A Note on the Rights Valuation Formula Commonly Presented in Finance Textbooks

Abstract:     
The approximate rights valuation formula provided in standard corporate finance textbooks is shown to imply the existence of arbitrage opportunities and, for reasonable parameter values, to significantly undervalue rights. The reason why the formula generates such pricing errors is that it ignores the time value of the subscription price and the option value embedded in a right. A discussion and examination of the factors that affect the size of the error is provided. A real-world rights offering example confirms that the approximate formula can lead to substantial pricing errors and suggests that in many circumstances, the approximate formula should be replaced by Smith's (1977) rights valuation formula.

JEL Classifications: G12, G32

Accepted Paper Series