Image Storage Corporation has 1,000,000 shares outstanding. It wishes to issue 5
ID: 2613083 • Letter: I
Question
Image Storage Corporation has 1,000,000 shares outstanding. It wishes to issue 500,000 new shares using a (North American) rights issue. If the current stock price is $50 and the subscription price is $47/share, the value of a right is calulated explain and interpret the results in a one page memo to management. The newly issued shares which are offered to the existing shareholders are known as right shares.
Suppose the rights required to buy one share is (1,000,000 / 500,000 =) 2.
The value of right during the cum-rights period = (Stock price – Subscription price) / (Rights required + 1)
= ($50 - $47) / (2 + 1)
= $1
The value of right during the ex-rights period = (Stock price – Subscription price) / (Rights required)
= ($50 - $47) / 2
= $1.50
Explanation / Answer
Shares that are trading cum-rights can be sold to another individual with the rights attached. This is the opposite of ex-rights, which do not allow the transfer of rights from an old shareholder to a new shareholder during the two business days prior to the record date.
The difference between the stock price and subscription price divided by the number of rights needed to subscribe to each stock gives us the value of each right. Ideally the price of the stock drops when it goes ex rights causing the value of rights in ex rights period to be less than than in cum period. This makes economic sense as post ex - rights the rights are not excercisable.