Market Price

Merrowfield Textiles sets the subscription price in its rights offering relative to the current market price of its common stock. What relationship would you expect?

1. A.Equal to the market price, so that no holder is advantagedWrong. With no discount a holder would buy in the market instead, and the offering would fail.
2. B.Above the market price, to maximize the capital raised per shareWrong. Pricing above market makes the right worthless and guarantees the raise falls short.
3. C.Set by the exchange based on the average price over the prior quarterWrong. The issuer and its underwriter set the subscription price; exchanges do not price offerings.
4. D.Below the market price, giving the right intrinsic valueCorrect. The discount is the incentive to subscribe and the source of the value of the right.

Why: A rights offering only works if shareholders find it worth exercising, so the subscription price is set below the prevailing market price. That discount is what gives a right intrinsic value and what makes a holder who does nothing worse off, since the discount is captured by whoever does subscribe. The size of the discount is a judgment about how certain the issuer wants the raise to be. If the subscription price were set at or above market, holders would simply buy shares in the open market instead and the rights would expire worthless.

Marchetti and Co. took a block of stock into inventory a week ago at 24.00. The market has since fallen and the prevailing price is now 20.00. The firm sells the shares to a retail customer at 25.20 as principal, arguing the charge is fair because it is only five percent above the firm's own cost. Which statement is most accurate?

1. A.The firm is correct, because a dealer is entitled to recover its inventory cost before any markup is measuredWrong. Nothing entitles a dealer to pass an inventory loss to a customer as a cost of the customer's trade.
2. B.The markup is measured from the 20.00 prevailing market price, making the charge 5.20, and the firm's inventory cost does not justify itCorrect. The benchmark is where the security trades now, so the charge is far larger than the firm's framing suggests.
3. C.The firm is correct so long as the confirmation discloses both the firm's cost and the price chargedWrong. Revealing an unfair price does not make it fair; the standard tests the charge, not the disclosure about it.
4. D.The fair-pricing analysis does not apply because the firm acted as principal rather than as agentWrong. Fair pricing reaches markups and markdowns on principal trades just as it reaches agency commissions.

Why: The reference point for a markup is the prevailing market price at the time of the customer's transaction, not what the dealer paid for its inventory. A dealer that bought high and watched the market fall has taken a position loss, and that loss belongs to the dealer; charging it through converts the firm's trading risk into the customer's cost. Measured properly the customer is paying 5.20 over a 20.00 market, roughly 26 percent, which no fairness analysis supports. Had the firm's cost sat near the current market, the same price would still have to be tested against the market — the cost simply never becomes the benchmark.