What is a Rights Issue?
A rights issue is an offering of rights to the existing shareholders of a company that gives them an opportunity to buy additional shares directly from the company at a discounted price rather than buying them in the secondary market. The number of additional shares that can be bought depends on the existing holdings of the shareowners.
Features of a Rights Issue
- Companies undertake a rights issue when they need cash for various objectives. The process allows the company to raise money without incurring underwriting fees.
- A rights issue gives preferential treatment to existing shareholders, where they are given the right (not obligation) to purchase shares at a lower price on or before a specified date.
- Existing shareholders also enjoy the right to trade with other interested market participants until the date at which the new shares can be purchased. The rights are traded in a similar way as normal equity shares.
- The number of additional shares that can be purchased by the shareholders is usually in proportion to their existing shareholding.
- Existing shareholders can also choose to ignore the rights; however, if they do not purchase additional shares, then their existing shareholding will be diluted post issue of additional shares.
Reasons for a Rights Issue
- When a company is planning an expansion of its operations, it may require a huge amount of capital. Instead of opting for debt, they may like to go for equity to avoid fixed payments of interest. To raise equity capital, a rights issue may be a faster way to achieve the objective.
- A project where debt/loan funding may not be available/suitable or expensive usually makes a company raise capital through a rights issue.
- Companies looking to improve their debt to equity ratio or looking to buy a new company may opt for funding via the same route.
- Sometimes troubled companies may issue shares to pay off debt in order to improve their financial health.
Example of a Rights Issue
Let’s say an investor owns 100 shares of Arcelor Mittal and the shares are trading at $10 each. The company announces a rights issue in the ratio of 2 for 5, i.e., each investor holding 5 shares will be eligible to buy 2 new shares. The company announces a discounted price of, for example, $6 per share. It means that for every 5 shares (at $10 each) held by an existing shareholder, the company will offer 2 shares at a discounted price of $6.
- Investor’s Portfolio Value (before rights issue) = 100 shares x $10 = $ 1,000
- of right shares to be received = (100 x 2/5) = 40
- Price paid to buy rights shares = 40 shares x $6 = $ 240
- Total number of shares after exercising rights issue = 100 + 40 = 140
- Revised Value of the portfolio after exercising rights issue = $ 1,000 + $240 = $1,240
- Should be price per share post-rights issue = $1,240 / 140 = $8.86
According to theory, the price of the share after the rights issue should be $8.86, but that is not how the markets behave. An uptrend in the share price will benefit the investor, while if the price falls below $8.86, the investor will lose money. The decline in share price can be attributed to several factors. Here are some of them:
- It gives a signal to the market that company may be struggling, which can be the reason the company issued shares at a discount.
- By issuing more shares, there is dilution in the value of available shares.
- Share capital increases depending on the rights issue ratio.
- The company gets positive cash flow (from financing), which can be used to improve its operations.
- Effective EPS, book value, and other per share metrics decline because of the higher number of shares (see diluted EPS).
- Market price gets adjusted (after book close) after the issuance of right shares.