Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

16. Raising Capital © The McGraw−Hill^575
    Companies, 2002

To execute a rights offering, the financial management of National Power will have
to answer the following questions:

1. What should the price per share be for the new stock?


2. How many shares will have to be sold?


3. How many shares will each shareholder be allowed to buy?

Also, management will probably want to ask:

4. What is likely to be the effect of the rights offering on the per-share value of the
   existing stock?

It turns out that the answers to these questions are highly interrelated. We will get to
them in just a moment.
The early stages of a rights offering are the same as those for the general cash offer.
The difference between a rights offering and a general cash offer lies in how the shares
are sold. In a rights offer, National Power’s existing shareholders are informed that they
own one right for each share of stock they own. National Power will then specify how
many rights a shareholder needs to buy one additional share at a specified price.
To take advantage of the rights offering, shareholders have to exercise the rights by
filling out a subscription form and sending it, along with payment, to the firm’s sub-
scription agent (the subscription agent is usually a bank). Shareholders of National
Power will actually have several choices: (1) exercise their rights and subscribe for
some or all of the entitled shares, (2) order some or all of the rights sold, or (3) do noth-
ing and let the rights expire. As we will discuss, this third course of action is inadvisable.

Number of Rights Needed to Purchase a Share

National Power wants to raise $5 million in new equity. Suppose the subscription price
is set at $10 per share. How National Power arrives at that price is something we will
discuss later, but notice that the subscription price is substantially less than the current
$20 per share market price.

CHAPTER 16 Raising Capital 547

TABLE 16.7

National Power

Company Financial

Statements Before

Rights Offering

NATIONAL POWER COMPANY

Balance Sheet

Assets Shareholders’ Equity

Assets $15,000,000 Common stock $ 5,000,000

Retained earnings 10,000,000

Total $15,000,000 Total $15,000,000

Income Statement

Earnings before taxes $ 3,030,303

Taxes (34%) 1,030,303

Net income $ 2,000,000

Shares outstanding 1,000,000

Earnings per share $ 2

Market price per share $ 20

Total market value $20,000,000