We have dwelt at some length on the prin ciples underlying an estimate of the value of the stock of a corporation after a declara tion of rights. Of course in practice the mat ter is taken care of by the market estimate. We are assuming now a stock with an active market. When the corporation announces its new issue and the right of shareholders to subscribe at the terms offered, dealing in the rights will begin immediately. Assume our former case, in which we estimated the value of the rights at $8.33. The market will probably place an estimate on the value of the rights at about that point, and the mar ket value so estimated will indicate at what price the stock will sell when it goes ex-rights. When the stock goes ex-rights the corpora tion will issue certificates to the stockholders of record at the designated time. Up to that time trading in the rights will be for delivery when issued, and the price of the rights will approximately indicate the quotation on the stock when it goes ex-rights.
The price of the rights may not be exactly their value computed in terms of the price of the stock. It is likely to run a little less. Otherwise a stockholder desiring to sell his rights would not afford a purchaser a good bargain. The purchaser might just as well buy the stock without taking the trouble to buy the rights first. Rights are likely to sell at a point that will give an opportunity for a possible arbitraging between the quotation on rights and the quotation on stock. If, for example, the rights we have been dis cussing, which entitle the holder of record of three shares of the old stock to subscribe for one share of the new at 100, were quoted at 7.75, and the stock were selling ex-rights at 125, they would afford an opportunity for a successful arbitrage transaction.
Under the stated circumstances let us sup pose a speculator has been able to pick up 300 rights at an average price of $7.75, and the quotation on the stock remains at 125. Ile can assure his profit on the transaction by selling 100 shares short at 125. At the designated time he can present his certifi cates for rights to the corporation and get a certificate for 100 shares on the payment of $10,000. Let us see how he has come out on his transaction: — Cost of 300 rights at 7.75. $2,22,5.00 Cost of 100 shares at 100. 10,000.00 Cost of Commission on short sale 12.50 Costs $12,237.50 Realized on short sale of 100 shares at 125 $12,500.00 Less costs of transaction . 12,237.50 Profit on transaction $262.50 These figures are given simply for clear ness of illustration. Probably the rights would not sell low enough to make such a profit possible. The costs include something more than those stated — as the transfer tax and interest on the $2225 capital tied up in the rights during the interval before the cer tificate could be obtained on the subscription from the corporation. Some 'speculative risk would be involved, during the time required to pick up the rights, of the quotation of the stock declining or the price of the rights go ing up before enough were acquired to com plete the transaction.
It should be mentioned that though in the New York market a right is that interest in the new stock which belongs to one share of the old, in some markets the term is used as meaning that interest in the new stock which entitles one to subscribe to one share.
Stockholders usually greet with pleasure an announcement of forthcoming rights. So far as the offering of the rights may indicate the opinion of the directors that the corpora tion may now distribute its earnings a little more freely, it affords a proper basis for self congratulation on the part of the stock holder. But of course the corporation cannot lift itself financially by its own boot-straps. If the directors have been declaring divi dends at the rate of 8 per cent per annum and are likely to continue an 8 per cent rate on the new stock, the stockholders are get ting greater immediate benefits from their holdings. Before the issuance of the new stock the corporation was earning, we as sumed, 13* per cent on the outstanding stock. On an 8 per cent dividend rate, they were carrying 5-1- per cent to surplus. After the issuance of the new stock to stockholders at par, we assumed that the corporation earns 122 per cent on the stock outstanding. Now on an 8 per cent dividend the directors will be carrying 4* per cent to surplus. What constitutes proper surplus provision depends, of course, on the nature of the business. As suming that 4* per cent on the amount of stock outstanding in this case makes ample provision for surplus, then the giving of rights has resulted in benefit to the stock holder. A present payment is of greater worth than one deferred. The offering of the rights raises a presumption in the mind of the stockholder that the dividend rate will not be cut, and that he will get the benefit of this immediate greater distribu tion.
If the management should be in a legal position to sell the stock at a premium so that they could obtain the full market value for it, they could treat the stockholder just as well as under the plan of offering rights. To give the same results in an increased dis tribution they would have to increase the dividend rate, and an offering of new stock at the premium would raise no such presump tion of increased distribution as an offering of rights. Market considerations, however, may favor the offering of rights rather than the sale at a premium. Distribution of the new stock by means of rights probably ab sorbs much of the shock of throwing a large block of new stock on the market. If the old stock were selling at 133, it is improb able that the new stock could be sold at that price. Even though the stock of the corpora tion would be worth just as much if the cor poration should realize 133 for the new stock and could continue, as we assume, to make as large returns from new capital in the en terprise as on the old, still the sudden large increase in the market supply would depress the market price. In the case of the rights the expectation of the increased distribu tion of earnings acts as an offset to the de pressing influence of the increase in the sup ply of stock in the market. Probably, too, more stockholders, rather than selling the rights, actually purchase the new stock on a granting of rights than would purchase at a premium that would represent the full market value. So the offering of the rights probably in this way widens the demand.