ABC has currently 1.5 million shares outstanding, and its stock price is $ 20. It has a new investment opportunity which cost $ 6 million and generates a present value of free cash flows of $ 20 million. However, the company knows that the project is too complicated to explain to the market. Hence the market will underestimate the value of the project and assume it is a zero net present value project. The company cannot issue debt and has to raise $ 6 million equity. It is considering two alternatives: 

1. A rights issue at an issue price of $ 12. Although the issue is not underwritten, at this price, the issue will succeed with 100 % certainty. Each share will have one right. However, because current shareholders have a poor opinion about the management's ability to create shareholder value (the stock used to trade at $ 40 per share a year ago) the company also believes that only 1/3 of the rights will be exercised by current investors, while the remaining 2/3 of the rights will be exercised by new investors who will buy them from the current investors. 

2. A public issue to new investors, underwritten (firm commitment) by an investment bank, at an issue price (net proceeds) of $ 20. Assume stock has a zero beta and the risk-free rate is zero.

 a) Calculate the wealth of current shareholders, in the long run, when the true value of the firm is revealed, if the company makes a rights issue 

 b) Calculate the wealth of the current shareholders in the long run when the true value of the firm is revealed, if the firm raises money through a public issue 

 c) It is often said that rights issues are superior to direct issues when the stock is undervalued. Given this, explain the difference (if any) between your answers to (1) and (2)

Answer rating: 100% (QA)

a Calculate the wealth of current shareholders in the long run when the true value of the firm is re... View the full answer