Rights Issue

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Rights Issue

Learning objective

After completing this chapter you will be able to answer to

these questions:

What is rights issue?

What are the reasons for such rights/

Under what circumstances the company shall decide on

rights issue?

What are the hazards in case of rights issue?

How the company should approach to price the rights/

shares conversion ratio?

What are the strategic points worth considering while

formulating the company’s strategy on rights?

Chapter Content

1. Definition

2. Features

3. Conditions to be satisfied by the firm

4. Impact on price of existing equity

5. Impact on shareholders’ wealth

6. Pricing of rights

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What is Rights Issue?

An existing company which has already gone for an IPO has a base of

its own stockholders. If the company has been doing quite well and its

stockholders are happy with its performance, it can approach the

existing equity shareholders for further finance in case of necessity like

expansion and launching new projects. Who could be a better choice

than its satisfied owners? The company has to make least efforts to

sell its equity in terms of marketing. It has very little to prove before

its own shareholders who are with them for quite some time. Both the

issue cost and time cost of the issue would be less than the cost had

the company gone for another public issue. And offering shares to

existing shareholders is called Rights Issue.

The nomenclature Rights is because under the company law in case of

all the subsequent public issues after the IPO, a company has to offer

first to its existing stockholders. Thus this is a right to the stockholders

given by law. That is why such an issue is called a Rights Issue. Rights

are not an Indian typicality only. Almost in every country similar law

exists. However, the stockholders themselves can relinquish this

provision by a passing a resolution that effect in a general meeting of

the company. In that case the company would not be allowed to go for

a Rights Issue. The shareholders can also relinquish their rights even

by part.

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What is ‘Rights’?

Popularly, shares issued through a Rights Issue are called rights

shares. In fact, there is a difference between rights and what is

referred to as rights shares.

A shareholder is entitled to rights equal to the number of equity shares

he is holding. That is the number of rights is exactly equal to the

number of shares held by the investor. These rights are converted into

equity shares at the conversion ration as decided by the management

of the company. Rights are negotiable and tradable like shares. This

indicates that the rights in the market has a price. Although it is

difficult to measure the possible market price of a right, on the basis of

the assumption that a shareholder’s wealth position can hardly be

affected by a Rights Issue, we may calculate some indicative price of

rights.

The assumption of no change in shareholders’ wealth position is quite

rational. When the shares are offered only to the existing

shareholders, the pre-issue and post-issue holders remain the same.

That is the demand side of the rights also remain the same, while the

supply side has gone up since the stockholders are in possession of

more shares from the same company. This must logically bring the

share price down in the market. The erosion in price should be exactly

to the extent of the so called extra benefit afforded to the existing

stockholders. Thus the wealth position of the stockholders maintains a

status quo. This also implies that if one existing stockholder does not

subscribe to the rights issue, his wealth position is bound to erode

since he will be left with the same holding, but at a lower market price.

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In reality this may not be the case. Since the rights are tradable and

having a market of their own, the market price of rights are likely to

be determined by the market forces of demand and supply. The rights

are derived from the shares. But it would not be always practical to

link rights with the movements of the underlying security. The price

may be influenced by many factors like the individual investors’

personal finance at the moment and their preferences that vary too

widely. Thus there are possibilities of different kinds of situational

movements resulting in rights being priced in sharp difference to the

indicative theoretical value of rights. Moreover, rights declaration may

also sometimes create a positive or negative vibe in the market. The

price of rights would be influenced by that too.

Rights are exercisable within a specified period of time, generally up to

thirty days.

The shareholders can also sell either in full or in part the rights they

are allotted to. Selling the rights would save them from the possible

ex-rights downfall in the price of the shares.

How to price a Rights Issue?

Pricing the issue seems to be not that important in case of rights as

in case of IPO. Only thing to ensure is that it should be substantially

underpriced. If the subscription price is not considerably below the

market price, the shareholders would not be motivated to buy it. But

how much underpricing should be done is not that material an issue

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here, since any dilution of price would be borne by the existing

shareholders only as they are the main buyers. The only thing is to

take note of is to see that the subscription price is attractive enough

for the target investors. The success of the rights issue largely

depends on how low the subscription price is.

Why Rights Issue is done by a company?

Rights Issue is done by a company for many a reason. The first major

one is it is far easier to sell the issue to the existing stakeholders than

to anybody else. Second, unlike public issue Rights Issue does not

have the possibility of control dilution.

The success of any issue much depends on the company’s consistent

track record. But in Rights Issue some extra protection is enjoyed by

the company since it is targeted to it own shareholders. So the

company has an edge in capitalizing the market through Rights.

In general, never the existing stockholders of a company would

welcome another issue of equity because rationally they do not like at

all their wealth and ownership to be divided with newcomers. But if it

is a Rights Issue they do not have to worry since both these are well

protected.

Rights issue is a weapon too in the hands of the company

management to avoid the dilution of control whenever the company

decides to raise finance through equity. Particularly, in case of a

closely held company it saves prevents the company to be taken over

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in the days of corporate predation. The company as a defence against

a hostile takeover bid may decide to go for a huge rights issue. The

ex-rights price would go down then substantially keeping the company

control intact. This is expected that this would discourage the

predating company from its takeover bids. This is a proven device and

popularly called as poison pills. The practice is that the shareholders

are issued long-dated rights which do not come in effect

immediately. They are automatically exercised when, during a hostile

takeover a company or an investor acquires a certain percentage of

shares, thereby diluting the takeover bid. In fact, many a company

has taken to the poison pill so far.

Market Value per share after the rights issue (ex- rights):

Value of one share after the rights issue (ex- rights):

(nMPS0 + SP)/ n +1,

Where,

N= no. of rights required to subscribe to one share

MPS0= market price per share before rights issue (cum-rights)

SP=Subscription price per share for rights issue

Theoretical value of one right then would be=

(MPS0-SP)/ n+1

The price advantage thus is being distributed among all the shares the

investor is going to have immediately after the rights issue (ex-rights

holding).

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The shareholder however neither gains nor loses through rights issue.

He has three options:

1. Exercising his rights by buying additional shares; or,

2. Selling his rights and get cash; or,

3. Allowing his rights to expire by doing nothing.

In the first two cases he is not likely to either gain or lose. By either of

these he is able to maintain his position. If he exercises his rights, he

will be in possession of additional shares. But due a fall in ex-rights

market price of shares, the value of his shareholding is likely to remain

the same.

In case he sells his rights, his holding size remains the same and due

to reduced ex-rights market price the value of his holding would come

down. But the loss incurred would be compensated by the cash he has

received from the sale of rights.

But in case he allows his rights to expire, he is neither in possession of

additional shares nor he additional cash from sale of rights. Therefore

he loses.

So, the investors should choose either of the first two options as

discussed.

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We can take the following example to prove this point.

A Ltd. has a capital base of 100 lakh equity shares of Rs. 10 each fully

paid. The company’s last balance sheet shows Rs. 6 crore in its

general reserve, and Rs. 2 crore in 10% Debentures. It has earned

15% on its total capital employed. The company is in a 40% corporate

tax bracket. The company’s shares enjoy a price-earning ratio of 12 in

the market.

The company now decides to raise finance through a further issue of

40 lakh equity shares of Rs.10 each. The half of the issue will be

treated as a rights issue. The subscription price has been determined

at Rs.12.

EBIT Rs.27000000

Interest Rs. 2000000

EBT Rs. 25000000

Tax @40% Rs. 10000000

EAT Rs. 15000000

Number of shares outstanding 10000000

EPS Rs.

1.50

Price earning ratio 12

Market price per share Rs. 18

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Now, suppose one investor Mr.X is holding 1000 shares in the

company. Thus he is entitled to 1000 rights in this case.

n will be= 10000000/2000000, or 5. That is he is entitled to 10 equity

shares in this rights issue.

Value of one right= (18-12)/(5+1)= Re.1

Ex-rights market price per share would be= ((n*MPS0+SP)/n+1)

=((5*18+12)/6))= Rs.17

The shareholders position if he exercises rights:

Cum-rights :

Investment value(1000 shares

@Rs.18 per share)

Rs.18000

Ex-rights :

Size of his

shareholding(1000+200)

1200 shares


Investment value(1200 shares @

Rs.17 per share)

Rs. 20400

Less: His cash outgo for

subscribing the additional

shares(200 shares @Rs.12 per

share)

Rs. 2400

Net value of investment Rs. 18000

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His net gain/ loss Nil

The shareholders position if he sells rights:

Cum-rights :


@Rs.18 per share)

Rs.18000

Ex-rights :

Size of his shareholding 1000 shares



Rs.17 per share)

Rs. 17000

Add: His cash income by selling

1000 rights @ Re.1

Rs. 1000

Net value of investment Rs. 18000

His net gain/ loss Nil

The shareholders position if he allows his rights to expire:

Cum-rights :


@Rs.18 per share)

Rs.18000

Ex-rights :

Size of his shareholding 1000 shares



Rs.17 per share)

Rs. 17000

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His net gain/ loss Rs. 1000

Can this theoretical value of rights differ from the value in the

market?

YES, for these two reasons in addition to what we have discussed in

some early paragraphs:

The value in the market could differ due to the transaction cost

in the market;

The company’s goodwill in the capital market at that point of

time is very important. More reputed the company is, greater

would be the demand because non-shareholders would also

throng the market for the company scrip. This accelerated

demand would move the value of rights upward;

Setting the subscription price for the existing shareholders in case of

rights issue:

All the discussion we have done so far on rights simply makes it clear

that the subscription price does not matter. The shareholder’s

position would be irrespective of the quantum of the subscription

price. Whatever may the SP, the shareholders either have to exercise

the rights or to sell the rights to maintain the status quo. Either of

However, the difference between MPS0 and SP determines a

shareholder’s extent of loss if he does not do anything with his

rights. His loss will increase if the subscription price is considerably

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lower than the MPS0. Either of these two activities is rationally

expected from the shareholders. No rational investor would allow his

rights to expire.

In case of any issue of shares, it is imperative to the company to

under price the subscription price. This is no exception to the rights

issue also. If the subscription price is not lower than the then market

price, there would be no reason to buy the share from the open

market. So, the success of the rights issue largely depends on how

low the subscription price is.

But at the same time lower the subscription price is, greater has to

be the issue size to collect the requisite funds.

Greater the number of shares, harder it would be for the company to

maintain its EPS and dividend per share (DPS) level.

So, these factors are to be seriously kept in mind while pricing.

Some other factors worth considering while setting the

subscription price:

Is it the right time to approach the market? Choosing the

appropriate time to approach the market is very vital. For this a

continual close observation is necessary. Generally both the

primary and secondary segments of the capital market move

hand in hand. So, at the time of overall buoyancy in the market,

at least the inclination toward buoyancy, is the clear indicator as

to the time to approach market.

Is the scrip doing steadily well in the market? No investor

would take a long position if the company is not doing well as

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compared to other firms in the market. If in the investors’

perception the scrip of the company is not an undervalued one

with strong potential to go higher and higher, it would certainly

not be the right situation for a rights issue.

Is the effective control of the company going to be

diluted after the issue? As we have already seen that losing

control over the company happens to be the least acceptable

consequence to the existing shareholders and the company

management. There are several devices to avoid dilution of

control. In fact a company tries a number of avenues like

preferential allotment and private placement with this object in

mind. So the management has to estimate the impact

beforehand.

Rights issue – the merits:

1. It is easier than the public issue in that the company is

approaching its own shareholders who already know the

company well. Thus lesser efforts are needed for the sale.

2. Therefore the company can either avoid or reduce underwriting

because of lesser risk of being under subscribed. A reduction in

underwriting commission makes the floatation cost of the issue

low.

3. It helps the company to expand its equity base without any

dilution in control.

Rights issue: the hazards:

1. Existing shareholders may not relish the idea of further

investment. Although it has been seen that by exercising rights

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they can maintain status quo. But they might not feel

comfortable with the idea of spending cash to buy this status

quo. In fact, they certainly lose marginally if the opportunity cost

of the cash outgo is considered;

2. For a company in which a sizable portion of its shares are held

by financial institutions, rights issue may not be a success prove

to be

Rights issue could also help the company if it is going through a

period of financial hardship.

Thus the rights issue, at times, should more be viewed as a

corporate strategy for preventing control dilution than a method of

raising finance. In other words, rights issue is a funding mode to the

company that has little threat to company management.

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Documents

Rights Issue