Rights Issue Funding Gap and the Deadline Instruction
A listed company announces a 2-for-5 rights issue at a subscription price of IRR 4,200 per new share. The record date is next week; the current cum-rights market price is IRR 6,500. A client holds 15,000 shares purchased at IRR 6,300 and has IRR 10 million cash in the brokerage account. The rights will trade for 10 days, and the subscription deadline is 20 days after the record date. The client instructs: "Subscribe for as many new shares as possible, but do not send any cash until I sell enough rights to cover the cost." The broker does not extend credit and settlement is T+2. The client also asks whether to sell the rights now or wait until the deadline. What should the dealer calculate and recommend?
1. Calculate the theoretical ex-rights price, the value per right, the full subscription cost, and the funding gap.
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The 2-for-5 ratio means 2 new shares for every 5 existing shares. The client's 15,000 shares entitle him to 15,000 × 2/5 = 6,000 new shares. Full subscription cost = 6,000 × IRR 4,200 = IRR 25.2 million. TERP = (5 × 6,500 + 2 × 4,200) / 7 = (32,500 + 8,400) / 7 = IRR 5,842.86. Value per right certificate = 6,500 − 5,842.86 = IRR 657.14, equivalently (6,500 − 4,200) / 3.5. The client has 15,000 rights, so their total theoretical value is about IRR 9.86 million. With IRR 10 million cash, even selling all rights at theoretical value yields only about IRR 19.86 million - a funding gap of about IRR 5.34 million. Therefore the client cannot subscribe for all 6,000 new shares without depositing more cash or arranging another source of funds. If partial subscription is permitted, the maximum affordable subscription is about IRR 19.86 million / IRR 4,200 ≈ 4,728 shares, subject to the company's rules on partial exercise.
2. How should the dealer respond to the instruction to wait until the deadline to sell rights, and what alternatives should be offered?
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The instruction is operationally risky. The rights trading period is only 10 days, while the subscription deadline is 20 days; if the client waits until the subscription deadline, the rights may no longer be tradable. Selling on day 10 would settle on T+2, around day 12, which is before day 20, but the sale price is not guaranteed and the proceeds may be less than assumed. More importantly, the total theoretical value of all 15,000 rights is about IRR 9.86 million, which does not cover the IRR 15.2 million gap after using the IRR 10 million cash. The dealer should explain that "subscribe for as many as possible without sending cash" cannot be met in full. Alternatives are: deposit at least IRR 5.34 million and subscribe fully; sell part of the rights during the trading window and subscribe partially if the company permits; sell all rights and accept dilution; or sell the existing shares. The dealer should not execute a subscription without cleared funds and should document the client's written choice. Waiting until the last moment should be discouraged because liquidity in rights can dry up.
3. What dilution and market-signal issues should the client understand before choosing?
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If the client does not subscribe, his ownership percentage falls because new shares are issued at a discount. Before the issue he owns 15,000 shares; after full subscription he would own 21,000 shares. If he sells all rights, he receives cash but retains only 15,000 shares in a larger share count, so his economic stake is diluted. The rights price itself is a market signal: a deep discount to the cum-rights price makes the rights valuable on paper, but the price can fall if the market expects the expansion to be value-destructive or if liquidity is poor. The client should compare the TERP with the current market price and with his purchase cost of IRR 6,300. The dealer should not promise that the rights will sell at theoretical value. The recommendation should be based on the client's cash capacity and risk tolerance, not on the hope that rights sale proceeds will arrive in time. All instructions should be confirmed in writing, especially any instruction to sell rights or to subscribe partially.