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^579
    Companies, 2002

The Underwriting Arrangements

Rights offerings are typically arranged using standby underwriting. In standby under-
writing, the issuer makes a rights offering, and the underwriter makes a firm commit-
ment to “take up” (that is, purchase) the unsubscribed portion of the issue. The
underwriter usually gets a standby feeand additional amounts based on the securities
taken up.
Standby underwriting protects the firm against undersubscription, which can occur if
investors throw away rights or if bad news causes the market price of the stock to fall
below the subscription price.
In practice, only a small percentage (less than 10 percent) of shareholders fail to ex-
ercise valuable rights. This failure can probably be attributed to ignorance or vacations.
Furthermore, shareholders are usually given an oversubscription privilege, which en-
ables them to purchase unsubscribed shares at the subscription price. The oversubscrip-
tion privilege makes it unlikely that the corporate issuer would have to turn to its
underwriter for help.

Rights Offers: The Case of Time-Warner

Rights offers have become less and less common in the United States. However, as me-
dia giant Time-Warner’s 1991 $2.76 billion offer indicates, they are far from dead. The
Time-Warner offer was the largest equity sale of any type in U.S. history, and it was the
largest rights offer since AT&T’s $1.4 billion issue in the 1970s. The offer was contro-
versial when it was originally proposed because the subscription price varied depending
on what percentage of the issue actually sold. This feature was later dropped, and the
stock was sold using a straight rights offer.
In the Time-Warner deal, the stock was trading in the $90 range just before the offer
became effective, and each right entitled the holder to purchase .6 new shares. The sub-
scription price was $80 per share, so 34.5 million shares were sold. Approximately 56
percent of the stockholders in Time-Warner exercised their options directly and pur-
chased stock. Another 42 percent sold their rights on the open market; these rights were

CHAPTER 16 Raising Capital 551

FIGURE 16.4

Ex-Rights Stock Prices

Rights on Ex rights

Announcement

date

Ex-rights

date

Record

date

September 30 October 13 October 15

Rights-on price $20.00

Ex-rights price $16.67

$3.33 = Value of a right

In a rights offering, there is a date of record, which is the last day that a

shareholder can establish legal ownership. However, stocks are sold ex rights

two business days before the record date. Before the ex-rights date, the

stock sells rights on, which means that the purchaser receives the rights.

standby underwriting

The type of underwriting

in which the underwriter

agrees to purchase the

unsubscribed portion of

the issue.

standby fee

An amount paid to an

underwriter participating

in a standby

underwriting agreement.

oversubscription

privilege

A privilege that allows

shareholders to

purchase unsubscribed

shares in a rights offering

at the subscription price.