Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy- Raising Capital © The McGraw−Hill^581
Companies, 2002
decline is very much like that in a stock split, a device that is described in Chapter 18.
The lower the subscription price, the greater is the price decline resulting from a rights
offering. It is important to emphasize that because shareholders receive rights equal in
value to the price drop, the rights offering does nothurt stockholders.
There is one last issue. How do we set the subscription price in a rights offering? If
you think about it, you will see that the subscription price really does not matter. It has
to be below the market price of the stock in order for the rights to have value, but, be-
yond this, the price is arbitrary. In principle, it could be as low as we cared to make it as
long as it was not zero. In other words, it is impossible to underprice a rights offer.
The Rights Offerings Puzzle
In the United States, firms use general cash offers much more often than rights offer-
ings. In Table 16.10, of the 578 total issues represented, about 94 (or 16 percent) were
rights offers. This reliance on general cash offers in the United States is something of a
mystery because rights offerings are usually much cheaper in terms of flotation costs.
CHAPTER 16 Raising Capital 553TABLE 16.10
Costs of Flotation as a
Percentage of ProceedsCash Offers
Compensation Other
as a Expenses as Total Cost as
Size of Issue Percentage a Percentage a Percentage
($ in millions) Number of Proceeds of Proceeds of Proceeds
Under 0.50 0 — — —
.50– 0.99 6 6.96% 6.78% 13.74%
1.00– 1.99 18 10.40 4.89 15.29
2.00– 4.99 61 6.59 2.87 9.47
5.00– 9.99 66 5.50 1.53 7.03
10.00– 19.99 91 4.84 .71 5.55
20.00– 49.99 156 4.30 .37 4.67
50.00– 99.99 70 3.97 .21 4.18
100.00–500.00 16 3.81 .14 3.95
Total/average 484 5.02% 1.15% 6.17%
Rights with Standby Underwriting Pure Rights
Compensation Other
as a Expenses as Total Cost as Total Cost as
Percentage a Percentage a Percentage a Percentage
Number of Proceeds of Proceeds of Proceeds Number of Proceeds
0 — — — 3 8.99%
2 3.43% 4.80% 8.24% 2 4.59
5 6.36 4.15 10.51% 5 4.90
9 5.20 2.85 8.06 7 2.85
4 3.92 2.18 6.10 6 1.39
10 4.14 1.21 5.35 3 .72
12 3.84 .90 4.74 1 .52
9 3.96 .74 4.70 2 .21
5 3.50 .50 4.00 9 .13
56 4.32% 1.73% 6.05% 38 2.45%
Source: C. W. Smith Jr., “Costs of Underwritten versus Rights Issues,” Journal of Financial Economics 5
(December 1977).