Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy(^582) 16. Raising Capital © The McGraw−Hill
Companies, 2002
To give an idea of the relative flotation costs, Table 16.10 shows these costs from one
study expressed as a percentage of the amount raised for different issue sizes and sell-
ing procedures. Overall, general cash offers had average flotation costs equal to 6.17
percentof the amount raised. For rights offerings with standby underwriting, total costs
were 6.05 percent. For pure rights offerings (those involving no underwriter), these
costs were only 2.45 percentof the amount raised, representing a significant savings.
Overall, Table 16.10 suggests that pure rights offerings have a pronounced cost ad-
vantage. Furthermore, rights offerings protect the proportionate interest of existing
shareholders. No one knows why rights offerings are not used more often, and it is an
intriguing anomaly.
Various arguments in favor of general cash offers with underwriting have been put
forth:
- Underwriters increase the stock price. This is supposedly accomplished because of
the selling effort of the underwriting group. - Underwriters provide insurance against a failed offering. This is true. If the market
price goes below the offer price, the firm does not lose, because the underwriter has
bought the shares at an agreed-upon price. However, this insurance cannot be worth
much, because the offer price is not set (in most cases) until within 24 hours of the
offering, when the final arrangements are made and underwriters have made a
careful assessment of the market for the shares. - Other arguments include the following: (a) the proceeds of underwritten issues are
available sooner than those of a rights offer, (b) underwriters provide a wider
distribution of ownership than would be possible with a rights offering, and
(c) consulting advice from investment bankers may be beneficial.
All of the preceding arguments are pieces of the puzzle, but none seems very con-
vincing. One study found that firms making underwritten rights offers suffered substan-
tially larger price drops than did firms making underwritten cash offers.^9 This is a
hidden cost, and it may be part of the reason that underwritten rights offers are uncom-
mon in the United States.
DILUTION
A subject that comes up quite a bit in discussions involving the selling of securities is
dilution. Dilution refers to a loss in existing shareholders’ value. There are several kinds:CONCEPT QUESTIONS
16.8a How does a rights offering work?
16.8bWhat are the questions that financial management must answer in a rights
offering?
16.8c How is the value of a right determined?
16.8dWhen does a rights offering affect the value of a company’s shares?
16.8eDoes a rights offering cause share prices to decrease? How are existing share-
holders affected by a rights offering?554 PART SIX Cost of Capital and Long-Term Financial Policy
(^9) Robert S. Hansen, “The Demise of the Rights Issue,” Review of Financial Studies1 (Fall 1988), pp. 289–309.
16.9
dilution
Loss in existing
shareholders’ value, in
terms of either
ownership, market value,
book value, or EPS.