What is wrong with rights issues?
Introduction
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 sell the stocks that they purchase under the open offer to other parties. The change in the UK occurred much later than the US, with the shift occurring in the 1990’s.
The purpose of this paper is to examine why this shift has occurred, and discover what academics believe to be wrong with rights issues. In order to achieve this goal two papers on the subject will be reviewed. The first paper to be reviewed will be Eckbo and Masulis (1992) and the second will be Armitage (2007). Once both papers are reviewed there will be a conclusion which will compare the two and conclude on their main contribution to knowledge.
Eckbo and Masulis (1992)
Background
Eckbo and Masulis (1992) open their paper by explaining the decline in rights issues and the surge in firm commitments. To show this Eckbo and Masulis use a sample of 1,249 equity offers between 1963-1981.
Eckbo and Masulis highlight the puzzle Smith (1977) presents. Smith finds that rights issues have lower costs than firm-commitments. Smith also states that the rights issuer can assure the success ...
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... that selling large blocks of shares plus rights is rather costly and means the apparent cost advantage of rights issue is illusory. The cost of selling new shares plus rights has not previously been documented as a material cost in rights issues.
Both the papers are credible in their own right and provide answers for the decline in rights issues. Eckbo and Masulis (1992) is more credible for US markets and Armitage (2007) is more credible for the UK markets. However, Armitage (2007) may be the more credible paper as it finds the long run abnormal returns following rights issues with pre-renounced shares are not consistently negative or significant, which would suggest the issuers were fairly valued. This finding slightly disproves Eckbo and Masulis (1992) abnormal return results and over/under valuation theory but Eckbo and Masulis (1992) sample is much greater.
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