10.7.1 Rights

Understanding Rights

A right is a privilege granted to an existing shareholder to acquire additional shares directly from the issuing company at no additional cost. Rights enable companies to raise capital by issuing additional common shares to their shareholders.

Mechanics of Rights Offers

When a company decides to raise capital through rights offers, shareholders receive rights that allow them to purchase additional shares in direct proportion to the number of shares they already hold. For instance, companies may issue one right per existing share, allowing shareholders to buy one additional share for every ten shares they hold. This would result in a 10% increase in outstanding shares.

The exercise price, also called the subscription or offering price, is the price shareholders pay to purchase additional shares. This price is often lower than the current market price, providing shareholders with an incentive to exercise their rights.

Key Terminology:

• Rights: Privilege for shareholders to purchase additional shares.
• Subscription Price: Price paid by shareholders for additional shares, usually lower than the market price.

Rights Offering Process

Key Dates:

• Record Date: The cut-off date to determine eligible shareholders who can receive the rights.
• Ex-Rights Date: The date on which shares trade without the rights attached, meaning new buyers are not entitled to the rights.
• Cum Rights trading: Period when shares are traded with the rights attached.

Example: ABC Co. Rights Offering

• Record Date: June 10
• Ex-Rights Date: June 9
• Number of Rights Required: 5 rights for 1 new share
• Subscription Price: $23
• Expiration Date: July 6

Actions by Rights Holders

Rights holders have several options:

1. Exercise Rights: Purchase additional shares.
2. Sell Rights: Trade rights on the stock exchange.
3. Buy Additional Rights: Acquire more rights for trading or exercising later.
4. Let Rights Expire: Not recommended, as it provides no benefit.

Intrinsic Value of Rights

Similar to options, rights have intrinsic value, especially when the subscription price is lower than the current market price. The intrinsic value will vary based on whether it’s the ex-rights or cum-rights period.

Intrinsic Value During Ex-Rights Period

In the ex-rights period, rights trade separately. The intrinsic value is calculated as follows:

$$ \text{Intrinsic Value of Rights} = \frac{S - X}{n} $$

Where:

• \(S\) = Market price of the stock
• \(X\) = Subscription price
• \(n\) = Number of rights needed to buy one share

Example Calculation:

For ABC Co., if:

• \(S\) = $25
• \(X\) = $23
• \(n\) = 5

The intrinsic value is calculated as:

$$ \text{Intrinsic Value of Rights} = \frac{25 - 23}{5} = \frac{2}{5} = 0.40 $$

Intrinsic Value During Cum-Rights Period

During the cum rights period, when rights are embedded in the stock price, the calculation is as follows:

$$ \begin{align*} \text{Intrinsic Value of Rights} &= \frac{S - X}{n + 1} \end{align*} $$

Example Calculation:

For ABC Co., if:

• \(S\) = $25.60
• \(X\) = $23
• \(n\) = 5

The intrinsic value would be:

$$ \text{Intrinsic Value of Rights} = \frac{25.60 - 23}{6} = \frac{2.60}{6} = 0.43 $$

Trading Rights

When a company’s shares are listed on a stock exchange, the rights automatically get listed as well. Trading continues until the rights expire, and settlements follow standard exchange procedures, with adjustments as the expiry date approaches.

Key Takeaways:

• Rights provide shareholders the ability to buy additional shares at a discount
• Rights can be traded on stock exchanges
• Intrinsic value calculations differ based on cum-rights and ex-rights periods
• Timely action is essential to avoid letting rights expire worthless

Glossary and Definitions

• Rights: Privileges allowing shareholders to purchase additional shares.
• Subscription Price: The price at which additional shares can be purchased during a rights offering.
• Intrinsic Value: The value rights have based on the difference between the market price and the subscription price.
• Record Date: The date to determine eligible shareholders for rights distribution.
• Ex-Rights Date: The first date shares trade without entitling the buyer to newly issued rights.
• Cum-Rights Period: The period in which the right is embedded in the common stock price and has not yet started trading separately.

FAQs

Q: What happens if I don’t exercise my rights?

A: If you do not exercise or sell your rights, they will expire worthless, and you will not benefit from the discount.

Q: Can rights be traded?

A: Yes, rights can usually be traded on the same exchange that lists the underlying stock.

Q: How is the intrinsic value of rights calculated?

A: The intrinsic value calculation changes based on whether the rights are in the ex-rights period or the cum-rights period. Refer to the formulas provided.

Q: Do I have to pay a commission to exercise my rights?

A: No commission is typically charged when exercising rights to acquire shares.

By understanding the mechanics, rights holders can make informed decisions about whether to exercise, sell, buy, or let their rights expire.