V Pattabhi Ram and A V Vedpuriswar
Wafers looked to be in shambles. The other morning she had bunked her CA classes. And now her friend’s notebook conveyed very little on the blessed “Rights Issue”. Wafers was clueless about what would constitute the best rights ratio and the best rights price. Would it be good for a company to offer more shares at a lower price? Say would a 2:1 (read two shares for every one held) ratio at Rs 25 be better than a 1:1 ratio at Rs 50? Two, it foxed her as to why stock prices changed during the rights offer.
Wafers poured her grief to China. She trusted him. Her senior at school by three years, the two had gotten along famously. He now studied at IIT, had an IQ of 160 plus, and one day hoped to work for the World Bank. The gang was at the coffee pub, generally chatting.
Oh how could she forget the pub? It was here, the previous fortnight, that the four of them had that large pasta. They had split it into four pieces and hogged like hungry dogs. The price: Rs 300 had shocked her. Cut into four, each piece had cost Rs 75. “So much dough for junk food?” she had wondered. Rinku, the journalist, always looking out for breaking stories, was half mad because he could have only one piece. The pasta had tasted great but Wafers wouldn’t let him have a second; it was too pricey!
Today, Muscles, the medical intern, told the floor captain that the pasta should not be cut. He wanted to do the honors himself! Knife in hand and a napkin tied around, with the pasta on the table, he looked like the surgeon that he would one day become. He sliced the pasta into 8 pieces. “What was your problem last fortnight?” he asked Wafers. “Each piece had cost Rs 75,” she said. “What does it cost now?” he asked smilingly. “Rs 37.5” Wafers responded, without battling an eyelid. “What was your problem last fortnight?” he asked Rinku. “I got only one piece,” said the scribe. “How much will you get today?” Muscles hissed. “Two”, said Rinku, a trifle annoyed. China, quick on the uptake, summed it up: “Last fortnight 1:1 at Rs 75. This fortnight 2:1 at Rs 37.5.”
“Where had she heard it before? 1:1 at 75. 2:1 at 37.5” wondered Wafers. And then it struck her. “Oh God. The rights ratio. And the rights price.” China egged her. “Are you better off today, than last fortnight?” “No”, she said. Last week I paid Rs 75 for a piece that was 6 inches long. This week I pay Rs 37.5 for two pieces, each 3 inches long.” China turned to Rinku. “Are you better off today, than last fortnight?” “No”, said the scribe. Last week I munched a piece 6 inches long. This week I munch two pieces, each 3 inches long.” The IITian closed out. “Ditto for rights issue. The rights ratio and the rights price do not increase the wealth of the shareholder. Just like the pieces of cake and its price didn’t make you eat more or pay more this fortnight than last.” Wafers screamed, “Lesson No 1.” The other diners turned around to her considerable embarrassment.
So the rights issue cannot increase the wealth of shareholders? Right? “Wrong” said China, reading Wafers’ mind. “If the rights money is invested in projects with positive NPV it would increase the wealth of the company and therefore of the shareholders”. If you add more wheat to the pasta, the size of the pasta would go up! “That’s fine”, said Wafers. “But how come the market price goes up immediately, pronto. After all, the NPV happens only after the event is over?”
Muscles decided to explain. “Suppose the four of us own a land whose market value is Rs 30 lakhs. Now if a geologist tells us that there are 4 kgs of gold underneath, what would happen?” Wafers said, “The value of the land would shoot up.” The doc asked, “By how much?” The CA intern replied, “If a kilo of gold costs Rs 5 lakhs, then by Rs 5 lakhs X 4 = 20 lakhs. Muscles continued with his Q&A mode of narrative. “So, the value of the land would jump to Rs 50 lakhs. But when would it happen?” If there was one thing Wafers hated more than taxation it was Muscles pontificating on finance. It almost always got her goat. “Ofcourse, immediately, silly”, she said. China jutted in smiling. He loved to see Wafers on the edge. “Provided the public believes in that information”. Oh, how could she have missed that wondered Wafers.
Rinku, yelled. “Hey, one correction. It may not go up by Rs 20 lakhs. After all it might take a year to dig the gold. So the land value would go up by the present value of the Rs 20 lakhs”. Wow! Wafers got into the groove. “Sorry, another correction. There is the money to be spent in extracting gold. So the value of the land will not go up by the present value of the gold but by the net present value. And it happens immediately.” She had hit the nail on the head.
The moral: if a project has a positive NPV and investors believe in it the market capitalization of the company goes up by the amount of positive NPV. The stock market discounts information ahead of time and so ups the price as soon as it receives information. “Lesson No 2”, said Wafers.
Rinku decided to play spoil sport. “What happens if at the year end instead of gold we find coal underneath the land?” China turned his eye towards Wafers. She didn’t disappoint him. “Well, simple. That day the price will crash”. The journalist wished to have the last word. “What if we found water?” Wafers wouldn’t allow him the pleasure. “Well, water is as precious as gold these days”. Even Muscles couldn’t help laughing.
As they finished sipping their coffee and began to check out of the restaurant, the floor captain remarked, “Hey folks, don’t start digging the ground. Even if you find gold underneath, under Indian laws, you will have to hand it over to the government!” What a distinct touché. Bravo, captain. Bravo.