Supernova makes a public announcement that it will raise equity finance through a rights issue of new

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Question:

Supernova makes a public announcement that it will raise equity finance through a rights issue of new shares to existing shareholders to finance a new project. The new project and the rights issue are announced simultaneously. The project has an NPV of $10 million and requires an initial outlay of $20 million. The rights issue shares will be priced at $2 each. Assume that before making public the information about the new project or its financing, the firm had 20 million shares with a market value of $3 per share. The market is semi-strong form efficient and there are no issuance costs. When answering this question, state any additional assumptions you may need to make. Show your calculations.

Required:

a) What is the value of a share in Supernova after the rights issue?

b) What is the value of a right to obtain one of the rights issue shares? Why should an outside investor be unwilling to pay more?

Now assume you are an investor who holds $1 million cash and 5% of the shares of Supernova prior to the rights issue.

c) Assume you exercise all of the rights offered to you. What is the change in your wealth after the rights issue, compared to your wealth before the public announcement was made?

d) What will be the change in your wealth if you choose to buy half of the rights issue shares offered to you and sell the rights to buy the other half?

e) What do your answers to parts c) and d) tell you about the relationship between rights issues, under-pricing, and dilution of existing shareholders? How might this affect a firm's equity issuance decision?