A rights issue is when a company invites its current shareholders to buy more shares at a discount. Shareholders get rights to purchase these new shares at a lower price than the market rate, which helps the company raise more money without bringing in new outside investors.
Rights issues can be a strategy for a company to finance growth initiatives, like acquiring other businesses or establishing new production or sales facilities. While this might dilute the existing shares due to the additional shares issued, the company's expansion can potentially boost capital gains for shareholders in the long run.
How does a right issue work?
Here's how the rights issue typically works:
- Announcement: The company announces its intention to issue new shares to existing shareholders. This is often done to fund expansion plans, pay down debt, or for other capital requirements.
- Proportional allocation: Existing shareholders are given the right to buy additional shares in proportion to their existing shareholding. The number of rights issued to each shareholder is typically determined by the number of shares they already own.
- Subscription price: The company sets a subscription price for the new shares, which is usually lower than the current market price. This discounted price is an incentive for existing shareholders to exercise their rights and subscribe to the new shares.
- Trading of rights: In some cases, shareholders can trade their rights on the stock market. This allows shareholders who do not wish to subscribe to the new shares to sell their rights to other investors who may be interested in buying them.
- Exercise period: Shareholders are given a specific period during which they can exercise their rights and purchase the new shares. If a shareholder chooses not to exercise their rights during this period, the rights may expire worthless.
Additional read: What is Share Market
Features of right issue of shares
- Discounted subscription price:
One of the defining features of a rights issue is the offering of shares at a discounted price compared to the current market value. This discount serves as an incentive for existing shareholders to exercise their rights and subscribe to the new shares. The discounted price can be attractive, encouraging participation in the issuance.
- Proportional allocation:
The allocation of rights is typically proportional to the number of shares a shareholder already holds. For example, the stock you bought recently has declared a 1:5 rights issue. This means you have the option to buy one new share for every five shares you currently own. For instance, if you hold 300 shares, you are eligible to purchase 60 additional shares at a predetermined price set by the company.
- Flexibility in use of funds:
Companies have flexibility in deciding how to use the funds raised through a rights issue. Whether it is for financing a new project, reducing debt, or strengthening the company's financial position, the capital raised can be directed according to the company's strategic priorities.
- Tradeability of rights:
In some cases, rights issued to existing shareholders can be traded on the stock exchange. This allows shareholders who do not wish to subscribe to the new shares to sell their rights to other investors who may find value in purchasing additional shares at a discount.
- Timeframe for exercise:
There is a specified timeframe during which existing shareholders can exercise their rights and subscribe to the new shares. This timeframe is critical, and shareholders must act within the stipulated period. If they choose not to exercise their rights during this window, their rights may expire.
- Impact on share price:
The announcement and execution of a rights issue can have an impact on the company's share price. Initially, the share price may experience a decline due to the dilution effect as new shares are issued at a discounted price. However, if the funds raised are used effectively and contribute to the company's growth, it can have positive long-term implications for the share price.
Reasons for a right issue of shares
- Capital expansion:
One of the primary reasons for a company to announce a rights issue is to raise additional capital. This capital can be used for various purposes such as funding expansion projects, acquiring new assets, or supporting research and development initiatives.
- Debt reduction:
Companies may opt for a rights issue to reduce existing debt. By using the funds raised to pay down debt, the company can improve its financial health, lower interest expenses, and enhance its creditworthiness.
- Strategic investments:
A company might announce a rights issue to make strategic investments. This could include entering new markets, acquiring complementary businesses, or investing in technologies to stay competitive in the industry.
- Working capital requirements:
In cases where a company needs to boost its working capital, a rights issue can provide the necessary funds. Adequate working capital is essential for day-to-day operations, and a rights issue can ensure liquidity.
- Research and development:
Companies in industries reliant on innovation may use funds from a rights issue to invest in research and development. This helps in creating new products, improving existing ones, and staying ahead in a rapidly evolving market.
- Market conditions and opportunities
Favourable market conditions or specific investment opportunities may prompt a company to issue rights. It allows the company to capitalise on positive market sentiment or take advantage of strategic opportunities that arise.
- Shareholder dilution management
While a rights issue can dilute the ownership percentage of existing shareholders, it allows them to maintain their proportional stake by participating in the issuance. This approach minimises the impact of dilution on existing shareholders.
Example of a rights issue
An example of a rights issue can be seen in a scenario where a publicly traded company, let's call it XYZ Ltd., decides to raise additional capital by offering its existing shareholders the right to purchase new shares at a discounted price.
Scenario:
- A owns 300 shares of XYZ Ltd. trading at Rs. 10 each.
- The company announces a rights issue in the 1-for-5 ratio.
- The rights issue is announced at a discounted price of Rs. 8 per share.
Calculations:
1. Portfolio value (before rights issue):
- Portfolio value = Number of shares owned * Current share price
- Portfolio value = 300 shares * Rs. 10 = Rs. 3,000
2. Number of right shares to be received:
- Number of right shares = (Number of existing shares * Rights issue ratio)
- Number of right shares = (300 * 1/5) = 60
3. Cost to buy the right shares:
- Total cost = Number of right shares * Rights subscription price
- Total cost = 60 shares * Rs. 8 = Rs. 480
4. Total number of shares after exercising rights issue:
- Total number of shares = Number of existing shares + Number of right shares
- Total number of shares = 300 + 60 = 360
5. Revised portfolio value after exercising rights issue:
- Revised portfolio value = Portfolio value before rights issue + Total cost of right shares
- Revised portfolio value = Rs. 3,000 + Rs. 480 = Rs. 3,480
6. Price per share post-rights issue:
- Price per share = Revised portfolio value / Total number of shares
- Price per share = Rs. 3,480 / 360 = Rs. 9.67
In theory, the share price after the rights issue should be Rs. 9.67. However, the actual market value may differ based on various factors. If the market value after the rights issue is higher than Rs. 9.67, it benefits the investor, while if it falls below, there could be a loss. Market dynamics and investor sentiment play crucial roles in determining the actual market value post-rights issue.
Benefits for company
Rights issues offer several advantages to the issuing company. Firstly, they provide a direct and efficient method for raising capital. By offering additional shares to existing shareholders, the company can access funds quickly to finance various initiatives such as expansion plans, research and development projects, debt reduction, or other strategic objectives. This direct access to capital allows the company to leverage the loyalty and commitment of its existing shareholders, fostering a sense of involvement and support in the company's growth trajectory.
Moreover, rights issues are a cost-effective means of raising funds compared to alternative sources such as debt financing or Initial Public Offerings (IPOs). Unlike IPOs, rights issues eliminate the need for underwriting fees and other associated costs, reducing the financial burden on the company. Additionally, rights issues reduce the company's reliance on external investors, allowing it to maintain greater control and ownership retention. By offering shares to existing shareholders first, the company can ensure that ownership remains within the existing shareholder base, thereby preserving the company's autonomy and strategic direction. Overall, rights issues serve as an efficient, cost-effective, and shareholder-friendly method for companies to raise capital and pursue their growth objectives.
Benefits for shareholders
Rights issues offer several benefits to shareholders:
- Opportunity to participate:
Existing shareholders are granted an exclusive opportunity to participate in the rights issue. This grants them the choice to increase their investment in the company by acquiring additional shares at a discounted price.
- Discounted share price:
The discounted price offered during a rights issue presents shareholders with an attractive opportunity to expand their investment at a lower rate than the prevailing market price. This discounted acquisition can positively influence the overall average cost of their investment.
- Maintaining proportional ownership:
The structure of a rights issue is designed to uphold proportional ownership for existing shareholders. By subscribing to the new shares, shareholders can ensure that their ownership stake in the company remains consistent with their pre-issuance percentage.
- Avoiding dilution through sale of rights:
Shareholders who opt not to exercise their rights have the option to sell them in the market. This provides an avenue for them to benefit from the value of the rights without necessarily increasing their investment or undergoing dilution.
Conclusion
A rights issue is a financial strategy that can provide crucial benefits to both the company and its shareholders. It serves as a means for companies to raise capital and pursue growth opportunities while allowing existing shareholders to actively participate in the company's future success. The success of a rights issue is often contingent on effective communication, transparent pricing, and alignment with the company's overall strategic vision.
