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10.7.1 Rights

A comprehensive guide on rights offers, intrinsic value of rights during ex-rights and cum-rights periods, and how rights are traded on stock exchanges.

Understanding Rights

A right is a privilege granted to an existing shareholder to acquire additional shares directly from the issuing company at no additional cost. Rights enable companies to raise capital by issuing additional common shares to their shareholders.

Mechanics of Rights Offers

When a company decides to raise capital through rights offers, shareholders receive rights that allow them to purchase additional shares in direct proportion to the number of shares they already hold. For instance, companies may issue one right per existing share, allowing shareholders to buy one additional share for every ten shares they hold. This would result in a 10% increase in outstanding shares.

The exercise price, also called the subscription or offering price, is the price shareholders pay to purchase additional shares. This price is often lower than the current market price, providing shareholders with an incentive to exercise their rights.

Key Terminology:

  • Rights: Privilege for shareholders to purchase additional shares.
  • Subscription Price: Price paid by shareholders for additional shares, usually lower than the market price.

Rights Offering Process

Key Dates:

  • Record Date: The cut-off date to determine eligible shareholders who can receive the rights.
  • Ex-Rights Date: The date on which shares trade without the rights attached, meaning new buyers are not entitled to the rights.
  • Cum Rights trading: Period when shares are traded with the rights attached.

Example: ABC Co. Rights Offering

  • Record Date: June 10
  • Ex-Rights Date: June 9
  • Number of Rights Required: 5 rights for 1 new share
  • Subscription Price: $23
  • Expiration Date: July 6

Actions by Rights Holders

Rights holders have several options:

  1. Exercise Rights: Purchase additional shares.
  2. Sell Rights: Trade rights on the stock exchange.
  3. Buy Additional Rights: Acquire more rights for trading or exercising later.
  4. Let Rights Expire: Not recommended, as it provides no benefit.

Intrinsic Value of Rights

Similar to options, rights have intrinsic value, especially when the subscription price is lower than the current market price. The intrinsic value will vary based on whether it’s the ex-rights or cum-rights period.

Intrinsic Value During Ex-Rights Period

In the ex-rights period, rights trade separately. The intrinsic value is calculated as follows:

$$ \text{Intrinsic Value of Rights} = \frac{S - X}{n} $$

Where:

  • \(S\) = Market price of the stock
  • \(X\) = Subscription price
  • \(n\) = Number of rights needed to buy one share

Example Calculation:

For ABC Co., if:

  • \(S\) = $25
  • \(X\) = $23
  • \(n\) = 5

The intrinsic value is calculated as:

$$ \text{Intrinsic Value of Rights} = \frac{25 - 23}{5} = \frac{2}{5} = 0.40 $$

Intrinsic Value During Cum-Rights Period

During the cum rights period, when rights are embedded in the stock price, the calculation is as follows:

$$ \begin{align*} \text{Intrinsic Value of Rights} &= \frac{S - X}{n + 1} \end{align*} $$

Example Calculation:

For ABC Co., if:

  • \(S\) = $25.60
  • \(X\) = $23
  • \(n\) = 5

The intrinsic value would be:

$$ \text{Intrinsic Value of Rights} = \frac{25.60 - 23}{6} = \frac{2.60}{6} = 0.43 $$

Trading Rights

When a company’s shares are listed on a stock exchange, the rights automatically get listed as well. Trading continues until the rights expire, and settlements follow standard exchange procedures, with adjustments as the expiry date approaches.

Key Takeaways:

  • Rights provide shareholders the ability to buy additional shares at a discount
  • Rights can be traded on stock exchanges
  • Intrinsic value calculations differ based on cum-rights and ex-rights periods
  • Timely action is essential to avoid letting rights expire worthless

Glossary and Definitions

  • Rights: Privileges allowing shareholders to purchase additional shares.
  • Subscription Price: The price at which additional shares can be purchased during a rights offering.
  • Intrinsic Value: The value rights have based on the difference between the market price and the subscription price.
  • Record Date: The date to determine eligible shareholders for rights distribution.
  • Ex-Rights Date: The first date shares trade without entitling the buyer to newly issued rights.
  • Cum-Rights Period: The period in which the right is embedded in the common stock price and has not yet started trading separately.

FAQs

Q: What happens if I don’t exercise my rights?

A: If you do not exercise or sell your rights, they will expire worthless, and you will not benefit from the discount.

Q: Can rights be traded?

A: Yes, rights can usually be traded on the same exchange that lists the underlying stock.

Q: How is the intrinsic value of rights calculated?

A: The intrinsic value calculation changes based on whether the rights are in the ex-rights period or the cum-rights period. Refer to the formulas provided.

Q: Do I have to pay a commission to exercise my rights?

A: No commission is typically charged when exercising rights to acquire shares.

By understanding the mechanics, rights holders can make informed decisions about whether to exercise, sell, buy, or let their rights expire.


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## What is a right in the context of finance? - [ ] A dividend paid to shareholders - [ ] A voting privilege at shareholder meetings - [x] A privilege granted to an existing shareholder to acquire additional shares directly from the issuing company - [ ] A federally mandated shareholder benefit > **Explanation:** A right in finance is a privilege given to existing shareholders to acquire additional shares directly from the issuing company at a specified price. ## How is the exercise price of a right typically compared to the market price of the shares when rights are issued? - [ ] Higher than the market price - [x] Lower than the market price - [ ] Equal to the market price - [ ] Irrelevant to market price > **Explanation:** The exercise price of a right, also known as the subscription price, is almost always lower than the market price of the shares at the time that the rights are issued. ## What is the term used for the price shareholders pay to purchase additional shares during a rights offering? - [x] Subscription price - [ ] Purchase price - [ ] Market price - [ ] Offer price > **Explanation:** The subscription price, or offering price, is the price shareholders pay to purchase additional shares of the company. ## What happens to the trading status of shares on the business day before the record date for rights? - [x] They trade ex-rights - [ ] They trade cum-rights - [ ] They cease trading - [ ] They are split > **Explanation:** On the day before the record date, shares trade ex-rights, meaning buyers of shares on or after this date are not entitled to receive the rights. ## What does 'cum rights' mean? - [ ] Rights have expired - [x] Stock buyers are entitled to receive rights if they hold until the record date - [ ] Rights are trading as a separate entity - [ ] Rights are not issued > **Explanation:** 'Cum rights' means that stock buyers are entitled to receive rights if they own the stock until at least the record date. ## Which of the following actions can a rights holder take? - [x] Exercise some or all of the rights and acquire the shares - [x] Sell some or all of the rights - [x] Buy additional rights to trade or exercise later - [x] Do nothing and let the rights expire worthless > **Explanation:** A rights holder can exercise the rights, sell them, buy additional rights or do nothing and let them expire. ## How is the intrinsic value of a right during the ex-rights period calculated? - [ ] (S + X) / n - [ ] (X - S) / n - [x] (S - X) / n - [ ] (S - X) * n > **Explanation:** The intrinsic value of a right during the ex-rights period is calculated using the formula (S - X) / n, where S is the market price of the stock, X is the exercise price, and n is the number of rights needed to buy one share. ## What happens to the intrinsic value of rights if the market price of the stock stays above the subscription price after rights are issued? - [ ] Rights have no intrinsic value - [x] Rights maintain intrinsic value - [ ] Rights must be sold - [ ] Rights are automatically exercised > **Explanation:** If the market price of the stock stays above the subscription price, the rights maintain their intrinsic value. ## When must a rights transaction be settled in Canada? - [ ] By the close of the same business day - [ ] By the next business day - [x] By the second business day after the transaction - [ ] By the end of the week > **Explanation:** Canadian trading practice requires that a rights transaction be settled by the second business day after the transaction takes place. ## Which exchange is mentioned as automatically listing trading rights for the common shares of the issuing company? - [ ] New York Stock Exchange (NYSE) - [ ] NASDAQ - [x] Toronto Stock Exchange (TSX) - [ ] London Stock Exchange (LSE) > **Explanation:** The Toronto Stock Exchange (TSX) is mentioned as automatically listing trading rights for the common shares of the issuing company.

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Tuesday, July 23, 2024