Question 1

The market price of the stock of the Bruce Corporation is $60 per share and there are five million
outstanding shares of the company. Suppose that the management of this corporation is
considering a rights offering in connection with the issuance of 2,500,000 new shares. The terms
of the rights offering are as follows: for four rights and $40 (the subscription price), a new share
can be acquired. Answer the following questions;

a) How many old shares given one right to the current shareholders?

b) Suppose that you have 2000 shares of the company, how many rights do you have?

c) Suppose that you have 2000 shares of the company, how many new shares can you buy under
the rights offering?

d) What is the market price after the rights offering?

e) What is the value of one right?

f) Determine the dilution effect of this rights offering.

Answer:

A)

4/1= 1 new share

Old shares/new shares = 5,000,000/2,500,000 =1/2=0.5

So it means i have 1 right for 2 old shares, 1 right = 2 old shares

B)

As 1 right = 2 old shares

2000 = X shares

X= 1*2000/2= 1000

So I have 1000 rights for 2000 old shares

C)

As 2 old shares = 1 right

8 old shares = 4 rights = 1 new share

1 old share = 1/8 new shares

Now i have 2000 old shares so, 2000*1/8= 250 new shares. i can buy 250 new shares if i have 2000 old
shares.

D)

Market capitalization before right issue= 5,000,000*60= 300,000,000

Market capitalization after right issue= 300,000,000 + (2,500,000) = 400,000,000

Market capitalization = no. of shares outstanding * share price

400,000,000= 7,500,000 * share price

Share price= 400,000,000/7,500,000= 53.33 market price after offering

E)

Value of right= $60 - $53.33= $6.67 is the value of one right.

F)

Dilution effect of this rights offering is that share price declined from $60 to $53.33

Question 4

Why do callable bonds typically have higher yield to maturity than non-callable bonds, holding
all other things constant? Is the yield differential between callable and non-callable bonds likely
to be constant over time? Why?

Answer:

The callable bonds can be called by issuers at any time, especially when the interest rates are
declining/falling. When the interest rate declines significantly the issuer of the bond call the bond and
refinance the issue at a lower interest, which forces and leaves the investor with reinvestment risk. Due to
this nature of a callable bond the yield to maturity for callable bonds is usually higher than non-callable
bonds.

No, the yield differential between callable and non callable bonds cannot be constant over time because
callable bond value depends upon the interest rates. When interest rates are higher in the market then the
yield offered by the callable bonds will be high for investors to buy these bonds because of the risk
factors include in it, because of this uncertainty the yield to maturity for callable bonds is usually higher.

Question 3
The common stockholder is considered the residual owner of a corporation. What does it mean in
terms of risk and return?

Answer:

The common share holders are the ultimate owners of the firm. Common shareholders own the firm and
also take risk associated with the ownership. The common shareholders are only entitled to the residual
earnings of the company and as an owner of the firm the shareholders claims in time of liquidity in only
on residual assets while their liabilities are restricted to the amount of investment by the shareholders.

During liquidation of the firm, first claim of all creditors and preferred stockholders are settled in full
after those common stockholders have claims on residual assets.

The common shareholders in long term might get high returns due the market value appreciation of their
share and as being the real owners of the firm they also bear the losses.

Question 2

What is the primary objective of replacing full capitalization based methodology with free float
based methodology for KSE-100 Index composition? Also differentiate between Sector Rules and
Free-float Capitalization Rules for the recomposition of the index.

Answer:

Primary objective of replacing full capitalization based methodology with free float based methodology:

Free float based methodology:

Before discussing the details of why full capitalization based methodology was replaced with free float
based methodology, we needs to understand what is free float based methodology for 100 Index. Free
float is that proportion of a company total issued shares which are easily and in ready condition available
in stock market. All that shares which are in hands of controlling directors or with sponsors and
promoters or held by government and not available in market for trading are not included in free float
based methodology. Here to calculate the actual shares held by controllers, directors, government,
sponsors etc are subtracting from total outstanding shares.

Primary Objectives:

1 – Better Market Representation: while using calculations done by free floating method construction of
stock indices will represent the stock market better than that calculation done by companies total free
float market capitalization.

2 – Weight for Constituent Companies: by using free float methodology the constituent companies get
their weight as per actual liquidity while large capitalized company cannot influence the market highly.
3 – Market Observation and Risk Management: The Stock Exchange uses this methodology for market
observations, management of risk and other regulatory purposes.

Difference between Sector Rules and Free-float Capitalization Rules

Sector Rules

1 – Time based Rules: For a company to enter the index, it has to maintain its position as the largest in its
sector by any value for two successive re-composition periods.

2- Value based Rules: For a company to enter the index based on its value, it has to surpass the current
largest cap companies in it sector by 10% for one re-composition period.

Free Float Capitalization Rules

1 – Time Based Rule: For a company to enter the index it has to exceed the market cap value of its stock
for two success re-composition periods automatically deleting the lowest cap stock in the index.