Roal Shoe Co. has concluded that additional equity financing will be needed to expand operations and that the needed funds will be best obtained through a rights offering. Presently there are…

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a) Advantages of Rights Offering

Rights offerings are a preferred method of raising equity capital for several reasons:

1. Cost-Effective for Existing Shareholders

   • Existing shareholders can subscribe to new shares at a discounted price (Rs. 700 vs. Rs. 760), preserving their ownership proportion.
   • Avoids underwriting fees (typically 5–10% in public offerings).

2. Maintains Shareholder Control

   • Existing shareholders retain voting rights and control over the company’s governance.
   • Dilution is limited to existing shareholders, not outsiders.

3. Preserves Market Value

   • Rights offerings do not trigger a market value dilution as severely as public offerings, as the subscription price is set below the current market price.

4. Avoids Underpricing Risks

   • Unlike IPOs, rights offerings eliminate the risk of underpricing (issuing shares below fair value) because the offer price is based on the existing stock’s valuation.

5. Tax Efficiency

   • In many jurisdictions (including Nepal), rights offerings are tax-advantaged for shareholders, as gains are deferred until the rights are exercised or sold.

6. Flexibility in Subscription

   • Shareholders can choose to subscribe, sell rights, or ignore them, providing liquidity options.

7. Signal of Confidence

   • A rights offering signals management confidence in the company’s future prospects, unlike a public offering which may indicate desperation for capital.

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b) Number of Rights Associated with One New Share

The rights ratio is calculated as: $$\text{Rights per new share}=\frac{\text{Existing shares outstanding}}{\text{New shares offered}}=\frac{350,000}{70,000}=5$$ Answer: 5 rights are associated with 1 new share.

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c) Theoretical Value of a Right

The theoretical ex-right price (Pₑ) is calculated using the gross proceeds method: $$P_e=\frac{(\text{Market price}\times \text{Existing shares})+(\text{Offer price}\times \text{New shares})}{\text{Total shares post-offering}}$$ $$P_e=\frac{(760\times 350,000)+(700\times 70,000)}{420,000}=\frac{266,000,000+49,000,000}{420,000}=\frac{315,000,000}{420,000}=\text{Rs. }750$$

The value of one right (Vᵣ) is then: $$V_r=\text{Market price}-P_e=760-750=\text{Rs. }10$$ Answer: The theoretical value of one right is Rs. 10.

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d) Ex-Rights Price of Stock

From the calculation above, the ex-rights price (Pₑ) is: $$P_e=\text{Rs. }750$$ Answer: The ex-rights price is Rs. 750.

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e) Wealth Position Before and After the Rights Offering

Given:

• Current holdings: 500 shares of Roal Shoe Co. (at Rs. 760 each) + Rs. 50,000 cash.
• Actions:
  • Sell 200 rights (at Rs. 10 each).
  • Exercise 300 rights (to buy new shares at Rs. 700 each).

Step 1: Calculate Initial Wealth (Before Rights Offering)

$${\text{Wealth}}_{\text{initial}}=(500\times 760)+50,000=\text{Rs. }380,000+\text{Rs. }50,000=\text{Rs. }430,000$$

Step 2: Determine Rights Entitlement

For 500 existing shares, the number of rights received: $$\text{Rights}=500\times 5=2,500\text{ rights}$$

Step 3: Sell 200 Rights

$$\text{Cash from selling rights}=200\times 10=\text{Rs. }2,000$$ Remaining rights after sale: $2,500-200=2,300$ rights.

Step 4: Exercise 300 Rights

Each right allows buying 1/5th of a new share (since 5 rights = 1 new share). $$\text{New shares bought}=\frac{300}{5}=60\text{ shares}$$ $$\text{Cost to exercise}=60\times 700=\text{Rs. }42,000$$ Cash after exercise: $50,000+2,000-42,000=\text{Rs. }10,000$

Step 5: Post-Offering Share Count

• Existing shares: 500 (unchanged, as rights are attached to them).
• New shares acquired: 60.
• Total shares post-offering: $500+60=560$ shares.

Step 6: Ex-Rights Market Price

The stock trades at Rs. 750 after the rights offering.

Step 7: Final Wealth Calculation

$${\text{Wealth}}_{\text{final}}=(\text{Total shares}\times \text{Ex-rights price})+\text{Cash}$$ $${\text{Wealth}}_{\text{final}}=(560\times 750)+10,000=\text{Rs. }420,000+\text{Rs. }10,000=\text{Rs. }430,000$$

Comparison:

Observation: The investor’s wealth remains unchanged (Rs. 430,000) because:

• The discount on new shares (Rs. 700) offsets the ex-rights price drop (Rs. 750).
• Selling unused rights generates cash, but the net position is neutral if all rights are optimally utilized.

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Key Takeaways for TU Examiners:

1. Rights offerings are zero-NPV transactions for shareholders if they act rationally (sell unused rights).
2. The ex-rights price is derived from the weighted average of old and new shares.
3. Wealth neutrality holds if investors sell or exercise rights optimally (no arbitrage opportunity).
4. Numerical precision is critical—always verify calculations using both gross proceeds and net proceeds methods for consistency.