1.4 Rights and Warrants

Stock Rights

Stock rights (subscription rights) let existing shareholders buy newly issued shares before the public, preserving their proportional ownership. They flow from preemptive rights, the antidilution protection many charters grant common holders.

Why Preemptive Rights Matter

Without preemptive protection, a new issue shrinks each holder's percentage. An investor owning 100,000 of 1,000,000 shares (10%) drops to 100,000 ÷ 1,500,000 = 6.67% if the firm sells 500,000 new shares and the investor does not buy in. A rights offering lets that holder buy enough new shares to stay at 10%.

Rights Offering Mechanics

In a rights offering the company distributes one right per outstanding share. A stated number of rights plus a cash subscription price (set below current market price) buys one new share. Key traits:

• Short-lived: usually 30–45 days to expiration.
• Tradable: rights trade in the secondary market during the subscription window.
• Issued only to existing shareholders.

Rights Valuation

Rights have intrinsic value when market price exceeds the subscription price. Two formulas — know which applies.

Cum-rights (rights-on) — stock still carries the right:

$\text{Value} = \frac{\text{Market Price} - \text{Subscription Price}}{\text{Rights to Subscribe} + 1}$

Ex-rights — stock trades without the right:

$\text{Value} = \frac{\text{Market Price} - \text{Subscription Price}}{\text{Rights to Subscribe}}$

The "+1" appears only cum-rights because the share price still embeds the value of the right itself. Example: stock at $50 cum-rights, 4 rights plus $40 buys a share → ($50 − $40) ÷ (4 + 1) = $2 per right. After the ex-date, if the stock is $48 → ($48 − $40) ÷ 4 = $2 per right. Both formulas reconcile because the share fell by the value of one right at the ex-date.

A Shareholder's Three Choices

1. Exercise — pay the subscription price and buy the discounted shares.
2. Sell — capture the rights' market value without adding capital.
3. Let expire — forfeit the value; never the recommended action.

Warrants

Warrants are long-term instruments granting the right to buy common stock at a fixed exercise price. Issuers attach them as sweeteners to bonds or preferred so the company can offer a lower coupon or dividend and still attract buyers.

Warrant Characteristics

A firm might sell 5% bonds with detachable warrants instead of plain 6% bonds, lowering its interest cost. If the stock later rises above the exercise price, warrant holders buy in and the company raises fresh capital.

Warrant Value

$\text{Intrinsic Value} = \text{Stock Price} - \text{Exercise Price} \quad (\text{floored at } 0)$

A warrant struck above the current stock price has zero intrinsic value but can still carry time value — the premium investors pay for the chance that the stock climbs before expiration. The long life of warrants makes time value far more significant than for rights.

Example: a warrant lets the holder buy stock at a $30 exercise price. With the stock at $42, intrinsic value = $42 − $30 = $12. If the warrant trades at $15, the extra $3 is time value. With the stock at $25 (below the $30 strike), intrinsic value is zero, yet the warrant may still trade at, say, $2 — entirely time value reflecting hope of future appreciation. At issuance, because the strike is set above market, warrants typically begin with no intrinsic value at all.

Worked Rights Subscription Example

Assume you own 600 shares and the company runs a rights offering: 1 right per share, 4 rights plus $20 buys one new share, stock at $26 cum-rights. You hold 600 rights, enough to subscribe to 600 ÷ 4 = 150 new shares for 150 × $20 = $3,000. The cum-rights value of each right is ($26 − $20) ÷ (4 + 1) = $6 ÷ 5 = $1.20. If you choose not to subscribe, selling all 600 rights yields roughly 600 × $1.20 = $720 — money you forfeit entirely if you let them expire. This is why "sell" beats "expire" on the exam.

How Rights and Warrants Originate

Rights are distributed in a rights offering as part of raising new equity from existing owners, often with a standby underwriter that agrees to buy any unsubscribed shares so the company is guaranteed its capital. Warrants are almost never issued alone — they ride along with a bond or preferred issue as a sweetener and are frequently detachable, meaning the warrant can be stripped off and traded separately from the host security. Recognizing the origin (rights from an equity offering to shareholders; warrants attached to a debt/preferred deal) is a fast way to tell them apart on a scenario question.

Rights vs. Warrants

Dilution

Exercising either instrument issues new shares, so EPS falls (same earnings spread over more shares) and existing percentage ownership shrinks. The offsetting benefit is the fresh capital the company collects, which can fund growth if deployed well.

Exam Focus

• Apply the correct cum-rights (÷ rights + 1) or ex-rights (÷ rights) formula.
• Distinguish rights (short, below market) from warrants (long, above market).
• Recognize preemptive rights as antidilution protection.
• Know warrants are sweeteners on bonds/preferred and that exercise dilutes existing holders.