SOLUTION TO FIN5FMA TOPIC 8 TUTORIAL WORK AND DISCUSSION PROBLEM

Question 1)

Number of shares to issue through the rights issue = $600,000 / $3.75 = 160,000

Rights issue terms = 800,000 / 160,000 = 5.0 (5 for 1) rights issue

Thus, if Colin currently holds 3,000 shares in Hughes Computer Equipment Limited, he will
receive 600 rights (3,000 / 5) as part of the issue.

Question 2)

The theoretical value of the right can be calculated as:

M −S $4.20 − $ 3.75
VR = n ( ) (
n +r
=5
5+1
= $0.375 )
Thus, each right is worth $0.375.

Question 3)

This requires the determination of the theoretical ex-rights price, which can be calculated
as:

VR $ 0. 375
PEX = M − = $ 4 .20 − = $ 4.125
n 5

Thus, the share price should open trading on the ex-rights date at $4.125 per share.

Question 4)

If the rights issue is underwritten, the underwriter takes on the risk that firm shareholders
will not elect to take-up and exercise the right to purchase additional shares and, if the
rights are renounceable, that there are not other investors in the market willing to purchase
the rights at the theoretical rights value. In either of these cases, it will be the responsibility
of the underwriter to acquire these rights and exercise them to purchase the associated
shares to ensure that the rights issue is fully subscribed. Thus, the underwriter will
potentially need to have funds available to purchase the rights and also to cover the
subscription price associated with exercising these rights.
As such, the likelihood of having to take-up unexercised rights is greater if the issue is non-
renounceable relative to if it was renounceable, as there are likely to be some investors
outside the company who are prepared to purchase at least some of the renounced rights,
alleviated the underwriter’s responsibility for these. Thus, greater risk associated with a
non-renounceable issue will result in the underwriter requesting a larger fee to compensate
for this higher risk compared to the underwriter fee that would be requested in association
with a less-risky renounceable issue.