An issue of new common stock offered to existing shareholders is called a rights offering. Corporations often offer new issues of common stock to existing shareholders before offering them to the general public in order to allow existing shareholders the opportunity to maintain their proportional ownership of the corporation. In fact, if a pre-emptive right is contained in the corporation’s articles of incorporation, the firm must offer any new shares to existing shareholders first.
In a rights offering, each shareholder receives one right for every share she owns. These rights are options that allow the shareholder to purchase new shares at a specified price and before an expiry date. In fact, rights, once granted in the form of a certificate, may be traded on a financial exchange.
Subscription Price: The amount that a holder of a right must pay to purchase each new share.
A corporation will decide how many new shares will be issued based on the following formula:
Often, it takes several rights to buy one new share. If it didn’t, every new issue of common stock would double the corporation’s shares.
Theoretical Value of a Right: The rights-on period is the period between when the new issue of shares is announced and up until the ex-rights date. The ex-rights date is the first day that shares trade ex-rights (without rights) and an investor who purchases a share ex-rights will not receive the right. According to stock exchange rules, the ex-rights date is typically four days before the date of record to allow the corporation time to compile an accurate list of holders-of-record.
We can find the value of a right during the rights-on period using the following formula:
R0 = The value of a right during the rights-on period
M0 = Common share price during the rights-on period
S = Subscription price
N = Number of rights required to buy one new share
When the stock is ex-rights, the rights can be exercised up until the expiry date. The value of a share should drop by the value of a right at the ex-rights date.
The value of a right during this period can therefore be calculated as:
RE = The value of a right during the ex-rights period
ME = Common share price during the ex-rights period