Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
Studying Market Reaction to Right Share Offers in
Bangladesh
Dr. Sharif Nurul Ahkam and Tawfiq Mostafa
We have examined the right offers made between January 2010 to
October 2012 by companies listed on the Dhaka Stock Exchange and
tested the speed of adjustment of market price of the issuers to the right
issues. The analysis leads to the conclusion that the adjustment is not
immediate, the market price is about 10-11 percent higher than the right
adjusted price on the average and the difference is statistically
significant. It takes about 15 days for the market price to reach a stage
where the difference between the market price and right adjusted price
is no longer statistically significant. This delay in adjustment can
actually lead to a profitable strategy for investors in which the investor
holds the stock till record date and then sells the stocks at the first
opportunity after the record date.
1. Introduction
Right issues and seasoned issues have received considerable attention of researchers. When
a firm chooses to raise new equity capital by offering shares to the general public, usually
through an underwriter, such a mode of offer is known as seasoned issue and it is prevalent in
the USA. In rest of the world, especially Europe and Asia, new offers are generally made
exclusively to the existing shareholders usually at a price which is substantially lower than the
market price and such an offer is known as a right offer. In some countries, firms are required
to make right offers to existing shareholders first in order to respond to probable dilution of
control of the business. In some cases, the firms’ articles take the option of an issue to the
general public out.
In Bangladesh, right offers are the norm when a firm chooses to raise new equity capital.
Usually, existing shareholders can take up new shares at a certain stated proportion to their
holding at the issue price which is generally substantially lower than the going market price.
The shareholder who is offered the rights, can choose to exercise or renounce in favor of a
nominated potential investors. Rights, however, do not trade independently in Bangladesh.
The most popular phenomenon researchers paid attention to is the market price reaction in
response to right offer announcements. Typically, event study methodology had been applied
to examine the phenomenon. Wood (1975) lists several reasons why there should be a market
price reaction. The most obvious one is the response to the lower diluted earnings per share
(EPS). However, market probably will also factor in the potential of increased EPS that may
result from investing the new capital. Therefore, the profit margin on the new capital, if it could
be estimated would contribute to price reaction. A second contributor to price reaction may be
the leverage effect. New equity issue via rights reduce the leverage of the firm and hence the
present value of tax shield and should have a negative effect on the value. A third factor
influencing the price may result from an expected change in the dividend policy that may be
intentionally or unintentionally conveyed through a decision to issue right shares.
_____________________________________________________
Dr. Sharif Nurul Ahkam, Associate Professor, School of Business, North South University
Tawfiq Mostafa, Lecturer, School of Business, North South University
Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
In a well functioning or an efficient market, the market price should reflect the average
expectation of the market due to all these factors. Therefore, it makes sense to postulate that
we will see market reaction to a rights announcement around the announcement date. Typically
we should expect a decline in price when the right is announced. We, however, contend that
the traditional event study methodology is not appropriate for studying this. We put forward a
new methodology in this paper which, we believe is more robust. We will discuss this
methodology in the section following literature review that follows now.
2. Literature Review
Unfortunately, most of the recent literature on this topic in the South Asian region is
flawed. Raheja, Bhadwaj and Priyanka (2011) have only 10 samples and report that the
EPS actually went up after right issue, which is contrary to expectation. They also
report a decline in the market price of the issuing firms which is consistent with
expectation, but the decline is not proportional to the issue ratio. They do not report
whether the differences are significant or not. Lukose and Rao (2003) had a more
extensive study of 392 right issues of Bombay Stock Exchange companies spanning
1991-2000 and concluded that market valuation decline during the post-issue period after
a run up in the pre-issue period. Their results of the study suggest that people overinvestment in the cum-right period and agency models can better explain the decline in
performance compared to asymmetric information hypothesis. Rinne and Suominen (2007)
also reported positive run-up before public cash offers, followed by a negative long-run
underperformance for those stocks whose investors have highly dispersed opinions
(measured using the dispersion in analysts' earnings estimates).
A paper by Pathak and Giri (2007) provides some contrary evidence in Nepalese Stock
Exchange. There was generally no run-up prior to announcement, and decline was not
necessarily the norm. However, the trading in the sample stocks was very thin and any
conclusion drawn is suspect. (Unfortunately, due to printing mistake, it is impossible to
determine the time of the right offers.) Miglani (2011) studied 32 right issues made in the
period 1995-2010 in India using event study methodology and found statistically significant
abnormal return on the announcement and surrounding days.
Mehjabeen and Haque (2010) studied 25 right issues in Bangladesh spanning a period of
2001-2008 applying event study methodology and report that there were run-up prior to the
announcement followed by decline. (Unfortunately, all the tables the authors referred to are
missing.) The authors attribute the decline to negative signal indicated by a new stock
issue while it appears that they totally ignore the dilution effect.
Kabir and Rosenboom (2002) examined the Netherland stock market announcement effect
of rights issues and observe that a statistically significant stock price decline takes place
when companies announce rights issues. They also observe further stock price decline
during the subscription period. When they analyzed post-rights issue operating performance
of firms, they found that, consistent with the announcement period decline in stock price,
rights issuing firms subsequently exhibit a statistically significant decline in their operating
performance. Additional investigation of both stock and operating performance decline
Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
provides full support for the information asymmetry hypothesis, partial support for the free
cash flow hypothesis but no support for the window of opportunity hypothesis.
3. Fundamentals of Right Share Valuation
Assumptions
The following simplifying assumptions are made:
1.
2.
3.
4.
5.
Current market price reflects fair value of the stock and all available information.
No dividend of any kind during the right share offer window.
Share value is not expected to grow within the right share offer window.
Market value utilizes a discounting process to determine the present value.
All shareholders will subscribe for the additional issue.
The following symbols are used to develop the initial specification.
P0 = current market price (before right offer is announced.)
k = the discount rate
α = the fraction of shares issued for each share held.
Q = issue price. If the issue price is discounted by a fraction, β, then Q = (1- β)* P0.
Factoring in Dilutive Effect
When a firm announces α shares for every one share held, the shareholder will hold (1+α)
shares after subscription. After announcement, the intrinsic value of one share with a right
to acquire α share at market price is given by
Value of 1 share with a right = [(P0 + α* P0)/(1+α)]/(1 + k/m)n.
(Equation 1)
In the above equation, m may be taken as 360 to convert the discount rate to daily discount
rate and n is the number of days till the acquisition of the right share.
If the offer price is discounted by a factor of β, then the above equation takes the following
form:
Value of 1 share with a right = [(P0 + α*(1-β)* P0)/(1+α)]/(1 + k/m)n.
(Equation 2)
To illustrate, assume the current market price per share before the announcement is Taka 80
and now the firm announces a right offer of 1 share per one share held at an issue price of Taka
40. The nominal value of one share and the right becomes (P0 + α*(1-β)* P0) = 80 + 1*(1.5)*80 = Taka 120. The nominal value of each share then becomes Taka 120/(1+1) = Taka
60. This price is to take effect after issuance of the right shares. At 20 percent annual rate
and 90 days to actual disbursement, the present value of each share will be Taka
60/(1+.20/360)90 = Taka 57.07.
Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
The equation that we used, which was a very convenient formula, is better explained by an
example. Assume that a right offer is made where one share will be issued for every two
shares held on record date for an issue price of Taka 20. Suppose the market price of the
firm’s share on record date is Taka 100. Thus the shareholder has to hold two shares worth
Taka 100 each which gets him one share at Taka 20. Once the right share is issued, he will
hold three shares. The total value of his holding at the time of issue, assuming no other
influence on price will be 2*100+20, producing an average price of Taka 220/3 = Taka 73.33
which should be discounted to present time. Thus, the value of one share will be
Value of 1 share with a right = [2*100+20)/(2+1)]/(1 + k/m)n.
(Equation 3)
Once the right share offer is announced, the market should factor in the adjustment
discussed above and should decline in value to reflect the right offer until the offer is
completed. In the mean time, assuming no other intervening price influencing factor, the
share price will fluctuate primarily influenced by market movement.
4. The Test Design
As one can see from the above discussion, the price of the shares of a firm issuing right
shares at a discount should immediately decline when the market absorbs the dilutive
information in the rights issue. However, as we have stated earlier, several studies
indicated that there is actually a price run up around the announcement day. From casual
discussion with several traders in Bangladesh, it appears that many investors feel that there
is a window of opportunity to grab the right shares at a cheap price. In order to test if the
market makes the dilutive price adjustment, we propose the following test design.
First, let us just assume that rights were not being offered. Assuming no other price
influencing factors other than the general market movement, the stock price of the specific
firm may be predicted by the following equation:
Pjt = a + b Pmt
(Equation 4)
Pjt in the above equation is the market price of the specific stock j at time t and Pmt is the
appropriate market index at time t. The estimate of a and b in the above equation may be
obtained on the basis 50 price pairs before the announcement. However, the model used
here to forecast the prices post the record date is a very simple one and we will have to
continue our search for a better model. At this point, this may be an weakness in this test
design.
Once we obtain the coefficient values for equation 4 for a select stock, necessary number of
forecasts to cover the subscription period up to credit date will be obtained using the
estimated equation. If the slope in the estimate is statistically insignificant, then the last
available price just preceding the right offer announcements may be taken as the best
estimate of the later prices had there been no right offer announcement. So, if we have 50
instances of rights issue in our observation period, we will have fifty sets of forecasts
providing us the best estimate of prices had there been no rights offer.
Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
We will use the above to form the basis for adjustment for rights. With fifty samples, we will
have fifty projected prices with adjustment for rights for each of the days of prices we track
(after the record date). The adjustments were made using equation 2. The discount rate
we used is 25 percent. This is a reasonable rate for Bangladesh and is based on two
recent articles, one by Ahkam and Rahman (2011), and a second one by Ahkam and
Hossain (2013). After the forecasted prices adjusted for rights are obtained, those will be
paired with actual market prices for each of the stocks. The plots for our first sample looks
like the following.
Actual price Versus Right Adjusted Price of Firm X
Projected and Actual price of Stock
1,000.00
900.00
800.00
700.00
600.00
500.00
Actual price
400.00
Right adjusted
300.00
200.00
100.00
0.00
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61
Days since the record date
If the adjusted price minus the paired market price remains consistently below zero, the
conclusion will be that the market does not make adequate downward adjustment for the
dilution effect of the right issue. If the market price is consistently lower than the adjusted price,
the implication is that the market over-adjusts for the right issue. The difference should
disappear after the right shares are issued. Thus, the null hypothesis is as follows:
Ho : μdiff = 0
Ha: μdiff ≠ 0
In this structure, the paired difference for each day for each firm is to be computed. For each
day, there will be a sample mean difference which is the test statistic. This difference will be
obtained for 50 days and a t test will aid us to draw conclusions regarding the statistical
significance of the differences and at what point, the difference stops to be statistically
significant if it does so. The o0bserved t value is given by the following equation:
t = Average sample difference/ sd /√ (n-1)
In order to accomplish the above, the following steps will be taken:
1. Select sample firms with right offers in last three years.
Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
2. Obtain the announcement date, date of SEC approval, and ex-right date (record
date).
3. Obtain stock price of each stock for 50 days preceding the ex-right date and
corresponding DGEN Index values.
4. For each stock, estimate the forecasting equation Pj = a + bPm using the price of the
stock and DGEN Index values for 50 days preceding the ex-right date. (If b is
insignificant, the latest price will be used as the best estimate of pre-adjustment
price.)
5. Using the estimated forecasting equation for a stock, generate the pre-adjusted price
for each stock for the days necessary.
6. Complete the adjustment for rights using equation 2 till the credit date.
7. Obtain the corresponding actual market price of the particular stock. Pair them with
step 6 values.
8. Compute paired differences for each stock for the necessary number of days.
9. Test for significance and draw conclusions.
Samples
We have obtained data for 48 companies listed on the DSE offering right shares during the
period spanning January 2010 to October 2012. The following Table gives an indication of the
industry classification (according to DSE) of these companies. It may be worth mentioning that
banks and financial institutions were required to increase their capital base during the sample
period and banks resorted to issuing right shares for this purpose. It may be assumed the other
firms in the sample issuing right shares were not forced by regulatory reasons to issue new
shares but did so for their own needs such as financing expansion or rebalancing and
modernization.
One problem with the design explained above is that the length of the subscription period varied
from company to company. Moreover, the distances between credit date and record date are
also different for the sample firms. As a result, the actual number of days the price deviation
was observed was different for different samples. This resulted in fewer sample observation of
the price differences for firms which took longer time to credit the right shares. This meant that
the sample size needed to estimate the standard error of the paired differences varied. We
have determined a confidence interval of the differences to see how many days did it take on
the average for the actual price to fully reflect right adjustment and typically it was less than a
month.
Table: Industry Group of Sample Firms
Industry Groups
Banks and Financial Institutions
Insurance
Textile
Cement
Ceramic
All others
Total
Number of Firms Offering Rights
20
13
4
2
1
8
48
Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
5. Findings
Theoretically, the market price should reflect the dilution right after the record date. However,
that does not seem to happen. Of the 48 companies, only eight companies had market prices
drop enough to reflect 100 per cent adjust for rights. The other companies reflected significant
delays in the adjustment. To examine how many days it took for the stock price to adjust, first
we obtained a ratio of market price to the price that should reflect rights adjustment using the
equation below:
Price ratio=Right adjusted price (per equation 2)/Market Price
Doing this states the right adjusted price as a ratio of the market price where the standard
market price is Taka 1. Thus, a ratio of 0.9 will indicate that the market price is about 11
percent higher than what it should be. When the market price fully adjusts to right shares, the
ratio should be one.
We tracked this ratio starting from record date till credit date and for each day, we computed the
average ratio with the corresponding standard error. The results are presented in the following
chart. The middle line of the chart tracks the ratio of the prices from the record date. The upper
and lower curves are the 2 sigma confidence interval of the ratio. From the chart, we can
conclude that on the first day when the right adjustment should take place, market price is
significantly higher (about 11 percent on the average) than what it should be. Individually, the
prices of some firms are much higher than the expected right adjusted prices. The average
ratio remains lower than one until about the 35th day indicating that it may take that long for the
market to fully reflect the adjustment for right shares. However, the upper band pushes above
the value of 1 around the 17th day which will lead us to conclude that the price difference by that
time may be just due to random fluctuation.
Chart: Ratio of Right Adjusted Price to Market price
1.2
1
0.8
0.6
0.4
0.2
0
1
3
5
7
9
11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47
Ratio of Theoretical Price to Actual Price
Upper Band
Lower Band
If this pattern persists, then it leads to an obvious profitable strategy. Investors should buy and
hold the shares till the record date and should sell the stocks immediately after the record date
to take advantage of the higher than the correct price. This will allow them to grab the right
shares at significant discount and the new issues should jump to the theoretical price. Thus, a
window of opportunity may actually exist for investors.
It is somewhat baffling to see why some stocks are not adjusting to the right issue. Consider
the following chart depicting the price trend of a sample firm. The market price of this stock was
Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
Taka 577 (which did show some decline from previous price) while the right adjusted price was
Taka 512. It is truly puzzling to see some investors paying that much knowing (perhaps not
knowing) that the stock should not sell at any price higher than Taka 512.
Chart: Difference between Actual Market Price and Right Adjusted Price
100.00
50.00
0.00
-50.00
23-06-2010
30-06-2010
08-07-2010
15-07-2010
22-07-2010
01-08-2010
08-08-2010
16-08-2010
23-08-2010
30-08-2010
08-09-2010
19-09-2010
26-09-2010
03-10-2010
Market price-Right Adjusted Price
150.00
Paired Difference
-100.00
-150.00
Days after record date
6. Concluding Remarks
We would like to examine why there is such delay in adjustment. One reason may be
attributable to an error in the forecasting and adjustment models. For example, the
adjustment depends on the discount rate. However, it does not seem plausible that the
discount rate itself can explain the difference in the theoretical and actual price. The price
forecasting model may not be correct for some stocks, but we doubt that it will significantly
sway the average. For some companies, the announcement of the issue of right shares
may send a positive signal to the investors where the message is the new capital will be
invested in projects which will significantly improve the profitability of the firm. Overall, we
feel that the evidence is quite convincing that there is a statistically significant delay in
adjustment to the right issues.
If the pattern of delayed adjustment persists, then the obvious strategy for investors and
traders is to purchase the stock prior to the record date, hold on to it till the record date, and
sell it in the market at the presumably higher than true value at the first opportunity. While
the adjustment is immediate for some stocks, for most the price disparity is significant it
remains there for at least 15-17 days. Since the average price in the market is about 10-11
percent higher than the right adjustment price on the first trading day after the record date,
the strategy should yield decent return for investors. It would appear that this profit, which is
almost an arbitrage profit, will be made at the cost of those traders in the market who are not
sophisticated enough to determine the fair price reflecting the adjustment for rights.
The appeal for this strategy is so obvious that we think that the investors recognizing this
opportunity will seek out these shares just before the record date. We wish to extend this
study to test if the trading activities and volume increase significantly surrounding the record
date.
Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
We wish to extend this study in several other directions. The most immediate issue we wish
to test is if there is a difference in market response between and banks and financial
institutions which were required to increase their capital base versus nonbank nonfinancial
institutions which did not have to face any regulatory requirement to do so. Next, we would
like to see if the stock performance was better for investors of those stocks which quickly
adjusted to rights versus those firms which were selling above the right adjusted price during
the period between record date and credit date. This will be a comparison for those stock
holders who bought the stocks after full adjustment versus those who held on to the stocks
at prices above the right adjusted price.
A point that had been made in the literature is that firms do not immediately show the
benefits of new capital raised through right issues. Perhaps, it takes a couple of years for
the investments made with the new capital to generate the cash flows and profits that will
show up on the profit and market price performance figures. This will require tracking the
performance of these companies for at least three years post the right issue.
References
Ahkam, SN and Rahman, A 2011, Interest rates, risk premium, and cost of capital in
Bangladesh, Cost and Management, Vol. XXXIX Number 6, pp. 12-16.
Ahkam, SN and Hossain, SM 2012-2013, Estimating annual returns and cost of equity
capital in Bangladesh, North South Business Review, Volume 4 and 5, Forthcoming.
Kabir, R and Rosenboom, P 2002, Can the stock market anticipate future operating
performance? Evidence from equity rights issues, ERIM Report Series Research in
Management, pp. 1-42.
Lukose, JPJ and Rao, SN 2003, Operating performance of firms issuing equity through right
offer”, VIKALPA • VOL. 28, NO. 4, pp. 25-40.
Mehjabeen and Haque (2010), Effect of seasoned offerings on share price: Evidence
from Dhaka Stock Exchange, IRCMF Conference Proceedings in 2010, pp. 151-165
Miglani, P 2011, An empirical analysis of impact of right issues on shareholders returns
of Indian listed companies, Journal of Arts, Science, and Commerce, Vol. II, Issue 4, pp.
169-176.
Pathak, HP and Giri D 2007, Right share issue practice in Nepal, The Journal of
Nepalese Business Studies, Vol. 5, No. 1, pp. 93-100.
Raheja, R, Bhadwaj, R and Priyanka, 2011, Impact of right issues on MPS and EPS,
Journal of Banking, Financial Services, & Insurance Research, Vol. 1, Issue 4, pp. 77-87.
Rinne, K and Suominen, MJ, 2007, A Behavioral Theory of Public and Rights Offerings:
Empirical Evidence from Europe, http://ssrn.com/abstract=966156
Wood, IR, 1975, An analysis of the possible effects of a right issue on the issuing company’s
share price, The Penrose Press, pp. 33-40.