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A major friction in capital markets are information asymmetries, which can lead to mispricing of shares. Such mispricing is of particular concern for shareholders and investors at the time when new shares are issued. On the one hand, shareholders fear that their holdings get diluted due to underpricing. On the other hand, prospective investors worry that they may end up purchasing overpriced shares.

In this paper we compare public offering and rights offerings in a setting where only some current shareholders know the value of the investment opportunity and strategically choose to subscribe. In public offerings, firms announce the issue size, and both current shareholders and new investors can subscribe. In addition, the firm may offer current shareholders some guaranteed allocation of the newly issued shares up to their fractional ownership, which we refer to as dilution protection. In rights offerings, firms announce the issue size and offer short-term in-the-money call options, i.e., rights, to current shareholders on a pro-rata basis. Current shareholders receive the rights for free and decide whether to exercise or to sell them to other investors who then exercise them.

As we demonstrate, there is a simple solution to the informational friction – a rights offering with a sufficiently low strike price, such that even the most pessimistic shareholders exercise their rights. If all current shareholders exercise their rights, their fractional ownership in the firm remains unchanged and no shares are issued to new investors. Accordingly, any dilution to the existing shares caused by a low strike price is exactly offset by the gains on the new shares. Thus, right offerings can achieve the full information outcome and therefore dominate public offerings which necessarily generate wealth transfers.

We then show that this ranking is reversed when some of the existing shareholders are wealth-constrained. Such cash-poor shareholders fare better in public offerings than in rights offerings, despite the fact that they obtain proceeds from selling their rights, but receive no (extra) compensation in a public offering. Intuitively, rights have a positive value only if the strike price is lower than the equilibrium price in a public offering. Such a lower strike price implies that more new shares must be issued in rights offerings to fund the investment. However, rights are priced at a discount on average due to the winner's curse problem, similar to Rock (1986). This implies more dilution to the existing holdings, which is not fully compensated by the proceeds from selling the rights.

More generally, the flotation methods and terms can be ranked according to the ex-ante (before shareholders learn the firm type/value) wealth transfer between cash-rich and cash-poor shareholders. First, cash-poor shareholders lose more to cash-rich shareholders in rights offerings.

This transfer increases with lower strike prices, because more new shares have to be issued, thereby diluting cash-poor shareholders more without due compensation from the sale of the rights.

Second, the public offering with full dilution protection of current shareholders is equivalent to the rights offering with a strike price chosen such that the equilibrium rights price is zero. Intuitively, current shareholders in a public offering with full dilution protection can maintain their fractional ownership by subscribing, replicating the outcome of a rights offering. Conversely, a zero rights price implies that current shareholders who do not exercise but sell their rights receive no additional income. Hence, their payoff in this rights offering is the same as in the public offering with full dilution protection.

Third, public offerings with less dilution protection entail less wealth transfer between cash- poor and cash-rich shareholders since the latter can purchase fewer shares, thereby reducing the adverse selection problem. In the limiting case of zero dilution protection, cash-rich shareholders receive no new shares even when they subscribe and are therefore the same as cash-poor shareholders. Hence, there is no redistribution among current shareholders

Thus, cash-poor (and cash-rich) shareholders are neither indifferent about the offer method nor the chosen strike price in rights offerings, respectively the dilution protection in public offerings. By contrast, new investors always break even on average and are therefore indifferent about offer mode and terms.

In the second part of the paper, we analyze how firms choose offer mode and terms when knowing their type. To examine the choice of flotation method which now serves as a signal to uninformed investors, we assume that firms maximize the total payoff to all current shareholders, or equivalently, minimize the payoff to new investors. As we show, only two kinds of equilibria can exist. On the one hand, there exist pooling equilibria in which all firms choose the same public offering, or alternatively all firms choose the same rights offering. On the other hand, there exist equilibria with a single rights and a single public offering. In such an equilibrium, high and low quality firms opt for the rights offering, while intermediate firm types choose the public offer. Low quality firms prefer a rights offering to sell a larger fraction of their overvalued firms. High quality firms favour a rights offering because it allows cash-rich shareholders to maintain their fractional ownership, thereby selling fewer undervalued shares to investors.

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