The Right to Buy More Stock If a corporation issues additional shares of stock, it is available for pur-

The Right to Buy More Stock If a corporation issues additional shares of stock, it is available for pur-

chase by anyone—existing shareholders and others. This opens up the possibility that a shareholder’s interest in the corporation may be diluted. If you own 1,000 shares of stock in a corporation, representing 10% of the 10,000 common shares outstanding, you control 10% of that corpo- ration. If the corporation issues 10,000 more shares and you do not buy any of these shares, your ownership drops to 5%.

Corporations can give the right to buy additional shares of new common stock through a rights offering—an offering of rights to exist- ing shareholders. First, the corporation gives each shareholder war- rants, the physical document that gives, according to the number of shares each shareholder already owns, the right to buy a specified num- ber of shares at a specified price, within a specified period of time. In other words, a warrant is a call option. When a shareholder receives warrants, he or she can:

■ throw these rights away; ■ exercise these rights, buying the shares; or

■ sell these rights. In some corporations, a current shareholder’s right to buy shares of

any new common stock offering is granted directly in the corporate charter. This is referred to as the preemptive right, and is the current shareholder’s right to buy additional shares of common stock to main- tain her or his proportionate share of ownership in the corporation.

Suppose you own 10% of the stock of a corporation. If the corpora- tion has a rights offering, you have the right to buy 10% of any new stock before it is offered to the public You don’t have to, but you have the right and will be given the opportunity.

A corporation makes a rights offering for two reasons. First, share- holders may view a preemptive right as attractive since they are able to maintain their proportionate ownership interest and, hence, their con- trol of a corporation. If shareholders view this as valuable, this right has the effect of increasing the value of the stock. If the price of shares is higher, a firm need not issue as many new shares when it wants to raise new capital.

Second, it usually costs a corporation less to issue shares in a rights offering than to sell new shares to the public. And a savings for the cor- poration is valuable to the owners—the shareholders.

Common Stock

Let’s look at an example of a rights offering. In 1991, Time Warner issued rights to its common shareholders. 6 For each share owned, share-

share. If you owned 100 shares, you were entitled to buy 60 shares of stock at $80 per share. The rights were granted July 16th and expired three weeks later, on August 5th. During that period, the higher the price of Time Warner stock, the more valuable this right.

At the time the rights were granted, Time Warner common stock was trading at $86.75 per share, making the right to buy at $80 worth at least $6.75 per right. But early on in this three week period the value of the right—the price of the rights traded on the stock exchange—was greater than the difference between the Time Warner stock price and $80. Why? Because the investors buying the rights at this price felt that before the three weeks were up, the price of the Time Warner stock would increase even more, making the right even more valuable. But as time passed, investors began to lose confidence that the stock would increase in price. So the value of the right wound up equal to the differ- ence between the stock price and the $80.

We can see the relation between the value of the right and the value

a share of Time Warner stock in Exhibit 16.1. The value of the right and the value of the stock move almost parallel. As the price of Time Warner stock increases, so does the value of the right to buy it at $80. Finally, just before expiration, the value of the right was equal to the difference between the Time Warner stock price and $80.