Chapter 13 Corporate Financing and Market Efficiency

1
Chapter 13 Corporate Financing and Market
Efficiency

1. Can Financing Decisions Create Value?
2. A Description of Efficient Capital Markets
3. The Different Types of Efficiency
4. The Evidence
5. Implications for Corporate Finance

2
Can Financing Decisions Create Value?

• Example Suppose Jays Electronics is thinking
  about relocating its plant to Mexico where labor
  costs are lower. In the hope that it can stay in
  Ontario, the company has submitted an application
  to the province to guarantee a five-year bank
  term loan for 2 million. With a provincial
  guarantee, a chartered bank has offered to make
  the loan (interest payments are paid at the end
  of each year) at an interest rate of 5 percent.
  This is an attractive rate because the normal
  cost of debt capital for Jays Electronics is 10.
  What it the NPV of this potential financing
  transaction?

3
What Sort of Financing Decisions?

• Typical financing decisions include
• How much debt and equity to sell
• When (or if) to pay dividends
• When to sell debt and equity
• Just as we can use NPV criteria to evaluate
  investment decisions, we can use NPV to evaluate
  financing decisions.

4
How to Create Value through Financing

• Fool Investors
• Empirical evidence suggests that it is hard to
  fool investors consistently.
• Reduce Costs or Increase Subsidies
• Certain forms of financing have tax advantages or
  carry other subsidies.
• Create a New Security
• Sometimes a firm can find a previously-unsatisfied
  clientele and issue new securities at favorable
  prices.
• In the long-run, this value creation is
  relatively small, however.

5
A Description of Efficient Capital Markets

• An efficient capital market is one in which stock
  prices fully reflect available information.
• The EMH has implications for investors and firms.
• Since information is reflected in security prices
  quickly, knowing information when it is released
  does an investor no good.
• Firms should expect to receive the fair value for
  securities that they sell. Firms cannot profit
  from fooling investors in an efficient market.

6
Ex How Does an Efficient Market Work?

• Suppose the F-stop Camera Corporation (FCC) is
  attempting to develop a camera that will double
  the speed of the auto-focusing system now
  available. FCC believes this research has a
  positive NPV.
• Consider the share of FCC. One of the determinant
  of the shares price is the probability that FCC
  will be the company to develop the new
  auto-focusing system first. In an efficient
  market we would expect the price of the shares of
  FCC to rise if this probability increases.
• Now, suppose a well-known engineer is hired by
  FCC to help develop the new auto-focusing system.
  Assuming an efficient market, what do you think
  will happen to FCCs share price when this is
  announced?

7
The Different Types of Efficiency

• Weak Form
• Security prices reflect all information found in
  past prices and volume.
• Semi-Strong Form
• Security prices reflect all publicly available
  information.
• Strong Form
• Security prices reflect all informationpublic
  and private.

8
Weak Form Market Efficiency

• Security prices reflect all information found in
  past prices and volume.
• Often weak-form efficiency is represented as
• Pt Pt-1 Expected return random error t
• Since stock prices only respond to new
  information, which by definition arrives
  randomly, stock prices are said to follow a
  random walk.

9
Testing Random Walk Theory

• The movement of stock prices from day to day DO
  NOT reflect any pattern.
• Statistically speaking, the movement of stock
  prices is random (skewed positive over the long
  term).

10
Random Walk Theory
Coin Toss Game
Heads
106.09
Heads
103.00
100.43
Tails
100.00
Heads
100.43
97.50
Tails
95.06
Tails
11
Random Walk Theory
12
Random Walk Theory
13
Random Walk Theory
14
Random Walk Theory
SP Composite (correlation -.07)
Return in week t 1, ()
Return in week t, ()
15
Efficient Market Theory
Microsoft Stock Price
90 70 50
Actual price as soon as upswing is recognized
Cycles disappear once identified
Last Month
This Month
Next Month
16
Why Technical Analysis Fails
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Stock Price
If it were possible to make big money simply by
finding the pattern in the stock price
movements, everyone would do it and the profits
would be competed away.
Time
17
Semi-Strong Form Market Efficiency

• Security prices reflect all publicly available
  information.
• Publicly available information includes
• Historical price and volume information
• Published accounting statements.
• Information found in annual reports.

18
Event Studies How Tests Are Structured

• Event studies are one type of test of the
  semi-strong form of market efficiency.
• This form of the EMH implies that prices should
  reflect all publicly available information.
• To test this, event studies examine prices and
  returns over timeparticularly around the arrival
  of new information.
• Test for evidence of underreaction, overreaction,
  early reaction, delayed reaction around the
  event.

19
How Tests Are Structured (cont.)

• Returns are adjusted to determine if they are
  abnormal by taking into account what the rest of
  the market did that day.
• The Abnormal Return on a given stock for a
  particular day can be calculated by subtracting
  the markets return on the same day (RM) from the
  actual return (R) on the stock for that day
• AR R Rm
• The abnormal return can be calculated using the
  Market Model approach
• AR R (a bRm)

20
Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Stock Price
Overreaction to good news with reversion
Delayed response to good news
Efficient market response to good news
-30 -20 -10 0 10 20 30
Days before (-) and after () announcement
21
Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Efficient market response to bad news
Stock Price
Delayed response to bad news
-30 -20 -10 0 10 20 30
Overreaction to bad news with reversion
Days before (-) and after () announcement
22
Event Studies Dividend Omissions
Efficient market response to bad news
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout Do
Dividend Omissions Signal Future Earnings or Past
Earnings? Journal of Investing (Spring 1997)
23
Event Studies Takeover Announcement
Announcement Date
24
Event Study Results

• Over the years, event study methodology has been
  applied to a large number of events including
• Dividend increases and decreases
• Earnings announcements
• Mergers
• Capital spending
• New issues of stock
• The studies generally support the view that the
  market is semistrong-form efficient.
• In fact, the studies suggest that markets may
  even have some foresight into the futurein other
  words, news tends to leak out in advance of
  public announcements.

25
The Record of Mutual Funds

• If the market is semistrong-form efficient, then
  no matter what publicly available information
  mutual-fund managers rely on to pick stocks,
  their average returns should be the same as those
  of the average investor in the market as a whole.
• We can test efficiency by comparing the
  performance of professionally managed mutual
  funds with the performance of a market index.

26
Efficient Market Theory
Average Annual Return on 1493 Mutual Funds and
the Market Index
27
Strong Form Market Efficiency

• Security prices reflect all informationpublic
  and private.
• Strong form efficiency incorporates weak and
  semi-strong form efficiency.
• Strong form efficiency says that anything
  pertinent to the stock and known to at least one
  investor is already incorporated into the
  securitys price.

28
Insider Trading

• Officers, directors, and major shareholders of a
  firm are considered insiders who may have
  non-public important information. The SEC, the
  Ontario Securities Commission (and its
  counterparts in other provinces) prohibited the
  trade of securities based on pieces of
  information that have not yet become news.
• To enforce regulation, the OSC and the SEC
  require insiders to reveal any trading they might
  do in their own companys share.

29
Relationship among Three Different Information
Sets
30
What the EMH Does NOT Say

• If EMH holds there should be no upward trend in
  stock price.
• If EMH holds, investors can not earn any return
• If EMH holds, investors can throw darts to select
  stocks.
• If EMH holds, stock prices should not go up over
  time.
• If EMH holds, daily fluctuations should not exist
  as prices reflect the fundamental value of the
  firm.
• EMH can not hold because there are not enough
  active traders.

31
Views Contrary to Market Efficiency

• Stock Market Crash of 1987, Dot.com bubble.
• The NYSE dropped between 20-percent and
  25-percent Monday following a weekend during
  which little surprising information was released.
• Nasdaq fell 72 during a two year period.
• Temporal Anomalies
• Turn of the year, month, week.
• Speculative Bubbles
• Sometimes a crowd of investors can behave as a
  single squirrel.
• Size
• Small cap stocks seem to outperform large cap
  stocks.
• Value versus Growth
• Value stock-price stocks outperform growth stocks.

32
Efficient Market Theory
2000 Dot.Com Boom
33
Why Doesnt Everybody Believe the EMH?

• There are optical illusions, mirages, and
  apparent patterns in charts of stock market
  returns.
• The truth is less interesting.
• There is some evidence against market efficiency
• Seasonality
• Small versus Large stocks
• Value versus Growth stocks
• The tests of market efficiency are weak.

34
Implications for Corporate Finance

• The EMH has three implications for corporate
  finance
• The price of a companys stock cannot be affected
  by a change in accounting.
• Financial managers cannot time issues of stocks
  and bonds using publicly available information.
• A firm can sell as many shares of stocks or bonds
  as it desires without depressing prices.
• There is conflicting empirical evidence on all
  three points.

35
Efficient Market Theory
IPO Non-Excess Returns
Year After Offering
36
Practice Questions q8

• Which statements contradicts EMH (specify type)
• Tax-exempt municipal bonds offer lower pretax
  returns than taxable government bonds.
• Managers make superior returns on their purchases
  of their companys stock.
• There is a positive relation between the return
  on the market in one quarter and the change in
  aggregate profits in the next quarter.
• There is disputed evidence that stocks which have
  appreciated unusually in the recent past continue
  to do so in the future.
• The stock of an acquired firm tends to appreciate
  in the period before the merger announcement.
• Stocks of companies with unexpectedly high
  earnings appear to offer high returns for several
  months after the earning announcement.
• Very risky stock on average give higher returns
  than safe stocks.

37
Chapter 14 Corporate Financing

• Common Stock
• Preferred Stock
• Corporate Long-Term Debt The Basics
• Patterns of Long-Term Financing

38
Example Western Redwood Corp.

• Formed in 1976 with 10,000 shares issued and sold
  for 1 per share.
• By 2004, the company had retained 100,000.
• Western Redwood Corporation Equity Accounts, 2004

Common stock (10,000 shares outstanding) 10,000
Retain earnings 100,000
Total shareholders equity 110,000
39
Example Western Redwood Corp.

• Issues 100,000 shares at 20 per share at 2004
• Western Redwood Corporation Equity Accounts, 2004

Common stock (10,000 shares outstanding) 210,000
Retain earnings 100,000
Total shareholders equity 310,000
40
Market Value and Book Value

• Market Value is the price of the stock multiplied
  by the number of shares outstanding.
• Also known as Market Capitalization
• Book Value
• The sum of par value, (contributed surplus
  value in access of par upon issue), accumulated
  retained earnings, and adjustments to equity is
  the common equity of the firm, usually referred
  to as the book value of the firm.

41
Enbridge Inc., 2003
42
Enbridge Inc., 2003
43
Enbridge Inc., 2003
44
Enbridge Inc., 2003
45
Authorized vs. Issued Common Stock

• The articles of incorporation must state the
  number of shares of common stock the corporation
  is authorized to issue.
• The board of directors, after a vote of the
  shareholders, may amend the articles of
  incorporation to increase the number of shares.
• Authorizing a large number of shares may worry
  investors about dilution because authorized
  shares can be issued later with the approval of
  the board of directors but without a vote of the
  shareholders.

46
Enbridge Inc., 2003
47
Shareholders Rights

• The right to elect the directors of the
  corporation by vote constitutes the most
  important control device of shareholders.
• Directors are elected each year at an annual
  meeting by a vote of the holders of a majority of
  shares who are present and entitled to vote.
• The exact mechanism varies across companies.
• The important difference is whether shares are to
  be voted cumulatively or voted straight.

48
Cumulative versus Straight Voting

• The effect of cumulative voting is to permit
  minority participation.
• Under cumulative voting, if there are N directors
  up for election, then 1/(N1) percent of the
  stock plus one share will guarantee you a seat.
• With cumulative voting, the more seats that are
  up for election at one time, the easier it is to
  win one.
• Straight voting works like a U.S. political
  election.
• Shareholders have as many votes as shares and
  each position on the board has its own election.
• A tendency to freeze out minority shareholders.

49
Cumulative vs. Straight Voting Example 1

• Imagine a firm with two shareholders
• Mr. MacDonald and Ms. Laurier.
• Mr. MacDonald owns 60 of the firm ( 600
  shares) and Ms. Laurier 40 ( 400 shares).
• There are three seats up for election on the
  board.

50
Cumulative vs. Straight Voting Example 2

• There are 2 million shares outstanding. How many
  shares do you need to own to be certain that you
  can elect at least one director under
• a) straight voting? b) cumulative voting?

51
Proxy Voting

• A proxy is the legal grant of authority by a
  shareholder to someone else to vote his or her
  shares.
• For convenience, the actual voting in large
  public corporations is usually done by proxy.
• If shareholders are not satisfied with
  management, an outside group of shareholders can
  try to obtain as many votes as possible via
  proxy.
• Proxy battles are often led by large pension
  funds like the Ontario Teachers Pension Board or
  the British Columbia Investment Management
  Corporation.

52
Dividends

• Unless a dividend is declared by the board of
  directors of a corporation, it is not a liability
  of the corporation.
• A corporation cannot default on an undeclared
  dividend.
• The payment of dividends by the corporation is
  not a business expense.
• Therefore, they are not tax-deductible.
• Dividends (of Canadian corporations) received by
  individual shareholders are partially sheltered
  by a dividend tax credit.
• Canadian corporations do not pay taxes on
  dividends for amounts they receive from Canadian
  corporations.

53
Classes of Shares

• When more than one class of share exists, they
  are usually created with unequal voting rights.
• Many companies issue dual classes of common
  stock. The reason has to do with control of the
  firm.
• Firms going public with dual classes of shares in
  Canada are often family controlled.
• Lease, McConnell, and Mikkelson found the market
  prices of U.S. stocks with superior voting rights
  to be about 5-percent higher than the prices of
  otherwise-identical stocks with inferior voting
  rights.

54
Corporate Long-Term Debt The Basics

• Interest versus Dividends
• Is It Debt or Equity?
• Basic Features of Long-Term Debt
• Different Types of Debt
• Repayment
• Seniority
• Security
• Indenture

55
Interest versus Dividends

• Debt is not an ownership interest in the firm.
  Creditors do not usually have voting power.
• The device used by creditors to protect
  themselves is the loan contract (i.e.,
  indenture).
• The corporations payment of interest on debt is
  considered a cost of doing business and is fully
  tax-deductible. Dividends are paid out of
  after-tax dollars.
• Unpaid debt is a liability of the firm. If it is
  not paid, the creditors can legally claim the
  assets of the firm.
• One of the costs of issuing debt is the
  possibility of financial failure.

56
Is It Debt or Equity?

• Some securities blur the line between debt and
  equity.
• Corporations are very adept at creating hybrid
  securities that look like equity but are called
  debt.
• Obviously, the distinction is important for tax
  purposes.
• A corporation that succeeds in creating a debt
  security that is really equity obtains the tax
  benefits of debt while eliminating its bankruptcy
  costs.

57
Basic Features of Long-Term Debt

• The bond indenture usually lists
• Amount of Issue (typically denominated with a
  1000 face value), Date of Issue, Maturity
• Denomination (Par value)
• Coupon, typically semiannual
• Security
• Sinking Funds
• Call Provisions
• Covenants
• Features that may change over time
• Rating
• Yield-to-Maturity
• Market Price

58
Enbridge Inc., 2003
59
Back to Preferred Shares

• A preferred share represents equity of a
  corporation, but is different from common stock
  because it has preference over common in the
  payments of dividends and in the assets of the
  corporation in the event of bankruptcy.
• Preferred shares have a stated liquidating value.
  
• For example, CIBC 2.25 preferred translates
  into a dividend yield of 9 of the stated 25
  value.
• Preferred dividends are either cumulative or
  noncumulative.
• Firms may have an incentive to delay preferred
  dividends, since preferred shareholders receive
  no interest on the cumulated dividends.
• Preferred shares have a lower yield than debt.

60
Tax loophole in Canada

• Corporate investors are exempt from income taxes
  on dividends ? they would be willing to pay a
  premium for these shares (compared to similar
  debt instruments) as a consequence, yields are
  low.
• Low taxed companies may therefore prefer to issue
  these shares compared to debt (i.e., for these
  companies the debt tax shield is of limited
  usage).

61
Tax loophole in Canada

• Zero Tax Ltd., a corporation not paying any
  income taxes, can issue preferred shares
  attractive to Full Tax Ltd., a second corporation
  taxable at a combined federal and provincial rate
  of 45. Zero Tax is seeking 1000 in financing
  through either debt or preferred stock. Zero Tax
  can issue either debt with a 10 coupon or
  preferred stock with a 6.7 dividend.
• Preferred (6.7) Debt (10)
• Issuer Zero Tax Ltd.
• Preferred dividend/interest paid 67.00 100.00
  
• Dividend tax at 40 26.80 0.00
• Tax deduction on interest 0.00 0.00
• Total financing cost 93.80 100.00
• After-tax cost 9.38 10.00
• Purchaser Full Tax Ltd.
• Before-tax income 67.00 100.00
• Tax 0.00 45.00
• After-tax income 67.00 55.00
• After-tax yield 6.70 5.50

62
Other Reasons for Preferred Shares

• Regulatory firms can pass the tax disadvantage to
  their customers.
• Firms issuing preferred shares can avoid the
  threat of bankruptcy while at the same time not
  surrender control (no voting rights on preferred
  shares).

63
Patterns of Long-Term Financing

• For Canadian firms, internally generated cash
  flow dominates as a source of financing.
• Firms usually spend more than they generate
  internallythe gap is financed by new sales of
  debt and equity.
• Net new issues of equity are dwarfed by new sales
  of debt.
• This is consistent with the pecking order
  hypothesis.
• Leverage ratios for Canadian firms are
  considerably higher than they were in the 1960s.

64
The Long-Term Financial Gap
65
Chapter 15 How Corporations Issue Securities

• Issuing securities involves the corporation in a
  number of decisions.
• This chapter looks at how corporations issue
  securities to the investing public.
• The basic procedure for selling debt and equity
  securities are essentially the same. This chapter
  focuses on equity.

66
Topics Covered

• Venture Capital
• The Initial Public Offering
• Other New-Issue Procedures
• Security Sales by Public Companies
• Rights Issue
• Private Placements and Public Issues

67
Venture Capital

• The limited partnership is the dominant form of
  intermediation in this market.
• There are five types of suppliers of venture
  capital
• Old-line wealthy families.
• Private partnerships and corporations.
• Large industrial or financial corporations with
  established venture-capital subsidiaries.
• The federal government (through crown-related
  firms).
• Individuals, typically with incomes in excess of
  100,000 and net worth over 1,000,000. Often
  these angels have substantial business
  experience and are able to tolerate high risks.

68
Stages of Financing

• Seed-Money Stage
• Small amount of money to prove a concept or
  develop a product.
• Start-Up
• Funds are likely to pay for marketing and product
  refinement.
• First-Round Financing
• Additional money to begin sales and
  manufacturing.
• Second-Round Financing
• Funds earmarked for working capital for a firm
  that is currently selling its product but still
  losing money.
• Third-Round Financing
• Financing for a firm that is at least breaking
  even and contemplating expansion a.k.a.
  mezzanine financing.
• Fourth-Round Financing
• Financing for a firm that is likely to go public
  within six months a.k.a. bridge financing.

69
U.S. Venture Capital Investments
70
Initial Offering

• Initial Public Offering (IPO) - First offering of
  stock to the general public.
• Underwriter - Firm that buys an issue of
  securities from a company and resells it to the
  public.
• Offering price The price of a share at IPO.
• Spread - Difference between public offer price
  and price paid by underwriter.
• Prospectus - Formal summary that provides
  information on an issue of securities.

71
The Top Managing Underwriters
72
The Public Issue in Canada

• Regulation of the securities market in Canada is
  carried out by provincial commissions.
• In the U.S., regulation is handled by a federal
  body (SEC).
• The regulators goal is to promote the efficient
  flow of information about securities and the
  smooth functioning of securities markets.
• All companies listed on the TSX come under the
  jurisdiction of the Ontario Securities Commission
  (OSC).
• Other provinces have similar legislation and
  regulating bodies.
• The Canadian Securities Administration (CSA)
  coordinates regulation.

73
New Issue Procedure

• Steps involved in issuing securities to the
  public
• Management obtains approval from the board of
  directors.
• The firm prepares a preliminary prospectus to the
  OSC.
• The OSC studies the preliminary prospectus and
  notifies the company of any changes required.
• Once the revised, final prospectus meets with the
  OSCs approval, a price is determined and a
  full-fledged selling effort gets under way.

74
The Process of Raising Capital
Steps in Public Offering Time 1.
Pre-underwriting conferences 2. Registration
statements 3. Pricing the issue 4. Public
offering and sale 5. Market
stabilization
Several months 20-day waiting period
Usually on the 20th day
After the 20th day 30 days after
offering
75

• The overallotment option known as the Green Shoe
  provision gives members of the underwriting group
  the option to purchase additional shares at the
  offering price less fees and commissions. The
  option has a short maturity and is limited to
  about 10 of original number of shares issued.
• Investment Dealers
• In 2003, RBC Dominion Securities was the leading
  underwriter by revenue.

76
Underwriting Spreads US (2003)
77
Average Initial IPO Returns
78
Initial Offering US

• Average Expenses on 1767 IPOs from 1990-1994

79
The Costs of Public Offerings

• Costs of Going Public in Canada 1984-97
• Fees 6.00
  
• Underpricing 7.88
• TOTAL 13.88

• The above figures understate the total cost
  because they ignore indirect expenses or the
  overallotment option.

80
From CNN.COM (Aug 18, 2004)

• Google plans to price the shares in a rare
  auction-style IPO. The deal promises to put more
  shares in the hands of ordinary investors rather
  than wealthy investment banking clients. The
  auction is also widely seen as a slap at Wall
  Street and the clubby culture that contributed to
  investigations into improper IPO trading
  activities at the height of the dot-com bubble.

81
General Cash Offers

• Seasoned Offering - Sale of securities by a firm
  that is already publicly traded.
• General Cash Offer - Sale of securities open to
  all investors by an already public company.
• Shelf Registration - A procedure that allows
  firms to file one registration statement for
  several issues of the same security.
• Private Placement - Sale of securities to a
  limited number of investors without a public
  offering.

82
Private Placements

• Avoid the costly procedures associated with the
  registration requirements that are a part of
  public issues.
• The OSC and SEC restrict private placement issues
  of no more than a couple of dozen knowledgeable
  investors including institutions such as
  insurance companies and pension funds.
• The biggest drawback is that the securities
  cannot be easily resold.

83
Market Reaction to SEO

• Suppose that the CFO of a restaurant chain is
  strongly optimistic about its prospect. From her
  point of view, the companys stock price is too
  low. Yet the company wants to issue shares to
  finance expansion into another county. What is
  she to do?

84
The Announcement of New Equity and the Value of
the Firm

• The market value of existing equity drops on the
  announcement of a new issue of common stock.
• Reasons include
• Managerial Information
• Since the managers are the insiders, perhaps
  they are selling new stock because they think it
  is overpriced.
• Debt Capacity
• If the market infers that the managers are
  issuing new equity to reduce their debt-to-equity
  ratio due to the specter of financial distress
  the stock price will fall.
• Falling Earnings

85
Rights

• An issue of common stock offered to existing
  shareholders is called a rights offering.
• Prior to the 1980 Bank Act, chartered banks were
  required to raise equity exclusively through
  rights offerings.
• If a preemptive right is contained in the firms
  articles of incorporation, the firm must offer
  any new issue of common stock first to existing
  shareholders.
• This allows shareholders to maintain their
  percentage ownership if they so desire.

86
Mechanics of Rights Offerings

• The management of the firm must decide
• The exercise (subscription) price (the price
  existing shareholders pay for new shares).
• How many rights will be required to purchase one
  new share of stock.
• These rights have value
• Shareholders can either exercise their rights or
  sell their rights.

87
Rights Offering Example

• National Power has 1 million shares outstanding.
  Each share sells for 20. The company wants to
  raise 5 million in new equity. Suppose the
  exercise (subscription) price is set at 10 per
  share. Find
• Market value of company after rights issue.
• Number of new shares.
• Number of rights needed to buy a share.
• The value of the share after the rights offering.
• The value of a right.
• The cost of a new share to an outside investor.

88
Time Line
Ex Right Date
Right Expiration Date
Right Issue Date
Rights announcement
P20 N1m
P16.67 N1m
P16.67 N1.5m
P16.67 N1m R3.33
89
Theoretical Value of a Right

• The theoretical value of a right during the
  rights-on period is
• R0 (M0 S) / (N 1)
• Where,
• M0 Common share price during the rights-on
  period
• S Subscription price
• N Number of rights required to buy one new
  share

90
Value of a Right after Ex-Rights Date

• When the stock goes ex-rights, its price drops
  by the value of one right.
• Me M0 R0
• Re (Me S) / N
• Where,
• Me is the common share price during the
  ex-rights period.

91
Self Practice

• Yoma Inc. is attempting to raise 5,000,000 in
  new equity with a rights offering. The
  subscription price will be 40 per share. The
  stock currently sells for 50 per share and there
  are 250,000 shares outstanding.
• a. How many new shares will Yoma issue?
• b. How many rights will be required to buy one
  share?
• c. At what price will the stock sell when it goes
  ex-rights if the total value of all stock
  increases by the amount of the new funds?
• d. What is the theoretical value of 1 right?