FIN208: Answers to Tutorial 3

Question 1:

Yes. The NPV is $1million. As long as the costs of financing (total expenses in issuing the rights) do not exceed
$1million, the project is desirable.

ii) and iii) The value of the firm increases by $1million on announcement of the project, so an individual share now
sells for $11million/500,000 = $22. At a "1-for-5" issue, we raise $2million with 100,000 shares; the subscription
price is $20.00.

The ex-rights price is (22 x 5 existing shares + 20 x 1 new shares) / 6 shares = $21.67.

Therefore value of rights to purchase 1 new share = Ex-right stock price – Subscription price = 21.67 - 20 = 1.67.
Since we need 5 rights to buy one new share, value per right=1.67/5 =$0.33.

At a "1-for-10" issue, we will raise $2million with 50,000 shares; the subscription price is therefore 2million/50,000
shares = $40.00 per share. No one will subscribe the new share in this case, since equity can be purchased in the
marketplace at $22/share.

iv) In this case, the rights offering may succeed if offered at "1-for-5", provided the share price does not drop below
$20. The offering is bound to fail at a "1-for-10" issue. Management should consider reducing the ratio to a "1-for-
4" or even "1-for-3" issue; the probability of failure drops as the ratio decreases.

Question 2:

i) Sub P = 80m/2.5m = 32
ii) NPV per share = $20million/10million = $2. Ex-right stock price = [4(36+2) + 1(32)]/5= 36.8
Value of each rights = (36.8 – 32) /4 = 1.20
iii) to ensure that the rights will be attractive to exercise- explain
not too critical for the pricing – need to ensure the subs price is set below current market price and in the
real world – the gap should be sufficient to take into account share price fluctuations over the period-
explain.

Question 3:

i) The maximum subscription price is the current stock price, or $34. The minimum price is anything greater
than $0.

ii) The number of new shares will be the amount raised divided by the subscription price, so:

Number of new shares = $40,000,000/$30 = 1,333,333 shares

And the number of rights needed to buy one new share will be the current shares outstanding
divided by the number of new share offered, so:

Number of rights needed = 3,400,000 shares outstanding/1,333,333 new shares = 2.55

iii) The investor will then have:

Ex-rights shares = 1 + 2.55

Ex-rights shares = 3.55

The ex-rights price per share is:

 PX = [2.55($34) + $30]/3.55 = $32.87

iv) The value of a right is:

Value of rights to buy a new share = Ex-right stock price – Subscription price = 32.87 – 30 = 2.87.
Thus, value of a right = 2.87/2.55 = 1.13

v) Before the offer, a shareholder will have the shares owned at the current market price, or:

Portfolio value = (1,000 shares)($34) = $34,000

After the rights offer, the share price will fall, but the shareholder will also hold the rights which
can be traded for $1.13 each, so:
Loss from 1000 existing shares = 1000 x (34-32.87) = 1130
Gain from selling the 1000 rights = 1000 x 1.13 = 1130
Overall effect: 0

Question 4:

Various theories/literature on underpricing:

- Winner’s Curse theory

- Signalling theory by Welch
- Substitution theory
- Investment banking conflicts with issuing firm and monopsony power of IB– example of LinkedIN’s IPO
in 2011 which was underpriced by more than 100% (IPO price=$45, first day closing=$94.25) – LinkedIn
executives were not happy about such a huge underpricing and blame the two underwriters, Morgan
Stanley and Merill Lynch for knowing such underpricing will take place but yet still go ahead with $45 per
share in order to benefit their clients: some ‘important’ institutional investors. These institutional investors
made tons of profits when they cash out some of their holding in the first day trading and it is the easiest
way to make money on Wall Street.
- Book building theory
- Bandwagon theory
- Underpricing to minimize the risk of undersubscription
 -

Question 5:

(a) Theoretical ex rights price

#shares = $120m/0.50 = 240m

Share price = earnings per share × price/earnings ratio= [$42m/(240m)] × 24 = $4.20

 Original shares 5 × $4.20 = 21.00

 Rights share 1 × ($4.20 × 0.6) = 2.52

 Total = 23.52

Ex-right stock price = $23.52/6 =3.92

(b) Value of rights

Ex-right stock price = 3.92
Cost of acquiring a rights share (subscription price) = 2.52
Value of 5 rights for 1 new share = 1.40
Value per right = 1.4/5 = 0.28

(c) Evaluation of options

Take up rights offer:
Gain from new shares = 200 new shares x (3.92 – 2.52) = 280
Loss from existing shares = 1000 existing shares x (4.20 – 3.92) = 280
Overall effect = neutral

Sell rights:
Gain from selling rights = 1000 rights x 0.28 = 280
Loss from existing shares = 1000 existing shares x (4.20 – 3.92) = 280
Overall effect = neutral

Allow rights offer to lapse:

Loss from existing shares = 1000 existing shares x (4.20 – 3.92) = 280

We can see that the wealth of the investor will be unaffected whether a decision is made to take
up the rights offer or to sell the rights. If, however, the investor allows the rights offer to lapse,
there will be a loss of wealth of $280.

(d)
Advantages of rights offering compared to public cash offering:

 Less costly (in the case of pure/standby rights issue), - standby underwriter will buy the unwanted stocks.
Rights could be under-subscribed due to the declining market price below the subscription price. In this
case, standby rights issue is better than the pure rights.
 Already existing market for the new shares,
 Underpricing is not a concern in right issue. The more the subscription price is underpriced, the higher will
be the value of the rights to the existing s/h, so they will not become worse off. But for the public cash
issues, the more serious the underpricing, the better it is for the NEW s/h at the expense of existing s/h.
 Current s/holders maintain control position (no dilution).

Disadvantages:

 Pure rights subject issuer to risks.

 It can be argued that the rights given to existing shareholders will prevent greater
competition for new shares in the business. This is because the offer is to a small section of the
potential market for the shares. This may, in turn, increase the costs of raising finance as other
forms of share issue (namely Public Cash Offer) could raise the necessary finance more cheaply because
there is opportunity to sell new shares at a higher price to some of the new shareholders who are willing to
pay for the shares.
 Not suitable if firm wants to broaden investor base. As mentioned above, broadening of investor base
could help to reduce the cost of issuing equity for the firm since some of the investors are willing to pay
higher price to purchase the issue. From k = (D1/P0) + g, if the P investors willing to pay is higher, k will be
lower.
 Public offering with underwriter helps in monitoring of the firm by the underwriter.

Question 6:

Some common reasons for IPO rejections by SC:

- Weak cash flow position

- Unsatisfactory profit track record
- Operating in highly competitive market without competitive advantage
- Corporate governance issue/ poor corporate governance

Question 7:

 Winner’s Curse Argument (Rock 1986)– firm (with intention) leaves money on the table. Reason is that
some or perhaps many uninformed investors may not want to take part in applying the IPO if the IPO is not
 intentionally underpriced due to the reason that they can’t differentiate whether the IPO is a good one or
not.

The reason they can’t differentiate is because they are not the insiders of the firm, they are the outsiders.
The buying of IPO could be a curse for the uninformed investor because he will ‘win’ all the IPO he applied
if the IPO is not a good one. But if the IPO is from a good prospect company, he will end up getting very few
IPO from the total he applied because most of the IPO will be applied and subscribed by the insiders before
it is open to the public! Insiders include the directors of board, the senior mgmt, and other parties who have
close relationship with the firm such as the suppliers, the close friends of the CEO...

 Asymmetric Information theory of underpricing (Welch 1989)- If the issuer is more informed than investors,
rational investors fear a lemons problem: only issuers with worse-than-average quality are willing to sell
their shares at the average price. To distinguish themselves from the pool of low-quality issuers, high-
quality issuers may attempt signal their quality. In these models, better quality issuers deliberately sell their
shares at a lower price than the market believes they are worth, which deters lower quality issuers from
imitating.

 Underpricing as Substitute for Costly Marketing Expenditures - Habib and Ljungqvist (2001) also argue
that underpricing is a substitute for costly marketing expenditures. Using a dataset of IPOs from 1991-1995,
they report that an extra dollar left on the table reduces other marketing expenditures by a dollar. As with
almost all other theories of underpricing, however, these tradeoff theories do not plausibly explain the
severe underpricing of IPOs during the internet bubble. During the bubble, the IPOs of many internet firms
were the easiest shares ever to sell because of the intense interest by many investors. It is difficult to believe
that an underwriter could not have easily placed shares with half the underpricing that was observed.

 ‘Bookbuilding’ argument (examples, Benveniste and Spindt 1989, Spatt and Srivastava 1991 ) – The
allocation of shares by underwriters - As a reward to the informed institutional investors for the information
provided by them to the underwriters and the issuing firm.

 Agency /conflict of interest between the underwriters and issuing firm (example: Loughran and Ritter 2002).
– For instance, underwriters have the tendency to underprice more in order to become popular among
investors. Especially if underwriters are given sole discretion in share allocations, the discretion will not
automatically be used in the best interests of the issuing firm. Underwriters might intentionally leave more
money on the table then necessary and then allocate these shares to favoured buy-side clients in return for
quid pro quos.

 Monopsony Power Hypothesis - To increase popularity among investors- Conflict of Interest argument. IB
has the tendency to underprice more compared to the issuing firm especially IB has the ‘monopsony’ power
in IPO issue. IB has superior knowledge of market condition of IPO.

 The Bandwagon Hypothesis –IPO is underpriced in order to induce the first few investors to buy so that it
will attract other investors to buy and create the bandwagon effect (will jump into the bandwagon- not to be
left out) to purchase the IPO.

 To reduce risk of under-subscription – especially for smaller firms

 Underpricing is positively related to the degree of asymmetric information. Emerging markets are not as
informationally efficient as the developed markets, underpricing may therefore become more serious.