What is wrong with rights issues?
A rights issue is an issue of rights to purchase new shares, which are issued pro rata to the existing shareholders, Armitage (2007). Rights issues were the dominate form of seasoned equity offers for fund raising in the United Sates and the United Kingdom . However, there has been a swing to other forms of share issues. The US has shifted towards firm commitments, Eckbo and Masulis (1992). In this the underwriter guarantees the sale of the issued stock at the agreed-upon price. The shift in the US occurred in the 1960’s. In the UK there has been a move towards open offers. Open offers are similar to rights issues but investors are unable to ...view middle of the document...
The results reconfirm the rights issue paradox.
As a result of this paradox, Eckbo and Masulis set out to find why firm commitments are dominant in the US.
Eckbo and Masulis analyse the impact of dividend reinvestment plans (DRIPS), where shareholders choose shares instead of cash dividends, on rights issues. To do this they use a sample of firms that are register and non-registered DRIPS from 1973-1981 and examine their equity offers. Eckbo and Masulis suggest DRIPS can partially explain the decline in rights issues but there is limited evidence.
Eckbo and Masulis suggest several additional costs that are not analysed in theirs and Smith’s paradox test for the reasons why rights issues are unpopular. These include;
“Capital gains taxes”, “Stock liquidity and transaction costs of reselling rights”, “Short-selling activity and the risk of rights offer failure”, “Anti-dilution clauses and wealth transfers to convertible-security holders”, “Adverse-selection costs of uninsured rights.” Eckbo and Masulis (1992) p308-309
Eckbo and Masulis decide to examine adverse-selection further. They develop a model that builds upon the Myers and Majluf (1984) framework. In Myers and Majluf framework, managers (assumed to maximize the intrinsic value of the firm’s shares) only issues shares for investment if the net issue benefit is nonnegative, b - (c +f) ≥ 0 . Myers and Majluf also assume that current shareholders do not participate in the issue. So, issuing signals there is no goal alignment between managers and current shareholders because there is no take-up;
“causing rational market participants to lower the secondary-market price of an issuer’s stock.” Eckbo and Masulis (1992) p 310
Eckbo and Masulis build upon this model, introducing k≡ (0, 1) which represents shareholder take-up level in a rights issue. They also use four assumptions. These assumptions are;
1. "The firm faces a profitable but short-lived investment opportunity requiring equity investment and management will maximize net issue benefit b - (c +f) given the expected shareholder take-up and recognizing that the equilibrium value of c itself depends on both the value of k and the flotation method
2. The value of k is determined by factors beyond managerial control. So, managers treat k as an exogenous factor.
3. Managers have better information than the market about k. So, low-k issuers cannot falsely signal a high k value. While high-k issuers can conceal their information on k by not selecting a rights offer.
4. Underwriter certification narrows, but does not eliminate, the information asymmetry between the firm and the market". Eckbo and Masulis (1992) p 310-311
If K=1 then there is full shareholder take-up, no wealth transfer and no adverse selection, so c=0
If K<1then the markets will assume there is no goal alignment between managers and current shareholders. Some undervalued firms find it too costly to issue, because of the dilution of current shareholder claims caused...