Rights Issue, Margin Covenant, and the Cost of Taking Up Rights
Meridian Industrial announces a 3-for-7 rights issue at a subscription price of $8.40 per new share. The shares trade cum-rights at $11.20. A discretionary client owns 21,000 Meridian shares in a margin account with an $84,000 loan. The margin agreement requires loan-to-value (LTV) of no more than 50%, measured using the market value of pledged securities. The subscription deadline is 14 days away, and the client has no spare cash. The client wants to 'take up the rights because the discount looks attractive' but also wants to keep the account compliant. The nil-paid rights will list and can be sold. The client's adviser estimates that, immediately after the shares go ex-rights, Meridian will trade at the theoretical ex-rights price; ignore fees and taxes. The client asks whether to subscribe fully, sell all rights, or do something else.
1. Calculate the theoretical ex-rights price, the value of one right to buy one new share, the value per existing share, and the client's current LTV. Show your formulas.
Read the worked answer
Theoretical ex-rights price (TERP). TERP = [(7 x $11.20) + (3 x $8.40)] / 10 = ($78.40 + $25.20) / 10 = $103.60 / 10 = $10.36.
Value of one right to buy one new share. $10.36 - $8.40 = $1.96 per new share. Because 3 new shares are issued for every 7 existing shares, the value per existing share is (3/7) x $1.96 = $0.84.
Client's current position and LTV. Existing shares: 21,000 x $11.20 = $235,200. Loan = $84,000. LTV = $84,000 / $235,200 = 35.71%. The account is currently compliant.
Rights available. 21,000 x (3/7) = 9,000 new shares. Full subscription cost = 9,000 x $8.40 = $75,600.
Post-subscription values. Shares after full subscription: 21,000 + 9,000 = 30,000. At TERP, value = 30,000 x $10.36 = $310,800. New loan = $84,000 + $75,600 = $159,600. New LTV = $159,600 / $310,800 = 51.35%.
2. Does full subscription breach the 50% LTV covenant? What should the adviser recommend? Show at least one compliant path.
Read the worked answer
Yes, full subscription breaches the covenant. The post-subscription LTV is 51.35%, above the 50% limit. The client cannot simply instruct the adviser to subscribe fully using margin.
Maximum loan at 50%. 50% x $310,800 = $155,400. The loan would be $159,600, so the client is short by $159,600 - $155,400 = $4,200.
Compliant path 1: inject cash. If the client contributes $4,200, the loan stays at $155,400 and LTV is exactly 50.00%. This preserves the full rights take-up but requires cash the client says is unavailable.
Compliant path 2: sell enough rights. Let x be the number of rights sold. New shares = 30,000 - x; new loan = $159,600 - $8.40x - $1.96x = $159,600 - $10.36x; new value = $310,800 - $10.36x. Requiring loan no more than 50% of value gives x at least 810.8, so sell at least 811 rights. The client subscribes for 8,189 new shares, pays $68,787.60, receives about $1,589.56 from the rights sale, and the resulting LTV is approximately 50.0%. A small buffer above 811 is prudent because the market price may differ from TERP.
Compliant path 3: sell all rights. This raises about 9,000 x $1.96 = $17,640 and reduces the loan to $66,360; LTV falls to about 30.5%, but the client gives up the new shares and the discount.
Recommendation. Compare the client's liquidity and risk tolerance. If no cash is available and the client wants to retain most of the discount, sell at least 811 rights and subscribe for the remainder. Full subscription without cash or rights sales is not compliant. The adviser should also note that the actual ex-rights price and nil-paid rights price may differ from theory.