Dont lap up that rights issue just yet, ascertain the companys motive

Written by P Saravanan | Updated: Aug 26 2014, 15:41pm hrs
SensexThe company offers a specific number of shares, according to the existing number of shares held, at a specified price. (PTI Photo)
This year, more than half a dozen companies have announced rights issues for their shareholders. Let us first understand what these are. Why do companies prefer a rights issue over a follow-on public offer (FPO) And when should one subscribe for it

What it is

When a company issues to its existing shareholders the right to buy additional shares of the company, it is called a rights issue. The company offers a specific number of shares, according to the existing number of shares held, at a specified price. Normally, the share is offered at a discount (compared to the prevailing market price) to encourage shareholders to accept the offer. The company also fixes a time limit within which the shareholder needs to express his consent to accept the offer. Simply put, rights issues are shares issued by a company only to its existing shareholders. If an existing shareholder is not interested in accepting the rights offer, he has the option to renounce the rights to an existing, or even someone who is not an existing, shareholder.

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The rationale

A company offers more shares to existing shareholders to raise additional funds. The reasons for raising funds could be many, such as investment in research and development, redemption of debt (so that the company reaches its ideal debt-equity ratio), expansion of the existing business or diversification. Generally, companies prefer a rights issue to an FPO as, under a rights issue, the promoters equity holding remains intact. Besides, a rights issue is cheaper than an FPO.

The mechanics

Let us understand the mechanics behind a rights issue. Suppose ABC company has 10 million shares outstanding in the market with a current market price of R80 per share. Now, the company wishes to raise R8 crore to finance its research and development activities. ABC needs to issue 5 million new shares of R6 each (since the company wants to offer a discount of 25% on the current market price). This will result in a 2:1 rights issue, which means that for every two shares owned, an existing shareholder will get another one share. Suppose shareholder X owns 1,000 shares in the

company. In this case, he is issued the right to buy an additional 500 shares

at R6 each.

Now X has the following options: (a) Buy further 500 shares for R3,000; (b) Just ignore ABC pharmas rights issue. In this case, Xs shareholding will be diluted along with the value of his current shareholding; and (c) Renounce (sell) his rights and

make a profit assuming that the rights are renounceable.

Theoretically, the market price of ABC pharma will change after

the rights issue. It can be computed

as follows.

X already owned 1,000 shares at the rate of R8, worth R8,000. He again subscribed to 500 shares at R6, worth R3,000. Adding the two values, we get R8,000 +R3,000 = R11,000. Dividing the total value, R11,000, by the total number of shares held, 1,500, gives us the revised market value per share of R7.33. But, as mentioned earlier, this is only a theoretical price. The actual price of a share is driven by many other factors that may boost or lower the price.

To subscribe or not

Rights issues offered at discounted prices can be tempting, but it is important to find out the reason for one. A company, for instance, may be using the cash flow as a quickfix to pay off the pressing debts, masking the real reason. This could be done to hide bad leadership or poor operating performance. While accepting a rights offer, a companys shareholders should exercise caution and, most importantly, ascertain the real reason for the exercise.

The writer is associate professor of finance and accounting at IIM Shillong