The Edsa Company Wishes To Finance An Expansion Program
The Edsa company wishes to finance an expansion program through the issue of new shares
The Edsa company wishes to finance an expansion program through the issue of new shares. It offers existing shareholders the opportunity to subscribe to new shares at P135, up to 50% of their holdings. The current market value of each share on June 1 is P150. The shares go ex-rights on June 2. Mendiola Corp. owns 2,000 shares of Edsa company, acquired at a total cost of P132,000. These shares are measured at fair value through other comprehensive income. Calculate the following:
- a. Theoretical market value of a right
- b. Total cost of the stock rights received
- c. Gain or loss on sale of stock rights, assuming Mendiola sold 1,000 rights at P5.50 each
Paper For Above instruction
The objective of this paper is to analyze and compute key financial metrics associated with the rights issue undertaken by Edsa Company, particularly focusing on the theoretical market value of a right, the total cost of stock rights received, and the gain or loss from selling rights. These calculations are essential for understanding shareholder value, market reactions, and investment returns in corporate finance contexts.
Introduction
Rights offerings are a common method for companies to raise additional capital from existing shareholders. When a company issues new shares through a rights offering, it grants existing shareholders the privilege to purchase additional shares at a specified price, typically below the current market value, proportionate to their holdings. This process involves rights, which are transferable and can be sold in the open market. Understanding the valuation of these rights and subsequent transactions is fundamental to assessing the financial implications for shareholders.
Understanding Rights and Their Valuation
The theoretical valuation of a right is based on the concept that a right confers the opportunity to purchase new shares at a price below the prevailing market price. The value of a right depends on several factors, including the number of rights needed to buy a new share, the subscription price, and the current market price of the stock.
Calculation of Theoretical Market Value of a Right
Given the information:
- Market price per share (Pm) = P150
- Subscription price (Psub) = P135
- Additional shares that can be purchased = 50% of holdings
To find the number of rights needed to purchase one new share, we need to determine the ratio of rights to the new shares. Since the company offers rights to subscribe for up to 50% of existing holdings, each shareholder can buy additional shares equal to half of the shares they currently hold, proportional to their ownership.
The number of rights required per new share is calculated as:
R = Number of rights needed
Given the rights are proportional, and assuming the rights are one-to-one with shares (each existing share grants one right), then:
Number of rights per existing share = 1
Total rights held by Mendiola:
Rights held = Number of shares owned = 2,000 rights
Number of rights necessary to buy the maximum allocation:
Number of new shares possible = 50% of existing shares = 1,000 shares
Since each new share requires rights proportional to current holdings:
Rights needed to buy 1,000 shares = 1,000 rights
Now, the theoretical value of a right (TVR) can be calculated as:
TVR = [(Pm) - Psub)] / (number of rights needed per new share + 1)
However, because rights are transferable, the market value of a right (MVR) under ideal conditions is:
MVR = (Pm - Psub) / (Number of rights per new share)
which simplifies as the following:
MVR = (150 - 135) / (1) = P15 per right
This theoretical value indicates the market valuation of each rights based on the differential between market price and subscription price.
Total Cost of the Stock Rights Received
The total cost of the rights received by Mendiola depends on how many rights they hold and the price at which these rights are valued. Since Mendiola owns 2,000 shares, and each share grants a right, the total rights held are 2,000 rights.
If Mendiola chooses to exercise all rights, they can acquire additional shares at P135 per share. The total cost for acquiring the additional shares (up to 50% of their holdings, i.e., 1,000 shares) would be:
Total cost = Number of new shares Subscription price = 1,000 P135 = P135,000
But to compute the actual cost of the rights themselves, compare the market value of rights to the subscription price.
Since rights are transferable, and under the assumption of fair valuation:
Total rights value = Rights held MVR = 2,000 P15 = P30,000
Alternatively, the total cash outlay when exercising rights (buying the shares) is P135,000, which is the amount paid to acquire the rights shares.
Thus, if considering rights as assets, the total cost of rights received equates to the market value of the rights held, which is P30,000. However, this does not affect cash outside of the actual purchase at P135 per share.
Gain or Loss on Sale of Stock Rights
Assuming Mendiola sells 1,000 rights at P5.50 each, the total proceeds from this sale are:
Proceeds = 1,000 rights * P5.50 = P5,500
The cost basis of the rights can be approximated as their market value (P15 per right) at the time of valuation, leading to an unrealized gain or loss. Since the rights are sold at P5.50, considerably below the theoretical value:
Gain or loss = Sale price - Market value of rights
= P5.50 - P15.00 = -P9.50 per right
Total loss:
= 1,000 * P9.50 = P9,500
This indicates a realized loss from the sale of rights, reflecting the market's valuation of the rights relative to their theoretical worth. The loss impacts Mendiola's overall investment portfolio, which considers both unrealized gains or losses and cash received from rights sale.
Conclusion
The rights issue by Edsa Company provides shareholders with an opportunity to purchase additional shares at a discounted price, with their rights being valuable in facilitating this process. The theoretical market value of a right, derived from the difference between the current market price and the subscription price, is P15. Mendiola’s total rights holdings are valued at P30,000, and selling 1,000 rights at P5.50 results in a tangible loss of P9,500 due to market conditions. These calculations are essential for investors to evaluate their investment position, make informed decisions about exercising or selling rights, and understand the implications of rights trading on shareholder value and financial performance.
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