This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
A stockholder who receives a valuable subscription privilege may make use of it, according to his own circumstances and judgment, in any one of the following ways:
1. He may actually purchase his share of the new issue at the special price, thus making an especially advantageous investment.
2. In case he does not have capital at hand for this purpose, he may decide to sell his "right" in the open market to some one else who would like to buy the stock or to speculate in the value of these "rights".
3. He may sell "short" - that is, without making delivery - an amount of stock equal to that which he may obtain at the special price under his subscription privilege; in this case he will later take up the stock to which he is entitled and with this stock make his delivery.
The first method is desirable if the stockholder happens to be in a position to buy of this particular stock at the time the privilege takes effect. As most people keep their money invested very closely, it is probable that most stockholders do not make use of their privilege in this manner.
The second method is the simplest, and probably the one that is most used. For this very reason it usually involves more or less sacrifice. Very seldom has it happened that the market quotations for a "right" equal the theoretical value of the "right" as above calculated. There is likely to be a strong pressure to make sales on the part of numerous stockholders, with a limited demand, which naturally makes a price that is favorable to the purchaser rather than to the seller. For this reason many stockholders of considerable means prefer the third method. By selling "short" they take advantage of the optimistic feeling which is likely to maintain the price of the stock nearly up to its former level during the period immediately after the subscription privilege is announced, though the theoretical value of the stock may have considerably decreased. The stockholder who sells "short" under these conditions is taking very little risk inasmuch as he is certain to be able to make delivery when the subscription privilege takes effect and is usually able to sell under the most favorable conditions.
Whether the shareholder exercises his "right," sells it to some one else, or sells "short" and then delivers his new stock, is presumably a matter of indifference to the corporation. In any one of these cases, the stockholder is clearing a profit and the capital which the corporation desires to secure has been obtained.
A question which often arises is whether a corporation needs the support in such a transaction of an underwriting syndicate. This question will be touched upon later (Chapter XV).