Directors of the corporation announce that stockholders of record of a stated day will have the right to subscribe for the new stock in the proportion of one share of the new for three shares of the old. This announcement at least, that part of it which says "stock holders of record of day of " bears some resemblance to a declaration of a dividend. As we shall see, the transaction resembles a declaration of dividends in more respects than just its language. Through these "rights" the stockholders are about to get an immediate distribution of surplus in a way that amounts to an extra dividend.
We have assumed that the old stock is sell ing at about 133 and that after the increase the stock of the corporation will be worth about 125. On this basis a man owning three of the old shares has the right, on paying $100, to buy a share of stock which will have a market value of $125. Since a single "right" that is, the interest of one share of the old stock in the issuance of the new may be bought and sold, obviously the value of this right equals one third of the $25 which the holder of three shares may re alize on exercising his right to subscribe. Or, to state the situation briefly, each right has a value of $8.33. For the sake of clear ness let us show the transaction in tabular form: Total stock outstanding . $9,000,000 Amount to be issued 3,000,000 Right: three of old to subscribe for one of new Market value of new stock $125.00 Subscription price for new stock 100.00 Value of subscription rights of three shares of old stock 25.00 Value of right 8.33 It is not to be assumed that these values all settle themselves in the precisely accur ate mathematical manner indicated. Prob ably the price of the old stock fluctuates a good deal in anticipation of the announce ment of the forthcoming rights. Though we have taken too small a corporation for our discussion to represent a reasonably typical issue of stock listed on the New York Stock Exchange, the results come to the same thing as if we had multiplied the amounts of old and new stock by three or four to present an issue of Stock Exchange size. Dealings in rights will begin immediately on the an nouncement that they will be given. The corporation will issue, to stockholders of record of the day stated, certificates repre senting the rights, and these certificates will be handled in just the same way as the certi ficates of shares of stock themselves.
So by making this appeal to and through its own stockholders, a corporation with a real surplus, part of which its managers are willing to distribute and have represented as capital stock rather than as surplus, can raise new capital without resorting to the bankers. Instead of increasing its capital
stock the corporation may even borrow in this way by offering bonds to its own share holders at something less than their actual market value. Presumably the corporation has a perfect right to do this so long as it gives to each stockholder the right to sub scribe in the manner just outlined, and pro vided it is not by so doing impairing the capital of the corporation.
If the stock of the corporation is selling only a little above par the situation offers less assurance that the corporation will be able to raise new capital by an appeal to its own stockholders. Issuance of new stock may reduce the market value of the stock to a point where a general decline in the market may carry the price to par or below. To il lustrate this situation, assume a corporation with Stock outstanding. $R5,000,000 To be issued 5,000,000 Market price for old stock . 105 To cut our computation short by using the market estimate of values, the capital and surplus of the corporation has a value, on the market price of the stock at 105, of $26, 250,000. On realizing par for the $5,000,000 new stock, the capital and surplus of the corporation will have a value of $31,250,000. But the corporation now has 300,000 shares of stock, so each share should be worth approximately 104. At this price the rights would be worth only 80 cents. On a decline of two points in the market for the stock, they would have a value of only 40 cents. Unless one owned a considerable number of shares this is hardly a sufficient inducement to put through the transaction in order to realize on it. With a price only four points above par a very small general decline in prices would wipe the premium out entirely and carry the quotation below par. Of course no one would pay the corporation par for stock which can be bought on the market at less than par. A situation like this, with so narrow a range of safety in the market, perhaps hardly affords a sound enough basis for a banker to underwrite the new issue of stock. Certainly, if the raising of the new funds were of great importance to the cor poration, it could not safely rely on procur ing them from stockholders without getting the banker's insurance.