Does a rights offering cause share prices to decrease? How are existing shareholders affected by a rights offering?

The Rights Offerings Puzzle

In the United States, firms use general cash offers much more often than rights offerings. 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.

		Cash Offers
		Compensation	Other	Total Cost as
		as a	Expenses as	a Percentage
Size of Issue ($ in millions)		Percentage of Proceeds	a Percentage of Proceeds	of Proceeds
	Number
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
	Compensationas aPercentageof Proceeds	OtherPercentageof Proceeds
	Total Cost as		Total Cost as
	a Percentage		a Percentage
Number	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%

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 selling procedures. Overall, general cash offers had average flotation costs equal to 6.17 percent of 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 percent of the amount raised, representing a significant savings. Overall, Table 16.10 suggests that pure rights offerings have a pronounced cost advantage. 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:

1. Underwriters increase the stock price. This is supposedly accomplished because of the selling effort of the underwriting group.

2. 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.

3. 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 convincing. One study found that firms making underwritten rights offers suffered substantially 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 uncommon in the United States.

C O N C E P T Q U E S T I O N S

a How does a rights offering work?

b What are the questions that financial management must answer in a rights offering?

c How is the value of a right determined?

d When does a rights offering affect the value of a company’s shares?

e Does a rights offering cause share prices to decrease? How are existing shareholders affected by a rights offering?