Size of the Offering

As far as the size of the rights issue is concerned, one could expect the discount to TERP to get bigger, the higher the amount of proceeds to be raised in the offering. Intuitively, this is due to the fact that a larger offering would normally lead to a higher level of uncertainty regarding the outcome of the issuance. In analyzing the actual amount of risk associated with the size of the rights issue, the following factors should also be taken into account:

• The relative size of the offering vs. market cap before announcement: More indicative than its absolute size, it also makes a comparison with previous (if any) rights issues.
• The relative size of the offering vs. average daily volumes traded (ADTV): Liquidity of the stock is an additional element to be taken into account when assessing the risk associated with the size of the offering.
• Precommitments from major shareholders to exercise their rights: The announcement that some existing shareholders have committed to use their rights reduces the amount of rights to be placed in the market and decreases the level of uncertainty associated with the offering. The amount of proceeds linked to a lack of commitment from existing shareholders is also referred to as market risk.
• The capital structure/level of capitalization following the rights issue: If the level of capitalization after completion of the offering is perceived by the market as inadequate, it is likely that investors will be less eager to exercise rights and the risk of not achieving a successful completion will be higher. This effectively results from the fear of possible future capital increases and is especially true for financial institutions subject to capital requirements.
• The time frame linked with a rights issue: All else being equal, a shorter timeframe reduces the risk of significant price fluctuations and might lead to a less conservative discount to TERP. Such time frames are often dictated by national legislation and may vary significantly from one country to another.

Market Environment

Market conditions are also an important component influencing the level of discount to TERP. Differently from the size of the offering, the issuer has less control on this characteristic, especially when the need to raise capital does not leave much flexibility on timing. In particular, the following factors will need to be carefully analyzed:

• Historical and implied volatility of equity markets: A higher volatility in the stock market will add risk to the offering and will normally require a larger discount.
• Historical and implied volatility of the specific stock: Similarly to the previous factor, risk increases with a higher stock volatility, but the impact on the level of the discount might be even stronger in this case.
• Market sentiment on the company and the sector: A negative outlook on the sector and specifically on the issuer will make subscription of new shares less attractive and will potentially induce the issuer to increase the discount. Vice versa, a positive market sentiment toward the sector and the company issuing new shares might provide more flexibility to the issuer on the level of discount to TERP.
• Relative valuation vs. peers: An attractive valuation of the issuer with respect to comparable companies will provide higher incentives for investors to subscribe for the newly issued shares and increase the chances of successful completion of the offering. For this reason, rights issues are often announced by the issuer together with the presentation of a new business plan, also with the aim of highlighting the strengths of the company and its potentially attractive valuation.

Previous Offerings

The level of discount in previous rights issues, especially if peers' previous issues are available, provides relevant guidance to the issuer regarding the proper level of discount to TERP. On the other hand, it is also an important reference for investors who will check how the discount compares to previous offerings and, in case of divergence, will try to understand the underlying reasons.

It goes without saying that any benchmarking with respect to previous offerings will need to take into consideration comparability across the different dimensions discussed earlier and in particular:

• Rights issue size as a percentage of market cap
• Market risk as a percentage of rights issue size
• Market risk as a percentage of market cap
• Time frame
• Market environment at time of issuance

Exhibit 16.2 summarizes how the different factors analyzed above may influence the level of discount to TERP set by the issuer.

Shareholders' Net Worth

Before announcement of the terms, the net worth of an investor whose only asset is a shareholding in the company is the following:

At announcement of the terms, the expected net worth of the investor will be equal to the sum of the expected value of its shareholding and the expected value of rights.

Assuming that (as one right is normally assigned to each existing share), and considering that , it is possible to express NW as follows:

It can be noticed that the level of net worth post-announcement is expected to be the same as before. In addition, such level does not depend on the discount to TERP set by the issuer.

Exhibit 16.7 compares the net worth of an existing shareholder before and after announcement of the terms for different levels of discount to TERP.

		Case 1	Case 2	Case 3
Market cap before rights issue announcement
Reference share price ($)	p	100	100	100
Outstanding shares (#)	n	1,000	1,000	1,000
Market cap ($)		100,000	100,000	100,000
Rights issue terms
Rights issue size ($)	S	20,000	20,000	20,000
Subscription ratio (new shares/old shares)	SR	1/5	1/4	1/2
Rights required to subscribe 1 new share (#)		5	4	2
New shares issued (#)		200	250	500
Subscription Price ($)		100	80	40
TERP ($)		100	96	80
Discount to TERP		-	17%	50%
Gross discount		-	20%	60%
Value of one right at announcement ($)		-	4	20
Investor's net worth before announcement
Shares owned (#)	ns	100	100	100
Net worth ($)		10,000	10,000	10,000
Investor's net worth at announcement
Value of shareholding ($)		10,000	9,600	8,000
Rights owned (#)		100	100	100
Value of rights owned ($)		-	400	2,000
Net worth ($)		10,000	10,000	10,000
Delta net worth ($)		-	-	-

From Exhibit 16.7 it is also possible to appreciate how the lower value associated with the shareholding as a result of a larger discount to TERP is compensated with a higher value of rights.

Dilution

The only way for an existing shareholder not to be diluted in a rights issue is to fully exercise his/her rights and subscribe for newly issued shares pro-quota. It is easy to show that the amount of cash that the shareholder needs to invest not to be diluted is independent of the discount to TERP and is equal to the portion of total proceeds corresponding to his/her shareholding in the company:

Any shareholder who is not willing to invest an amount of cash equal to C will be diluted as a result of a rights issue. The question is whether the extent of such dilution is impacted by the level of discount to TERP. As a larger discount to TERP results in a higher number of newly issued shares for a given amount of proceeds, one could be inclined to think that the dilution borne by an investor who does not intend to invest any additional cash in the company is higher for increasing levels of discount to TERP. In order to show why this is not the case, the concept of tail swallowing will be introduced.

In a tail swallowing, an existing shareholder decides to finance the purchase of new shares through the sale of rights. In particular, it is possible to compute the maximum number of new shares that can be bought in a cash-neutral transaction as follows:

1. NS: new shares that can be bought in a cash-neutral transaction

The shareholding of the investor in percentage terms following the tail swallowing can be computed as:

1. SH: investor's shareholding in percentage terms following the tail swallowing

Simple calculations will show that SH is not impacted by the level of discount to TERP and can be computed as the ratio of the value of the investor's shareholding before the rights issue to the expected market cap of the issuer following the rights issue:

Therefore, in terms of dilution, existing shareholders should be theoretically indifferent among the different possible levels of discount to TERP, even when they are not willing to participate in the offering.

Exhibit 16.8 compares the shareholding in percentage terms of an existing shareholder following the tail swallowing for different levels of discount to TERP.

		case 1	case 2	case 3
Market cap before rights issue announcement
Reference share price ($)	p	100	100	100
Outstanding shares (#)	n	1,000	1,000	1,000
Market cap ($)		100,000	100,000	100,000
Rights issue terms
Rights issue size ($)	S	20,000	20,000	20,000
Subscription ratio (new shares/old shares)	SR	1/5	1/4	1/2
Rights required to subscribe 1 new share (#)		5	4	2
New shares issued (#)		200	250	500
Subscription price ($)		100	80	40
TERP ($)		100	96	80
Discount to TERP		-	17%	50%
Gross discount		-	20%	60%
Value of one right at announcement ($)		-	4	20
Tail swallow for an existing shareholder
Shares owned (#)	ns	100	100	100
Shareholding at announcement		10%	10%	10%
Rights owned (#)		100	100	100
New shares bought in a cash neutral transaction (#)		-	4	25
Shares owned after tail swallowing (#)		100	104	125
Shareholding after tail swallowing		8.33%	8.33%	8.33%
Equivalent to		8.33%	8.33%	8.33%

In reality, other considerations might come into play and lead shareholders to prefer a higher or lower discount to TERP:

• Lower dilution for those investors who may not be familiar with the concept of tail swallowing (e.g., retail investors) in case of a lower discount
• Reduced execution risk associated with a higher discount
• Lower underwriting fees possibly associated with a higher discount (which reduces the risk borne by the underwriters)
• The possibility to appear stronger than other companies who have gone through the same process in previous years as a result of a lower discount to TERP