Cash-strapped companies can turn to rights issues to raise money when they really need it. In these rights offerings, companies grant shareholders a chance to buy new shares at a discount to the current trading price. Let's look at how rights issue work, and what they mean for all shareholders.
Defining a Rights Issue and Why It's Used
A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. More specifically, this type of issue gives existing shareholders securities called "rights", which, well, give the shareholders the right to purchase new shares at a discount to the market price on a stated future date. The company is giving shareholders a chance to increase their exposure to the stock at a discount price.
But until the date at which the new shares can be purchased, shareholders may trade the rights on the market the same way they would trade ordinary shares. The rights issued to a shareholder have a value, thus compensating current shareholders for the future dilution of their existing shares' value.
Troubled companies typically use rights issues to pay down debt, especially when they are unable to borrow more money. But not all companies that pursue rights offerings are shaky. Some with clean balance sheets use them to fund acquisitions and growth strategies. For reassurance that it will raise the finances, a company will usually, but not always, have its rights issue underwritten by an investment bank.
How Rights Issues Work?
So, how do rights issues work? The best way to explain is through an example.
Let's say you own 1,000 shares in VT Telecom, each of which is worth rs 5.50. The company is in a bit of financial trouble and sorely needs to raise cash to cover its debt obligations. VT therefore announces a rights offering, in which it plans to raise 30 million by issuing 10 million shares to existing investors at a price of rs 3 each. But this issue is a three-for-10 rights issue. In other words, for every 10 shares you hold, VT is offering you another three at a deeply discounted price of rs 3. This price is 45% less than the rs 5.50 price at which VT stock trades. (For further reading, see Understanding Stock Splits.)
As a shareholder, you essentially have three options when considering what to do in response to the rights issue. You can:
(1) subscribe to the rights issue in full,
(2) ignore your rights or
(3) sell the rights to someone else.
Here we look how to pursue each option, and the possible outcomes.
1. Take Up The Rights To Purchase In Full
To take advantage of the rights issue in full, you would need to spend rs 3 for every VT share that you are entitled to under the issue. As you hold 1,000 shares, you can buy up to 300 new shares (three shares for every 10 you already own) at this discounted price of rs 3, giving a total price of rs 900.
However, while the discount on the newly issued shares is 45%, it will not stay there. The market price of VT shares will not be able to stay at rs 5.50 after the rights issue is complete. The value of each share will be diluted as a result of the increased number of shares issued. To see if the rights issue does in fact give a material discount, you need to estimate how much VT share price will be diluted.
In estimating this dilution, remember that you can never know for certain the future value of your expanded holding of the shares, since it can be affected by any number of business and market factors. But the theoretical share price that will result after the rights issue is complete - which is the ex-rights share price - is possible to calculate. This price is found by dividing the total price you will have paid for all your VT shares by the total number of shares you will own. This is calculated as follows:
1,000 existing shares at rs 5.50 = rs 5,500
300 new shares for cash at rs 3 = rs 900
Value of 1,300 shares rs 6,400
Ex-rights value per share rs 4.92 (rs 6,400.00/1,300 shares)
Value of 1,300 shares rs 6,400
Ex-rights value per share rs 4.92 (rs 6,400.00/1,300 shares)
So, in theory, as a result of the introduction of new shares at the deeply discounted price, the value of each of your existing shares will decline from rs 5.50 to rs 4.92. But remember, the loss on your existing shareholding is offset exactly by the gain in share value on the new rights: the new shares cost you rs 3, but they have a market value of rs 4.92. These new shares are taxed in the same year as you purchased the original shares, and carried forward to count as investment income, but there is no interest or other tax penalties charged on this carried-forward, taxable investment income.
2. Ignore The Rights Issue
You may not have the rs 900 to purchase the additional 300 shares at rs 3 each, so you can always let your rights expire. But this is not normally recommended. If you choose to do nothing, your shareholding will be diluted thanks to the extra shares issued.
3 Sell Your Rights To Other Investors
In some cases, rights are not transferable. These are known as "non-renounceable rights". But in most cases, your rights allow you to decide whether you want to take up the option to buy the shares or sell your rights to other investors or to the underwriter. Rights that can be traded are called "renounceable rights", and after they have been traded, the rights are known as "nil-paid rights".
To determine how much you may gain by selling the rights, you need to estimate a value on the nil-paid rights ahead of time. Again, a precise number is difficult, but you can get a rough value by taking the value of ex-rights price and subtracting the rights issue price. So, at the adjusted ex-rights price of rs 4.92 less rs 3, your nil-paid rights are worth rs 1.92 per share. Selling these rights will create a capital gain for you.
The Bottom Line
It is awfully easy for investors to get tempted by the prospect of buying discounted shares with a rights issue. But it is not always a certainty that you are getting a bargain. But besides knowing the ex-rights share price, you need to know the purpose of the additional funding before accepting or rejecting a rights issue. Be sure to look for a compelling explanation of why the rights issue and share dilution are needed as part of the recovery plan. Sure, a rights issue can offer a quick fix for a troubled balance sheet, but that doesn't necessarily mean management will address the underlying problems that weakened the balance sheet in the first place. Shareholders should be cautious.