Rights and Warrants

Rights and warrants are equity-related securities that give holders the ability to purchase common stock. While they share similarities, they serve different purposes and have distinct characteristics that Series 7 representatives must understand.

Stock Rights

Stock rights (also called subscription rights or preemptive rights) give existing shareholders the opportunity to purchase additional shares before a public offering, maintaining their proportional ownership in the company.

Preemptive Rights

Preemptive rights protect shareholders from ownership dilution when a company issues new shares. Without these rights, new share issuance would reduce existing shareholders' percentage ownership.

Example: An investor owns 10% of a company with 1 million shares (100,000 shares). If the company issues 500,000 new shares without preemptive rights, the investor's ownership drops from 10% to 6.67% (100,000 ÷ 1,500,000).

Rights Offerings

In a rights offering, the company issues rights to existing shareholders, typically allowing them to buy new shares at a subscription price below the current market price.

Key characteristics of rights:

• Short-term instruments (typically 30-45 days)
• Usually trade on exchanges during the subscription period
• One right is issued per existing share
• Multiple rights are typically needed to purchase one new share

Rights Value Calculations

Rights have intrinsic value when the market price exceeds the subscription price.

Cum-Rights (Rights-On) Value: When stock still trades with the rights attached

Value = (Market Price − Subscription Price) ÷ (Number of Rights + 1)

Ex-Rights Value: When stock trades without the rights

Value = (Market Price − Subscription Price) ÷ Number of Rights

Example: A stock trades at $50 cum-rights. Shareholders need 4 rights plus $40 to buy one new share.

Cum-rights value = ($50 − $40) ÷ (4 + 1) = $10 ÷ 5 = $2 per right

After the ex-date, if the stock trades at $48: Ex-rights value = ($48 − $40) ÷ 4 = $8 ÷ 4 = $2 per right

Rights Options

Shareholders receiving rights can:

1. Exercise the rights—purchase additional shares at the subscription price
2. Sell the rights—capture the value without additional investment
3. Let them expire—lose the value (not recommended)

Warrants

Warrants are long-term securities that give the holder the right to purchase common stock at a specified exercise price. Unlike rights, warrants are typically issued as "sweeteners" to make other securities (like bonds) more attractive.

Warrant Characteristics

Why Companies Issue Warrants

Companies attach warrants to securities to:

• Lower the coupon rate on bonds
• Make offerings more attractive to investors
• Raise additional capital if warrants are exercised

Example: A company issues bonds with a 5% coupon plus detachable warrants. Without warrants, the bonds might require a 6% coupon to attract buyers.

Warrant Valuation

Warrants have two components of value:

Intrinsic Value = Market Price of Stock − Exercise Price (if positive)

Time Value = Premium paid above intrinsic value for potential future appreciation

Warrants with exercise prices above the current stock price have no intrinsic value but may still have time value based on the stock's potential to rise before expiration.

Rights vs. Warrants Comparison

Dilution Effects

Both rights and warrants can cause dilution when exercised because new shares are created:

• Earnings per share decreases (same earnings, more shares)
• Existing ownership percentage decreases
• Book value per share may change

However, the company receives capital when securities are exercised, which may offset dilution effects if invested productively.

On the Exam

The Series 7 exam frequently tests:

• Calculating rights values (both cum-rights and ex-rights formulas)
• Distinguishing between rights and warrants based on characteristics
• Understanding the purpose of preemptive rights
• Knowing that warrants are typically long-term while rights are short-term