market Work?

Suppose the F-stop Camera Corporation (FCC) is
attempting to develop a camera that will double the speed
of the auto-focusing system now available. FCC believes
this research has a positive NPV.
Consider the share of FCC. One of the determinant of the
shares price is the probability that FCC will be the
company to develop the new auto-focusing system first.
In an efficient market we would expect the price of the
shares of FCC to rise if this probability increases.
Now, suppose a well-known engineer is hired by FCC to
help develop the new auto-focusing system. Assuming an
efficient market, what do you think will happen to FCCs
share price when this is announced?
6

The Different Types of Efficiency

Weak Form
Security prices reflect all information found in past
prices and volume.

Semi-Strong Form
Security prices
information.

reflect

all

publicly

available

Strong Form
Security prices reflect all informationpublic and
private.
7

Weak Form Market Efficiency

Security prices reflect all information found in
past prices and volume.
Often weak-form efficiency is represented as
Pt = Pt-1 + Expected return + random error

Since stock prices only respond to new

information, which by definition arrives
randomly, stock prices are said to follow a
random walk.

Testing Random Walk Theory

The movement of stock prices from day to
day DO NOT reflect any pattern.
Statistically speaking, the movement of
stock prices is random (skewed positive over the
long term).

Random Walk Theory

Coin Toss Game
Heads

Heads

$106.09

$103.00
Tails

$100.43

$100.00
Heads
Tails

$100.43

$97.50
Tails

$95.06
10

Random Walk Theory

11

Random Walk Theory

12

Random Walk Theory

13

Random Walk Theory

S&P Composite

Return in week t + 1, (%)

(correlation = -.07)

Return in week t, (%)

14

Efficient Market Theory

Microsoft
Stock Price
$90
Actual price as soon as upswing is
recognized

70

50
Cycles
disappear
once
identified

Last
Month

This
Month

Next
Month
15

Stock Price

Why Technical Analysis Fails

Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Sell
Sell
Buy
Buy

If it were possible to make

big money simply by
finding the pattern in the
stock price movements,
everyone would do it and
the profits would be
competed away.

Time

16

Semi-Strong Form Market Efficiency

Security prices reflect all publicly
available information.
Publicly available information
includes:
Historical price and volume information
Published accounting statements.
Information found in annual reports.
17

Event Studies: How Tests Are Structured

Event studies are one type of test of the semistrong form of market efficiency.
This form of the EMH implies that prices should
reflect all publicly available information.
To test this, event studies examine prices and
returns over timeparticularly around the arrival
of new information.
Test for evidence of underreaction, overreaction,
early reaction, delayed reaction around the event.
18

How Tests Are Structured (cont.)

Returns are adjusted to determine if they are
abnormal by taking into account what the rest of the
market did that day.
The Abnormal Return on a given stock for a
particular day can be calculated by subtracting the
markets return on the same day (RM) from the
actual return (R) on the stock for that day:
AR= R Rm
The abnormal return can be calculated using the
Market Model approach:
AR= R ( + Rm)
19

Reaction of Stock Price to New Information in

Efficient and Inefficient Markets
Stock
Price

Overreaction to good
news with reversion
Delayed
response to
good news

Efficient market
response to good news
-30

-20

-10

+10

+20

Days before (-) and

after (+) announcement

+30
20

Reaction of Stock Price to New Information

in Efficient and Inefficient Markets
Stock
Price

Efficient market
response to bad news

-30
-20
-10
Overreaction to bad
news with reversion

Delayed
response to
bad news

+10

+20

+30

Days before (-) and

after (+) announcement
21

Cumulative abnormal returns

(%)

Event Studies: Dividend Omissions

Cumulative Abnormal Returns for Companies Announcing
Dividend Omissions
1
0.146 0.108
-8

-6

0.032
-4
-0.72

0
-0.244
-2 -0.483 0
-1

Efficient market
response to bad news

-2
-3
-3.619
-4
-5

-4.563-4.747-4.685-4.49
-4.898
-5.015
-5.183
-5.411

-6

Days relative to announcement of dividend omission

S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout Do Dividend Omissions Signal Future Earnings or Past Earnings?
Journal
22
of Investing (Spring 1997)

Event Studies: Takeover Announcement

Announcement Date

23

Event Study Results

Over the years, event study methodology has been
applied to a large number of events including:
Dividend increases and decreases
Earnings announcements
Mergers
Capital spending
New issues of stock
The studies generally support the view that the market
is semistrong-form efficient.
In fact, the studies suggest that markets may even have
some foresight into the futurein other words, news
tends to leak out in advance of public announcements.
24

The Record of Mutual Funds

If the market is semistrong-form efficient, then
no matter what publicly available information
mutual-fund managers rely on to pick stocks,
their average returns should be the same as
those of the average investor in the market as a
whole.
We can test efficiency by comparing the
performance of professionally managed mutual
funds with the performance of a market index.
25

Efficient Market Theory

Average Annual Return on 1493 Mutual Funds and the
Market Index

26

Strong Form Market Efficiency

Security prices reflect all informationpublic and
private.
Strong form efficiency incorporates weak and
semi-strong form efficiency.
Strong form efficiency says that anything
pertinent to the stock and known to at least one
investor is already incorporated into the
securitys price.

27

Insider Trading
Officers, directors, and major shareholders of a
firm are considered insiders who may have nonpublic important information. The SEC, the
Ontario Securities Commission (and its
counterparts in other provinces) prohibited the
trade of securities based on pieces of
information that have not yet become news.
To enforce regulation, the OSC and the SEC
require insiders to reveal any trading they might
do in their own companys share.
28

Relationship among Three Different

Information Sets
All information
relevant to a stock
Information set
of publicly available
information
Information
set of
past prices

29

What the EMH Does NOT Say

If EMH holds there should be no upward trend in stock
price.
If EMH holds, investors can not earn any return
If EMH holds, investors can throw darts to select
stocks.
If EMH holds, stock prices should not go up over time.
If EMH holds, daily fluctuations should not exist as
prices reflect the fundamental value of the firm.
EMH can not hold because there are not enough
active traders.
30

Views Contrary to Market Efficiency

Stock Market Crash of 1987, Dot.com bubble.
The NYSE dropped between 20-percent and 25-percent
Monday following a weekend during which little surprising
information was released.
Nasdaq fell 72% during a two year period.
Temporal Anomalies
Turn of the year, month, week.
Speculative Bubbles
Sometimes a crowd of investors can behave as a single
squirrel.
Size
Small cap stocks seem to outperform large cap stocks.
Value versus Growth
Value stock-price stocks outperform growth stocks.

31

Efficient Market Theory

2000 Dot.Com Boom

PV (index ) March 2000

Div
154.6

12,883
r g .092 .08

PV (index )October 2002

Div
154.6

8,589
r g .092 .074
32

Why Doesnt Everybody Believe the EMH?

There are optical illusions, mirages, and
apparent patterns in charts of stock market
returns.
The truth is less interesting.
There is some evidence against market
efficiency:
Seasonality
Small versus Large stocks
Value versus Growth stocks
The tests of market efficiency are weak.
33

Implications for Corporate Finance

The EMH has three implications for corporate finance:
1. The price of a companys stock cannot be
affected by a change in accounting.
2. Financial managers cannot time issues of stocks
and bonds using publicly available information.
3. A firm can sell as many shares of stocks or bonds
as it desires without depressing prices.

There is conflicting empirical evidence on all three

points.

34

Efficient Market Theory

IPO Non-Excess Returns

Year After
Offering
35

Practice Questions: q8
Which statements contradicts EMH (specify type)
A. Tax-exempt municipal bonds offer lower pretax returns than
taxable government bonds.
B. Managers make superior returns on their purchases of their
companys stock.
C. There is a positive relation between the return on the market in
one quarter and the change in aggregate profits in the next
quarter.
D. There is disputed evidence that stocks which have appreciated
unusually in the recent past continue to do so in the future.
E. The stock of an acquired firm tends to appreciate in the period
before the merger announcement.
F. Stocks of companies with unexpectedly high earnings appear to
offer high returns for several months after the earning
announcement.
G. Very risky stock on average give higher returns than safe stocks.

36

Chapter 14: Corporate Financing

Common Stock
Preferred Stock
Corporate Long-Term Debt: The Basics
Patterns of Long-Term Financing

37

Example: Western Redwood Corp.

Formed in 1976 with 10,000 shares issued and sold for $1
per share.
By 2004, the company had retained $100,000.
Western Redwood Corporation Equity Accounts, 2004
Common stock
(10,000 shares outstanding)

Retain earnings
Total shareholders equity

$ 10,000

100,000
$ 110,000
38

Example: Western Redwood Corp.

Issues 100,000 shares at $20 per share at 2004
Western Redwood Corporation Equity Accounts, 2004

Common stock
(10,000 shares outstanding)

Retain earnings
Total shareholders equity

$ 210,000

100,000
$ 310,000
39

Market Value and Book Value

Market Value is the price of the stock multiplied by
the number of shares outstanding.
Also known as Market Capitalization
Book Value
The sum of par value, (contributed surplus
value in access of par upon issue),
accumulated retained earnings, and
adjustments to equity is the common equity of
the firm, usually referred to as the book value of
the firm.
40

Enbridge Inc., 2003

41

Enbridge Inc., 2003

42

Enbridge Inc., 2003

43

Enbridge Inc., 2003

44

Authorized vs. Issued Common Stock

The articles of incorporation must state the number of
shares of common stock the corporation is authorized
to issue.
The board of directors, after a vote of the
shareholders, may amend the articles of incorporation
to increase the number of shares.
Authorizing a large number of shares may worry
investors about dilution because authorized shares
can be issued later with the approval of the board
of directors but without a vote of the shareholders.
45

Enbridge Inc., 2003

46

Shareholders Rights
The right to elect the directors of the corporation
by vote constitutes the most important control
device of shareholders.
Directors are elected each year at an annual
meeting by a vote of the holders of a majority of
shares who are present and entitled to vote.
The exact mechanism varies across
companies.
The important difference is whether shares are to
be voted cumulatively or voted straight.
47

Cumulative versus Straight Voting

The effect of cumulative voting is to permit minority
participation.
Under cumulative voting, if there are N directors up
for election, then 1/(N+1) percent of the stock plus
one share will guarantee you a seat.
With cumulative voting, the more seats that are up for
election at one time, the easier it is to win one.
Straight voting works like a U.S. political election.
Shareholders have as many votes as shares and
each position on the board has its own election.
A tendency to freeze out minority shareholders.
48

Cumulative vs. Straight Voting: Example 1

Imagine a firm with two shareholders:
Mr. MacDonald and Ms. Laurier.
Mr. MacDonald owns 60% of the firm ( = 600
shares) and Ms. Laurier 40% ( = 400 shares).
There are three seats up for election on the
board.

49

Cumulative vs. Straight Voting: Example 2

There are 2 million shares outstanding. How
many shares do you need to own to be certain
that you can elect at least one director under:
a) straight voting? b) cumulative voting?

50

Proxy Voting
A proxy is the legal grant of authority by a shareholder to
someone else to vote his or her shares.
For convenience, the actual voting in large public
corporations is usually done by proxy.
If shareholders are not satisfied with management, an
outside group of shareholders can try to obtain as many
votes as possible via proxy.
Proxy battles are often led by large pension funds like
the Ontario Teachers Pension Board or the British
Columbia Investment Management Corporation.

51

Dividends
Unless a dividend is declared by the board of directors of
a corporation, it is not a liability of the corporation.
A corporation cannot default on an undeclared
dividend.
The payment of dividends by the corporation is not a
business expense.
Therefore, they are not tax-deductible.
Dividends (of Canadian corporations) received by
individual shareholders are partially sheltered by a
dividend tax credit.
Canadian corporations do not pay taxes on dividends for
amounts they receive from Canadian corporations.
52

Classes of Shares
When more than one class of share exists, they are
usually created with unequal voting rights.
Many companies issue dual classes of common
stock. The reason has to do with control of the firm.
Firms going public with dual classes of shares in
Canada are often family controlled.
Lease, McConnell, and Mikkelson found the market
prices of U.S. stocks with superior voting rights to
be about 5-percent higher than the prices of
otherwise-identical stocks with inferior voting rights.

53

Corporate Long-Term Debt: The Basics

Interest versus Dividends

Is It Debt or Equity?
Basic Features of Long-Term Debt
Different Types of Debt
Repayment
Seniority
Security
Indenture
54

Interest versus Dividends

Debt is not an ownership interest in the firm. Creditors
do not usually have voting power.
The device used by creditors to protect themselves is
the loan contract (i.e., indenture).
The corporations payment of interest on debt is
considered a cost of doing business and is fully taxdeductible. Dividends are paid out of after-tax dollars.
Unpaid debt is a liability of the firm. If it is not paid, the
creditors can legally claim the assets of the firm.
One of the costs of issuing debt is the possibility of
financial failure.

55

Is It Debt or Equity?
Some securities blur the line between debt and
equity.
Corporations are very adept at creating hybrid
securities that look like equity but are called debt.
Obviously, the distinction is important for tax
purposes.
A corporation that succeeds in creating a debt
security that is really equity obtains the tax
benefits of debt while eliminating its bankruptcy
costs.
56

Basic Features of Long-Term Debt

The bond indenture usually lists
Amount of Issue (typically denominated with a $1000 face
value), Date of Issue, Maturity
Denomination (Par value)
Coupon, typically semiannual
Security
Sinking Funds
Call Provisions
Covenants
Features that may change over time
Rating
Yield-to-Maturity
Market Price
57

Enbridge Inc., 2003

58

Back to Preferred Shares

A preferred share represents equity of a corporation, but is
different from common stock because it has preference
over common in the payments of dividends and in the
assets of the corporation in the event of bankruptcy.
Preferred shares have a stated liquidating value.
For example, CIBC $2.25 preferred translates into a
dividend yield of 9% of the stated $25 value.
Preferred dividends are either cumulative or noncumulative.
Firms may have an incentive to delay preferred dividends,
since preferred shareholders receive no interest on the
cumulated dividends.
Preferred shares have a lower yield than debt.
59

Tax loophole in Canada

Corporate investors are exempt from income

taxes on dividends they would be willing to
pay a premium for these shares (compared to
similar debt instruments); as a consequence,
yields are low.
Low taxed companies may therefore prefer to
issue these shares compared to debt (i.e., for
these companies the debt tax shield is of
limited usage).

60

Tax loophole in Canada

Zero Tax Ltd., a corporation not paying any income taxes, can issue preferred shares
attractive to Full Tax Ltd., a second corporation taxable at a combined federal and provincial
rate of 45%. Zero Tax is seeking $1000 in financing through either debt or preferred stock.
Zero Tax can issue either debt with a 10% coupon or preferred stock with a 6.7% dividend.
Preferred (6.7%)
Debt (10%)
Issuer: Zero Tax Ltd.
Preferred dividend/interest paid
$67.00 $100.00
Dividend tax at 40%
26.80 0.00
Tax deduction on interest 0.00
0.00
Total financing cost
$93.80 $100.00
After-tax cost
9.38% 10.00%
Purchaser: Full Tax Ltd.
Before-tax income
$67.00 $100.00
Tax 0.00
45.00
After-tax income $67.00 $55.00
After-tax yield
6.70% 5.50%

61

Other Reasons for Preferred Shares

Regulatory firms can pass the tax
disadvantage to their customers.
Firms issuing preferred shares can avoid the
threat of bankruptcy while at the same time
not surrender control (no voting rights on
preferred shares).

62

Patterns of Long-Term Financing

For Canadian firms, internally generated cash flow
dominates as a source of financing.
Firms usually spend more than they generate
internallythe gap is financed by new sales of debt
and equity.
Net new issues of equity are dwarfed by new sales
of debt.
This is consistent with the pecking order hypothesis.
Leverage ratios for Canadian firms are considerably
higher than they were in the 1960s.
63

The Long-Term Financial Gap

Uses of Cash Flow
(100%)

Sources of Cash Flow

(100%)

Capital
spending

Internal cash
flow (retained
earnings plus
depreciation)
68.3%

Net
working
capital plus
other uses

Internal
cash flow

Financial
deficit
Long-term
debt and
equity 31.7%

External
cash flow
64

Chapter 15
How Corporations Issue Securities
Issuing securities involves the corporation
in a number of decisions.
This chapter looks at how corporations
issue securities to the investing public.
The basic procedure for selling debt and
equity securities are essentially the same.
This chapter focuses on equity.

65

Topics Covered

Venture Capital
The Initial Public Offering
Other New-Issue Procedures
Security Sales by Public Companies
Rights Issue
Private Placements and Public Issues

66

Venture Capital

The limited partnership is the dominant form of

intermediation in this market.
There are five types of suppliers of venture capital:
1. Old-line wealthy families.
2. Private partnerships and corporations.
3. Large industrial or financial corporations with established
venture-capital subsidiaries.
4. The federal government (through crown-related firms).
5. Individuals, typically with incomes in excess of $100,000
and net worth over $1,000,000. Often these angels have
substantial business experience and are able to tolerate
high risks.
67

Stages of Financing
1.
2.
3.
4.

5.

6.

Seed-Money Stage:
Small amount of money to prove a concept or develop a product.
Start-Up
Funds are likely to pay for marketing and product refinement.
First-Round Financing
Additional money to begin sales and manufacturing.
Second-Round Financing
Funds earmarked for working capital for a firm that is currently
selling its product but still losing money.
Third-Round Financing
Financing for a firm that is at least breaking even and
contemplating expansion; a.k.a. mezzanine financing.
Fourth-Round Financing
Financing for a firm that is likely to go public within six months;
a.k.a. bridge financing.
68

U.S. Venture Capital Investments

69

Initial Offering
Initial Public Offering (IPO) - First offering of
stock to the general public.
Underwriter - Firm that buys an issue of securities
from a company and resells it to the public.
Offering price The price of a share at IPO.
Spread - Difference between public offer price and
price paid by underwriter.
Prospectus - Formal summary that provides
information on an issue of securities.
70

The Top Managing Underwriters

71

The Public Issue in Canada

Regulation of the securities market in Canada is
carried out by provincial commissions.
In the U.S., regulation is handled by a federal body
(SEC).
The regulators goal is to promote the efficient flow
of information about securities and the smooth
functioning of securities markets.
All companies listed on the TSX come under the
jurisdiction of the Ontario Securities Commission
(OSC).
Other provinces have similar legislation and
regulating bodies.
The Canadian Securities Administration (CSA)
coordinates regulation.

72

New Issue Procedure

Steps involved in issuing securities to the public:
1. Management obtains approval from the board of
directors.
2. The firm prepares a preliminary prospectus to the OSC.
3. The OSC studies the preliminary prospectus and
notifies the company of any changes required.
4. Once the revised, final prospectus meets with the
OSCs approval, a price is determined and a fullfledged selling effort gets under way.
73

The Process of Raising Capital

Steps in Public Offering

Time

1. Pre-underwriting conferences
Several months
2. Registration statements
20-day waiting period
3. Pricing the issue
Usually on the 20th day
4. Public offering and sale
After the 20th day
5. Market stabilization
30 days after offering

74

 The overallotment option: known as the Green Shoe

provision gives members of the underwriting group the
option to purchase additional shares at the offering
price less fees and commissions. The option has a
short maturity and is limited to about 10% of original
number of shares issued.
Investment Dealers:
In 2003, RBC Dominion Securities was the leading
underwriter by revenue.

75

Underwriting Spreads US (2003)

76

Average Initial IPO Returns

77

Initial Offering US
Average Expenses on 1767 IPOs from 1990-1994
Value of Issues
Direct Avg First Day
Total
($mil)
Costs (%)
Return (%) Costs (%)
2 - 9.99

16.96

16.36

25. 16

10 - 19.99

11.63

9.65

18. 15

20 - 39.99

9.7

12.48

18. 18

40 - 59.99

8.72

13.65

17. 95

60 - 79.99

8.2

11.31

16. 35

80 - 99.99

7.91

8.91

14. 14

100 - 199.99

7.06

7.16

12. 78

200 - 499.99

6.53

5.70

11. 10

500 and up

5.72

7.53

10. 36

All Issues

11.00

12.05

18. 69
78

The Costs of Public Offerings

Costs of Going Public in Canada: 198497
Fees
6.00 %
Underpricing
7.88 %
TOTAL
13.88 %
The above figures understate the total
cost because they ignore indirect
expenses or the overallotment option.

79

From CNN.COM (Aug 18, 2004)

Google plans to price the shares in a rare
auction-style IPO. The deal promises to
put more shares in the hands of ordinary
investors rather than wealthy investment
banking clients. The auction is also widely
seen as a slap at Wall Street and the
clubby culture that contributed to
investigations into improper IPO trading
activities at the height of the dot-com
bubble.
80

General Cash Offers

Seasoned Offering - Sale of securities by a firm
that is already publicly traded.
General Cash Offer - Sale of securities open to all
investors by an already public company.
Shelf Registration - A procedure that allows firms
to file one registration statement for several
issues of the same security.
Private Placement - Sale of securities to a limited
number of investors without a public offering.
81

Private Placements
Avoid the costly procedures associated with the
registration requirements that are a part of public
issues.
The OSC and SEC restrict private placement
issues of no more than a couple of dozen
knowledgeable investors including institutions
such as insurance companies and pension
funds.
The biggest drawback is that the securities
cannot be easily resold.
82

Market Reaction to SEO

Suppose that the CFO of a restaurant chain is
strongly optimistic about its prospect. From her
point of view, the companys stock price is too
low. Yet the company wants to issue shares to
finance expansion into another county. What is
she to do?

83

The Announcement of New Equity and the

Value of the Firm
The market value of existing equity drops on the
announcement of a new issue of common stock.
Reasons include
Managerial Information
Since the managers are the insiders, perhaps they are
selling new stock because they think it is overpriced.
Debt Capacity
If the market infers that the managers are issuing new
equity to reduce their debt-to-equity ratio due to the
specter of financial distress the stock price will fall.
Falling Earnings
84

Rights
An issue of common stock offered to existing
shareholders is called a rights offering.
Prior to the 1980 Bank Act, chartered banks were
required to raise equity exclusively through rights
offerings.
If a preemptive right is contained in the firms articles
of incorporation, the firm must offer any new issue of
common stock first to existing shareholders.
This allows shareholders to maintain their percentage
ownership if they so desire.
85

Mechanics of Rights Offerings

The management of the firm must decide:
The exercise (subscription) price (the price
existing shareholders pay for new shares).
How many rights will be required to purchase
one new share of stock.

These rights have value:

Shareholders can either exercise their rights
or sell their rights.
86

Rights Offering Example

1.
2.
3.
4.
5.
6.

National Power has 1 million shares outstanding. Each

share sells for $20. The company wants to raise $5
million in new equity. Suppose the exercise
(subscription) price is set at $10 per share. Find
Market value of company after rights issue.
Number of new shares.
Number of rights needed to buy a share.
The value of the share after the rights offering.
The value of a right.
The cost of a new share to an outside investor.
87

Time Line

Ex Right Date

Right Issue Date

P=$20

P=$16.67

P=$16.67

P=$16.67

N=1m

N=1m

N=1m

N=1.5m

Rights
announcement

Right Expiration
Date

R=$3.33

88

Theoretical Value of a Right

The theoretical value of a right during the rights-on
period is:
R0 = (M0 S) / (N +1)
Where,
M0 = Common share price during the rights-on period
S = Subscription price
N = Number of rights required to buy one new share

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Value of a Right after Ex-Rights Date

When the stock goes ex-rights, its price
drops by the value of one right.
Me = M 0 R 0
Re = (Me S) / N
Where,
Me is the common share price during the
ex-rights period.
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Self Practice
Yoma Inc. is attempting to raise $5,000,000 in new
equity with a rights offering. The subscription price will be
$40 per share. The stock currently sells for $50 per
share and there are 250,000 shares outstanding.
a. How many new shares will Yoma issue?
b. How many rights will be required to buy one share?
c. At what price will the stock sell when it goes exrights if
the total value of all stock increases by the amount of the
new funds?
d. What is the theoretical value of 1 right?

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