Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy(^580) 16. Raising Capital © The McGraw−Hill
Companies, 2002
subsequently exercised by the purchasers. As is typical of rights offers, about 2 percent
of the rights were neither exercised nor sold, so some stockholders apparently did not
act to protect their interests. Only about 586,000 shares were initially unsold, and sub-
scribers sought more than five times that amount in oversubscription rights, so none of
the stock ultimately went unsold.
The underwriters, led by Salomon Brothers, earned substantial fees for their services.
For managing the offer and promising to buy unsold shares (of which there were none),
the basic compensation was 3 percent of the amount of the issue, or $82.8 million. Fur-
thermore, the underwriters were given the right to buy stock at a 3 percent discount on
the subscription price, or $77.60 per share. By purchasing rights in the open market, ex-
ercising the rights and buying the stock at a discount, and then reselling the stock, the
underwriters earned an additional profit of roughly $27.6 million. The total compensa-
tion was thus approximately $110 million, or about 4 percent of the issue proceeds. Be-
cause this was somewhat high for such a large deal, Time-Warner and its chairman,
Stephen Ross (no relation to the noted financial economist and textbook author of the
same name), were criticized by various groups.
Motion picture giant Metro-Goldwyn-Mayer (MGM) has been one of the more ac-
tive users of rights offerings in the United States. MGM completed rights offerings of
$200 million in 1988, another $100 million in 1992, and $700 million in October 1998.
In November 1999, MGM completed a $721 million rights offering resulting in the is-
suance of about 50 million new shares. Under the terms of the offer, each shareholder
received .328 transferable subscription rights for each common share; each right had an
exercise price of $14.50 per share. About 99.3 percent of MGM’s shareholders exercised
their rights, and the offer was oversubscribed by nearly 3.9 million shares.
Outside the United States, large rights offerings are not uncommon. For example, in
September 2000, Spanish Internet portal Terra Networks raised $2 billion in a rights of-
fer to help finance its planned merger with Lycos. In June 2001, British Telecommuni-
cations completed the largest rights offering ever when it raised $8.3 billion.
Effects on Shareholders
Shareholders can exercise their rights or sell them. In either case, the stockholder will
neither win nor lose because of the rights offering. The hypothetical holder of two
shares of National Power has a portfolio worth $40. If the shareholder exercises the
rights, they end up with three shares worth a total of $50. In other words, with an ex-
penditure of $10, the investor’s holding increases in value by $10, which means that the
shareholder is neither better nor worse off.
On the other hand, if the shareholder sells the two rights for $3.33 each, he or she
would obtain $3.33 2 $6.67 and end up with two shares worth $16.67 and the cash
from selling the right:
Shares held 2 $16.67$33.33
Rights sold 2 $3.33 6.67
Total $40.00
The new $33.33 market value plus $6.67 in cash is exactly the same as the original hold-
ing of $40. Thus, stockholders cannot lose or gain by exercising or selling rights.
It is obvious that after the rights offering, the new market price of the firm’s stock
will be lower than the price before the rights offering. As we have seen, however, stock-
holders have suffered no loss because of the rights offering. Thus, the stock price
552 PART SIX Cost of Capital and Long-Term Financial Policy