Farnsworth Furniture Industries

Rights Offerings

Introduction

Farnsworth Furniture is one of the largest manufacturers of Early American furniture in the
United States, organized in 1932. The company experienced a steady rate o growth in the
post-World war II period, when the demand for housing was particularly strong. The key note
of Farnsworth is to provide value excellence of design, pride in quality craftsmanship, and
fair prices. Most Wall Street analysts point to this attitude of pride and the “family”
atmosphere of Farnsworth furniture Industries as the key elements of the company’s
outstanding market success.

In the mid-1980s, the demand for pine early American furniture increased because of falling
interest rates due to which homeowners were willing to spend extra money furnishing their
houses with long lasting quality furniture. The demand for Farnsworth furniture also
increased due to increasing families after World War II. Another reason for increasing
demand for Farnsworth was that many young adults who were setting up household for the
first time were making higher than average salaries and were not averse to “upscale”
consumption, including expensive furniture. To meet the increased demand, Farnsworth
Furniture Industries is undertaking a major capital expansion program with approximately
$45 million in new capital out of which $22.5 million has already been borrowed as a long
term loan form a group of five insurance companies. The loan agreement which was already
been finalized required Farnsworth to raise an additional $22.5 million through the sale of
common stock. The company is considering following alternative proposals:

Proposal 1
The company can go for initial public offering (IPO) at a subscription price of $48 per share.
Out of this amount $ 2.5 will be charged by an investment banker as a commission and the
company would receive $45.5 per share.
Proposal 2
The company can issue rights share to the existing shareholders at a subscription price of $45
and commission to the investment banker for the subscribed shares is $1.5 per share and the
company would net $43.5 .commission for the unsubscribed shares is $3.5 and in his case the
company would receive $41.5 per share.

Proposal 3
The company can issue rights share at a price of $40 per share with underwriting cost of
$0.75 for each share subscribed and $3.5 for each unsubscribed share purchased by the
investment banker.

Proposal 4
Sell shares to current stockholders at a subscription price of $25 with underwriting cost of
$0.25 for the subscribed shares by the stockholders and $3.5 per share taken by the
investment banker.

Proposal 5
Shares can be sold to current stockholders at a subscription price of $5 per share. Assistance
of the investment banker would not be necessary as the company could be quite sure that all
shares offered would be taken.

Major issues
 How can Farnsworth raise an additional $22.5 million in new equity funds?
 Which proposal would be best suited for Farnsworth Furniture Industries to raise the
additional fund through the sale of common stock?
 What would be the EPS and MPS of the company?
 What would be the number of shares outstanding for the company?
Case Analysis

1. How many additional shares of stock would be sold under each of the proposal
submitted by B. F. Hudson? Assume all shares are subscribed.
Solution

Funds Required = $22.5 million

Number of additional shares = Funds Required/ Price received per share
Price Received per Share = Subscription Price – Floatation Cost
If all the shares will be subscribed then the number of additional shares to be issued will
be:

Proposal 1 Proposal 2 Proposal 3 Proposal 4 Proposal 5

Subscription Price (Ps) $48 $45 $40 $25 $5
Floatation Cost $2.5 $1.5 $0.75 $0.25 -
Price Received per Share $45.5 $43.5 $39.25 $24.75 $5
No. of additional shares 494, 506 517, 242 573, 249 909, 091 4,500,000

2. How many rights will be required to purchase one new share under each of the four
rights proposals?
Solution

No. of rights required = No. of old shares

No. of new shares
No. of Outstanding Shares (old) = 4,000,000

Proposal 2 Proposal 3 Proposal 4 Proposal 5

No. of new shares 517, 242 573, 249 909, 091 4,500,000
No. of Rights Required 7.73 6.98 4.4 0.89
3. What is the market value of each right under each of the proposals? Do you think
that the average stockholder would bother to exercise the rights or to sell them at
these prices? Use the rights formula to answer this question.
Solution

Current market price (Po) = $49

Market value of each right = Po – Ps
α+1

Proposal 2 Proposal 3 Proposal 4 Proposal 5

Subscription Price (Ps) $45 $40 $25 $5
No. of Rights 7.73 6.98 4.4 0.89
Market value of right (MVR) $0.46 $1.13 $4.44 $23.28

An average stockholder would not bother either to exercise the rights or to sell them at
these prices. It is because if this price (Ex – right price) prevails in the market after issue
of the rights then the stockholder’s net assets would remain unchanged whatever
alternative is selected.

4. What is the price per share immediately after issue of new shares under each of the
four proposals? Use the rights formula to answer this question.
Solution

Using rights formula, the market price per share (MPS) will be the sum of Subscription
price and the product of value of right and number of rights. Therefore,

MPS (Ex Right) = Value of Right * No. of Rights + Ps

Proposal 2 Proposal 3 Proposal 4 Proposal 5

Value of Right $0.46 $1.13 $4.44 $23.28
No. of Rights 7.73 rights 6.98 rights 4.4 rights 0.89 rights
Subscription Price (Ps) $45 $40 $25 $5
MPS (Ex – Right) $48.56 $47.89 $44.54 $25.72
5. Selling stock through a rights offering with the subscription price set below the
current market price has an effect that is similar to that of a stock split or stock
dividend. What is the percentage of the stock dividend that would have to be
declared to have the same effect – that is, produce the same final price per share – as
each of the proposals for rights offering?
Solution

To have the same effect on final market price for stock dividend and rights issue,
following situation should prevail:

Stock Dividend (%) = (Current Total Wealth/ (Current Outstanding

Shares * Ex Right MPS) – 1) * 100%
Current Total Wealth = Current MPS * Current Outstanding Shares
Current Outstanding Shares = 4,000,000
Current MPS = $49
Current Total Wealth = $196,000,000

Proposal 2 Proposal 3 Proposal 4 Proposal 5

Ex Right MPS $48.56 $47.89 $44.54 $25.72
Stock Dividend (%) 0.91% 2.32% 10.01% 90.51%

6. Assume that the company increases its total assets by $22.5 million in net proceeds
by issuing common stock at the start of 1997? (Ignore all other sources of funds,
such as debt or retained earnings, for this calculation.) The company earns 10%
after interest and taxes on its beginning assets in 1997. Spelled out in more detail,
this implies that: (a) the company earns 10% after interest and taxes on total assets
in 1997; (b) the company obtained only $22.5 million of new equity financing during
1997; that is, the debt financing is deferred until 1998; (c) new outside capital is fully
employed during the entire year of 1997; (d) additions to retained earnings in 1997
are not employed until 1998; and (e) that current liabilities remain at their 1996
level. (Note: the company’s stock issue was sold to the market for more than $22.5
million, but the investment bankers retained the difference to cover floatation
charges. Therefore, capital stock increases by exactly $22.5 million.) What will the
rate of return on net worth, earnings per share, and the price per share of the stock
(assuming a price/ earnings ratio of 20) be in 1997 under each of the alternative
methods? Do not use the formula to answer this question.
Solution

The Balance Sheet of Farnsworth at year end 1997 will look like following after the issue
of shares worth $22.5 million:

Assets Amount ($) Capital & Liabilities Amount ($)

Total Current Liabilities 35,500,000
Long Term Debt 30,000,000
Capital Stock 42,500,000
Retained Earnings 55,950,000
Total Assets 163,950,00 Total Capital & Liabilities 163,950,000
0

Now,
Total Assets = $163,950,000
Net Income of the year = 10% of Total Assets
= 10% of $163,950,000
= $16,395,000
Net Worth = Capital Stock + Retained Earnings
= $42,500,000 + $55,950,000
= $98,450,000
No. of Shares Outstanding (Old) = 4,000,000
Price Earning Ratio (PE Ratio) = 20

Particulars Proposal 1 Proposal 2 Proposal 3 Proposal 4 Proposal 5

Net Income (Million $) 16,395,000 16,395,000 16,395,000 16,395,000 16,395,000
Net Worth (Million $) 98,450,000 98,450,000 98,450,000 98,450,000 98,450,000
Return on Net Worth 16.65% 16.65% 16.65% 16.65% 16.65%
No. of Additional Shares 494, 506 517, 242 573, 249 909, 091 4,500,000
Total Outstanding Shares 4,494,506 4,517,242 4,573,249 4,909,091 8,500,000
EPS 3.65 3.63 3.58 3.34 1.93
PE Ratio 20 20 20 20 20
 MPS $73 $72.60 $71.60 $66.80 $38.60
Return on Net Worth = Net Income/ Net Worth * 100%
Total No. of Outstanding Shares = No. of Outstanding Shares (Old) + No. of
Additional Shares
Earnings per Share (EPS) = Net Income/ Total Outstanding Shares
Market Price per Share (MPS) = PE Ratio * EPS

7. Why do the price–per–share figures in Question 6 differ from those found in

Question 4? Which seem more realistic?
Solution

The summary of Ex Right MPS from Question 4 and Question 6 under each rights
proposal is given below:

Proposal 2 Proposal 3 Proposal 4 Proposal 5

MPS (Q 4) $48.56 $47.89 $44.54 $25.72
MPS (Q 6) $73 $72.60 $71.60 $66.80

The price–per–share figures in Question 6 differ from those found in Question 4 because
the share price figures in Question 6 are the year end price and takes in to account the
10% net income after interest and taxes on Total Assets for year 1997 as well besides the
issue of new capital. On the other hand, the share price figures in Question 4 are that of
the beginning of year and consider only the addition to share capital and not the earnings
of the year 1997. Due to this, the EPS in Question 6 are higher than those in Question 4
and thus, higher MPS.

The price–per–share figures in Question 4 seem more realistic because it contains fewer
assumptions than in Question 6. Question 6 assumes that the company will earn 10% net
income after interest and taxes on Total Assets in year 1997 and that the Price/Earning
Ratio of the company is 20. These two assumptions are realistic and hence, the figures
 are not realistic as well. Since Question 4 does not contain such assumptions, the figures
are more realistic.
8. What are the maximum and minimum floatation costs under each of the proposals?
Assume that the probability of the subscription percentage may be estimated by
using the following probabilities for maximum and minimum floatation costs:

Proposal 1 2 3 4 5
Probability of no rights being exercised - 0.30 0.20 0.10 0.00
Probability of 100% of the rights being exercised - 0.70 0.80 0.90 1.00

What are expected floatation costs as a percentage of gross funds raised under each
proposal? What specific conditions might generate the maximum cost?
Solution

The maximum and minimum floatation costs and the expected floatation costs as a
percentage for each of the proposal are calculated below:

If no rights are exercised then all the shares will be absorbed by the underwriter. In this
case the number of shares to be issued would be calculated as follows:

No. of shares to be issued = Total Fund Required/ Price received per share
Price received per share = Subscription price – Underwriting cost

Proposal 2 Proposal 3 Proposal 4 Proposal 5

Funds Required $22,500,000 $22,500,000 $22,500,000 $22,500,000
Subscription Price $45 $40 $25 $5
Underwriting cost $3.50 $3.50 $3.50 -
Price received per share for unsubscribed shares $41.50 $36.50 $21.50 $5
No. of new shares to be issued 542,169 616,439 1,046,512 4,500,000

Now calculating Floatation costs and percentage floatation costs:

Under Proposal 1
The maximum and minimum floatation costs are the same for proposal 1 because there is
only one category of underwriting commission. Hence, the expected floatation cost is also
the same as floatation costs.

Expected Flotation Cost = Flotation Cost

= Number of shares to be issued * Floatation cost per share
= 494,506 * $2.5
= $1,236,265

Expected Flotation costs in percentage = Expected floatation cost/ Funds Required

= $1,236,265/ $22,500,000 * 100%
= 5.49%

Under Proposal 2
Probability of no rights being exercised = 0.3
Probability of 100% of the rights being exercised = 0.7

If no rights are exercised:

Flotation Cost = Number of shares to be issued * Floatation cost per share
= 542,169 * $3.5
= $1,897,592
This is the maximum flotation cost under this proposal.

If the shares are fully subscribed by the shareholders:

Flotation Cost = Number of shares to be issued * Floatation cost per share
= 517,242 * $1.5
= $775,863
This is the minimum floatation cost under this proposal.

Expected flotation cost = 0.3 * $1,897,592 + 0.7 * $775,863

= $1,112,382

Expected Flotation costs in percentage = Expected floatation cost/ Funds Required

= $1,112,382/ $22,500,000 * 100%
 = 4.94%

Under Proposal 3
Probability of no rights being exercised = 0.2
Probability of 100% of the rights being exercised = 0.8

If no rights are exercised:

Flotation cost = Number of shares to be issued * Floatation cost per share
= 616,439 * $3.5
= $2,157,537
This is the maximum flotation cost under this proposal.

If the shares are fully subscribed by the shareholders:

Flotation Cost = Number of shares to be issued * Floatation cost per share
= 573,249 * $0.75
= 429,937
This is the minimum floatation cost under this proposal.

Expected flotation cost = 0.2 * $2,157,537 + 0.8 * $429,937

= $775,457

Expected Flotation costs in percentage = Expected floatation cost/ Funds Required

= $775,457/ $22,500,000 * 100%
= 3.45%

Under Proposal 4
Probability of no rights being exercised = 0.1
Probability of 100% of the rights being exercised = 0.9

If no rights are exercised:

Flotation cost = Number of shares to be issued * Floatation cost per share
= 1,046,512 * $3.5
 = $3,662,792
This is the maximum flotation cost under this proposal.

If the shares are fully subscribed by the shareholders:

Flotation Cost = Number of shares to be issued * Floatation cost per share
= 909,091 * $0.25
= $227,273
This is the minimum floatation cost under this proposal.

Expected flotation cost = 0.1 * $3,662,792 + 0.9 * $227,273

= $570,825

Expected Flotation costs in percentage = Expected floatation cost/ Funds Required

= $570,825 / $22,500,000 * 100%
= 2.54%

Under proposal 5
Probability of no rights being exercised = 0
Probability of 100% of the rights being exercised = 1.0

The subscription price is so less under this proposal that the company is so sure of selling
all the shares to current shareholders without the assistance of investment bankers. Since
there is cent percent probability that all the right will be exercised and that assistance of
investment banker is not required under this proposal, there are no floatation costs and
hence floatation cost in percentage is 0%.

9. What effects do you think a rights offering, as opposed to an offering to the general
public, would have on “stockholders loyalty” to the company?
Solution
 If the preemptive right is contained in the charter of the company, then the firm must
offer any new common stock to existing stockholders, which is called rights offering. The
terms and conditions of the rights offering are stated in a piece of paper called a right.

If the company undertakes rights offering, as opposed to an offering to the general public
then it would have great effect on the existing stockholders’ loyalty. In the right offering
the existing stockholders get the first option to buy any issue of new stock. The
subscription price is less than the current market price of the stock. Therefore
stockholders are able to buy additional shares at a price lower than the prevailing market
price. This would also preserve the control power and ownership of the existing
stockholders. There would not be any chance of reduction in earning per share of the
company; it means the earnings of the company would not be distributed among large
number of stockholders. Thus if company is offering the rights to its stockholders, it is
said to be showing loyalty to existing stockholders than by offering to the general public.

10. Examine advantages and disadvantages of each proposal and decide which method
of financing Hruska should recommend to the board of directors?
Solution

The summary of case analysis is given below:

Particular Proposal 1 Proposal 2 Proposal 3 Proposal 4 Proposal 5

Number of share outstanding 4,494,506 4,517,242 4,573,249 4,909,091 8,500,000
EPS 3.65 3.63 3.58 3.34 1.93
Ex-right price - 48.56 47.89 44.54 25.72
Price per share after 1 year 73 72.60 71.60 66.80 38.60
Floatation costs 5.49% 4.94% 3.45% 2.54% -

The advantages and disadvantages of each proposal are given below:

Proposal 1:
Advantages
 Allows greater distribution of stock
throughout the market
 It can attract knowledgeable investors
with genuine interest in the operations
and objectives of the company
Disadvantages
 Effects on the stockholders loyalty;
dilution in control power and earnings
 Higher floatation costs i.e. about
5.49% (generally IPO is sold at
discount price).
 If issued at minimal discount this will
result in minimum dilution in Market
price and Earning per share
 The company has to disclose the
Proposal 2:
Advantages
 Showing loyalty to the shareholders
by giving opportunity to maintain their
position at a discount.
 Rights offering at high subscription
price would result in the least amount
of dilution of EPS
 Lower number of shares
outstanding results in higher EPS
Proposal 3:
Advantages
 It provides an adequate margin of
safety against downward market price
fluctuations
 Protects the Shareholders form
excessive equity dilutions and gives an
appealing purchase at discount.
 Lower flotation costs than that of
proposal 1 and 2
Proposal 4:
Advantages
 Preserve the control power and
participation of the existing
shareholders
 Lower flotation cost comparing to
alternatives 1,2 and 3
 The resulting ex-right price would
appeal to a wide range of investors
 The company must conform to
Securities and Exchange Commission
(SEC) requirement, which is sometime
very stringent
sensitive information to the outsiders.
Disadvantages
 Absence of wider distribution of
shares
 High flotation cost among the
other four rights offering
alternatives.
 High subscription price caters to a
small percentage of the shareholders
who may have immediate funds
available for reinvestment, while
leaving the large percentage of
shareholders no choice but to sell
their rights.
Disadvantages
 Absence of wider distribution of
the shares
 High subscription price compels
large number of shareholders with no
immediate funds to sell their rights
 Provides adequate safety margin
but the ex-right price per share would
be above the optimum trading range
 Dilution in market price per share
Disadvantages
 Absence of wider distribution of
shares to outside investors
 larger number of shares
outstanding results in lower EPS
 Excessive equity dilution
  Subscription price of $25 put the
stock in a popular trading range

Proposal 5:
Advantages
 Preserves the control power and
earnings of the existing shareholders
 Low subscription price or $5 per
share would appeal to a wider range or
shareholders
 There would be greater chance of
acceptance of the rights by existing
shareholders
 It will enhance the shareholders
relations and maintain sound agency
relationship in the company.
 It eliminates the need for assistance
of investment bankers; this will reduce
the flotation cost.
Disadvantages
 Absence of wider distribution of
shares
 If the subscription price is low
then the amount of capital would be
low and number of shares would be
large which is not good for company
and investors.
 Absence of assistance form
investment bankers means the risk of
not subscribing the shares by
stockholders should be borne by the
company itself
 This proposal goes to opposite
extreme and neglects the hard-earned
reputation of the company’s share
price.

Final Decision:
After analyzing each of the alternatives separately we arrive to the conclusion that the
Hruska should recommend the proposal 4 to the board of directors as the best method of
common stock financing. Proposal 4 seems to be more favorable than other alternative
proposals, because of the following reasons:

 This method of financing preserves the control power and earnings of the existing
shareholders, which shows that company is showing loyalty to its shareholders. This
will also reduce the agency problem and enhance the shareholders relationship.
 The floatation cost is low comparing to proposal 1, 2 and 3. But it is higher than that
of proposal 5, yet this proposal is better than proposal 5 because the company does
not have to bear the risk of not exercising the rights by the existing stockholders due
to the absence of agent or intermediary (i.e. Investment Bank).

 Low Subscription price of $25 put the stock in a popular trading range and the
resulting ex-right price would appeal to a wide range of investors. This means there is
very low chances of not subscribing the shares by the existing shareholders.