* Launches rights issue with bigger-than-expected discount
* Second part of three-stage, 3 bln euro fundraising
* Rights issue at a 41 pct discount
* Shares surge in afternoon trading (Updates with board appointments, closing shares)
By Laurence Frost
PARIS, April 29 (Reuters) - French carmaker PSA Peugeot Citroen launched the second stage of a long-awaited 3 billion euro ($4.2 billion) capital increase to fund its "Back in the Race" recovery plan and tie-up with China's Dongfeng .
As its new board met on Tuesday, the troubled firm surprised markets by issuing more stock than expected at a larger discount to raise 1.95 billion euros from existing shareholders.
Peugeot shares surged in afternoon trading, outpacing a broader European stock rally on hopes that recovering regional demand can help the recapitalized carmaker rebound.
The rights issue, in addition to a 1.05 billion stock sale to the French state and Dongfeng Motor Group, allows investors to purchase seven new shares at 6.77 euros for every 12 held, a 41 percent discount to Monday's comparable closing price.
That means future dividends will be divided among 877 million outstanding shares, a greater number than many analysts had anticipated.
"Our share price target is likely to halve on the back of this transaction," said Mike Dean of Credit Suisse.
The extent of existing shareholders' dilution is "further negative news for Peugeot following an underwhelming 'Back in the Race' presentation," the London-based analyst said.
But the stock reacted positively, building on tentative morning gains to close at 12.73 euros - a 10.6 percent advance excluding the mechanical effect of a parallel warrants issue that had cut the price by 1.53 euros overnight.
The rally was "probably a reflection of people being relieved" at the company's refinancing progress, said Erich Hauser of ISI Group, which had trimmed its Peugeot rating to "neutral" from "strong buy" following the Feb. 14 strategy presentation by new Chief Executive Carlos Tavares.
The former Renault second-in-command has pledged to simplify model lineups and slash production costs in pursuit of a 2 percent operating margin goal for 2018, rising to 5 percent by 2023.
The capital hike will see the French government and state-owned Dongfeng each acquire 14.1 percent of the carmaker, which posted more than 7 billion euros in net losses for 2012-13, as well as take two board seats each.
Meeting for the first time on Tuesday under new Chairman Louis Gallois, the board named his predecessor Thierry Peugeot as one of three vice-chairmen, alongside representatives of Dongfeng and the French state.
Peugeot said the rights issue subscription period would run from May 2-14, underwritten by a syndicate led by BNP Paribas, Morgan Stanley and seven other major banks. Settlement, delivery and listing of the new shares will take place on May 23.
The deal terms imply that Peugeot shares would be valued at seven times forecast 2015 earnings after the capital hike, compared with a multiple of 4.1 beforehand, Paris-based brokerage Exane said.
That valuation is higher than profitable rival Renault, at 6.6, and not far behind German powerhouse Volkswagen , which trades at 8.5 times forecast earnings.
Peugeot may raise up to 800 million euros more over a two-year period beginning next April, as the separate warrants are exercised for the purchase of additional stock.
Shareholders approved the three-stage capital increase at the carmaker's annual general meeting on Friday.
($1 = 0.7223 Euros) (Editing by Mark Potter and Erica Billingham)