Textbook
1. Common stock
1.1 Introduction and SIE review
1.2 Equity securities & trading
1.2.1 Rights & warrants
1.2.2 Stock splits & dividends
1.2.3 American depositary receipts (ADRs)
1.2.4 Foreign investments
1.2.5 Corporate actions
1.2.6 Tender offers
1.2.7 The primary & secondary market
1.2.8 Cash dividends
1.3 Suitability
1.4 Fundamental analysis
1.5 Technical analysis
2. Preferred stock
3. Bond fundamentals
4. Corporate debt
5. Municipal debt
6. US government debt
7. Investment companies
8. Alternative pooled investments
9. Options
10. Taxes
11. The primary market
12. The secondary market
13. Brokerage accounts
14. Retirement & education plans
15. Rules & ethics
16. Suitability
17. Wrapping up
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1.2.1 Rights & warrants
Achievable Series 7
1. Common stock
1.2. Equity securities & trading

Rights & warrants

We’ll discuss rights and warrants in this section, which are equity-related securities allowing the purchase of common stock at a fixed price. Both have similarities and differences, which are tested commonly on the exam.

Rights

As we discussed in the common stock review, authorized shares are established when the company is founded, which is the number of shares a company can sell to investors. If a company authorizes 1 million shares, it may sell up to 1 million shares of stock. Companies give up ownership (stock) in return for capital (money).

Most companies do not sell all of their authorized shares during their initial public offering (first public sale of their shares), allowing the opportunity raise additional capital later by selling “leftover” authorized shares.

The number of shares a company sells during its initial public offering (IPO) is referred to as issued shares. Once shares are issued, they trade in the secondary market among investors. Assume a company authorizes 1 million shares but decides to issue 500,000 shares. Let’s assume you purchase 50,000 shares, which is a 10% ownership position. Simply stated, you own 10% of the outstanding shares of this company.

Several years pass and the company needs to raise additional capital. They still have 500,000 authorized shares to sell, so let’s say they decide to sell all of them. This action would dilute your 10% ownership down to 5%.

Shares owned Shares outstanding Percent ownership
Before 50,000 500,000 10%
Diluted 50,000 1,000,000 5%

As you can see, your percent ownership of the outstanding shares fell from 10% to 5% just because the company wanted to sell more shares. When you vote now, your vote is worth half as much. Doesn’t seem fair, does it? Good news for you: the company cannot do this without offering the new shares to you and the other current stockholders first.

This is called the pre-emptive right, which gives current stockholders the right to buy the new shares the company is issuing before they’re publicly offered. In our example, you owned 10% of the outstanding shares in the beginning. Prior to the public sale of these new shares, you’ll have the opportunity to purchase 10% of the offering to maintain the same ownership percentage.

How exactly does this work? The company issues pre-emptive rights to its current stockholders to purchase these new shares. Investors receive one right for every share of stock owned.

You owned 50,000 shares in the beginning, so you’ll gain 50,000 rights. Each right will have a specific value - for example, you may need 5 rights to purchase 1 full new share. Don’t worry about doing any math to figure this out, though. The questions you’ll see on the exam will give you this information.

For this rights distribution, we’ll keep it simple. Let’s assume the following:

  • 1 right needed to purchase 1 new share
  • Current market price of stock = $50
  • Rights exercise price = $40

Rights have intrinsic value, which means they have immediate value. For each right that a stockholder has, they can purchase 1 new share from the company for $40, which is $10 cheaper than its current market value of $50. This is another way of saying the right is issued with $10 of intrinsic value. The company automatically provides this value because they’re saving money by avoiding the services of an underwriter.

You learned about underwriters when you prepared for the SIE exam. To refresh on the topic, underwriters are hired to help organizations market and sell their securities to the public. For example, when Facebook went public in 2012, they hired Morgan Stanley, JP Morgan and Goldman Sachs as their lead underwriters.

As a social media company, Facebook didn’t have the required resources or network to sell its stock in the financial markets. That’s why they hired large investment banks (underwriters). Underwriters are not cheap; Facebook’s underwriters collected hundreds of millions of dollars for their services.

If the company only sells new shares to current stockholders, an underwriter isn’t needed. Essentially, the savings are passed on to stockholders by offering shares at a discounted price.

When receiving rights, investors have a few options. Investors can exercise them and purchase the new shares at the exercise price. If an investor doesn’t want to buy the new shares, they may sell the rights in the market. Remember, rights have intrinsic value and another investor would be happy to purchase them for the right price. Last, investors can let the rights expire. Rights don’t last forever and typically expire within 60-90 days of issuance. Although it wouldn’t be smart, an investor could let them expire and not gain anything from them.

Sidenote
Case study: Bain Capital rights offering

To better understand rights, let’s analyze a real-world rights offering conducted by Bain Capital (ticker: BCSF):

The Company will issue to stockholders of record on May 13, 2020 transferable rights to subscribe for an aggregate of up to 12.9 million shares of the Company’s common stock. Record stockholders will receive one right for each share of common stock owned on the record date. The rights will entitle the holders to purchase one new share of common stock for every four rights held.

The subscription price for the shares to be issued pursuant to the rights offering will be 92.5% of the volume-weighted average of the market price of the Company’s shares of common stock on the New York Stock Exchange (NYSE) for the five consecutive trading days ending on the Expiration Date.

Bain Capital is doing an additional offering of 12.9 million shares, which they are giving the first rights to current shareholders to purchase. Shareholders on record (settled shareholders) on May 13, 2020 will receive rights that they can exercise, trade (transferable), or allow to expire.

Shareholders receive one right for every share of stock owned and can purchase one new share of stock for four rights. The subscription price will be 92.5% of the market price, which is a discount on the current market price.

Let’s assume an investor owns 100 shares of Bain Capital, which is trading at $10 per share. Can you figure out how many shares they can purchase and the price they’ll pay per share?

(spoiler)

Answer: 25 shares at $9.25/share

The investor owns 100 shares, giving them 100 rights. They can purchase one new share for four rights.

=

The subscription price is 92.5% of the market price, which is $10 per share.

If an investor wants to trade rights in the secondary market, there are two formulas that can be used to determine the value of a right. If the stock is trading cum-rights (with rights; before the ex-date for rights), this is the formula used:

Trading cum-rights means the stock is trading with rights. In the case study above, this formula would be used prior to May 13, 2020, which is the ex-date for the rights distribution. With the record date being May 13th, the investor must purchase the stock by May 12th to obtain the rights (T+1 settlement). If the stock is purchased on May 13th (ex-date), the investor will not receive the rights.

Let’s assume the same information provided in the case study:

  • Market price = $10
  • Subscription price = $9.25
  • Rights needed per new share = 4

Can you find the value of the right (cum-rights)?

(spoiler)

Answer: $0.15

On the ex-date for the rights distribution, the stock value will fall. The stock is worth slightly less as it no longer provides rights to investors. The formula adjusts slightly to factor out the falling stock price:

The only difference between the formulas is whether or not 1 is added in the denominator. Assuming the market price falls a little, let’s try an ex-rights calculation:

  • Market price = $9.85
  • Subscription price = $9.25
  • Rights needed per new share = 4

Can you find the value of the right (ex-rights)?

(spoiler)

Answer: $0.15

The value of. a right won’t always be exactly the same cum-right to ex-right, but it certainly can occur.

Try to simplify these formulas as much as possible. The only difference between the two is whether 1 is added to the denominator. An easy way to remember is with word association. “Cum” is Latin for “with,” and “ex” is Latin for “without.” In the cum-rights formula, add 1 (with). In the ex-rights formula, don’t add 1 (without).

By offering pre-emptive rights, companies provide stockholders the opportunity to maintain their percent ownership of outstanding shares. If a stockholder exercises all their rights, their ownership is not diluted.

Warrants

Warrants are very similar to rights as they provide the right to purchase shares from a publicly traded company at a fixed price. We’ll first discuss the characteristics of warrants, then compare and contrast them with rights.

Assume a company’s stock is trading at $50. If a warrant is issued, it will have a fixed exercise price, but at a premium to the market price. For example, let’s say a warrant is issued with an exercise price of $60. Up front, it makes no financial sense to exercise the warrant. Why would you purchase stock at $60 through a warrant, when you can just go to the market and purchase shares at $50?

Warrants have time value, meaning the length of time they exist gives them value. Sure, buying stock at $60 when the market price is $50 isn’t smart. However, warrants typically don’t expire for five or more years. The $60 exercise price remains fixed over that time, but the market price won’t. If the market price rises to $80 after a few years. Now, that exercise price of $60 sounds much better. This is why warrants can be valuable over time.

Warrants are usually issued as a “sweetener” during the sale of another security. For example, a company that’s having trouble marketing a new bond can make the offering more attractive by attaching a warrant to the bond. Remember those infomercials that offer a bunch of extra items? Buy this TV and we’ll give you a toaster for free! It’s kind of like that - buy this bond and we’ll give you a warrant for free!

The issuance of warrants is a dilutive action. If a publicly traded company issues warrants, they’re giving out new shares, but not to everyone. Therefore, the issuance of warrants requires stockholder approval.

Rights vs. warrants

In conclusion, warrants are similar to rights but have some distinct differences. Here’s a breakdown of the important points to know for the exam:

Rights

  • Right to purchase new shares at a fixed price
  • Intrinsic value exists at issuance
  • Little time value at issuance
  • Short term (typically 60-90 days or less)
  • Possible outcomes for rights:
    • Exercise
    • Trade
    • Expire

Warrants

  • Right to purchase new shares at a fixed price
  • No intrinsic value at issuance
  • Significant time value at issuance
  • Long term (typically 5 years or longer)
  • Possible outcomes for warrants:
    • Exercise
    • Trade
    • Expire

Additionally, here’s a video that will help you understand the type of question to expect on rights and warrants:

Key points

Rights

  • Right to purchase new shares at a fixed price
  • Provided to current stockholders during additional offerings
  • One right for every share owned
  • Intrinsic value exists
  • Little time value
  • Short term (typically 90 days or less)
  • Possible outcomes:
    • Exercise
    • Trade
    • Expire

Rights value (cum-rights) formula

  • Used prior to ex-date

Rights value (ex-rights) formula

  • Used on or after ex-date

Warrants

  • Right to purchase new shares at a fixed price
  • Issued as a sweetener with other securities
  • No intrinsic value
  • Time value exists
  • Long term (typically 5 years or longer)
  • Possible outcomes:
    • Exercise
    • Trade
    • Expire

Issuing warrants

  • Dilutive action requiring stockholder approval

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