What are Rights Issue Shares?
If you’re an investor, it’s important that you understand how rights issuing of shares work.
In simple terms, when a company taps into the existing shareholders for additional capital and issue shares at a discount particularly for these existing shareholders, we call it rights issue shares. The idea is to get the additional capital from the existing shareholders without trying any external methods.
This is particularly useful for the companies that are deeply in debt.
Rights Issue Example
We will take a simple rights issue example to illustrate this. Mr. John is an existing shareholder of TMC Company. He owns 20 shares of $200 each of the company.
- TMC Company issues right shares to John and offers a discount of 30% on the market price of the share. And the rights issues shares are on 1 for every 2 existing shares.
- As a result, John is able to buy 10 right issue shares at a price of $140 each.
- In this scenario, it may seem that Mr. John is benefiting from the rights issue shares. And yes, if he sells off all his right issue shares at a market price to another investor before the expiration date, he would enjoy a little profit.
But if we look closely, we would see that there’s a dilution in the share price.
If add the number of shares and find an average, we would see –
- [(20 * $200) + (10 *140)] / 30 = ($4000 + $1400) / 30 = $5400 / 30 = $180 per share.
So you can see that even if it seems that Mr. John is getting a discount of 30%, i.e. $60 off from each share of the rights issue, he actually gets $20 off per share.
Why right issue shares?
This is a big question because if companies go to the bank or the financial institution, they can get a loan. Why go for the rights issue shares then? It turns out that there are a couple of valid reasons for which a company goes for the rights issue and not for external debt.
Here are the following reasons for which a company goes for rights issue shares-
- When companies are cash-strapped: When companies don’t have cash or they’re already in debt, they don’t want to go to another bank or financial institution to raise money. Rather they go to the existing shareholders and ask them whether they are interested in some extra shares at a discounted rate. Not all existing shareholders are interested, but some like the idea and right shares are issued.
- When companies want to grow: To issue right shares, not all companies need to be financially unhealthy. Many companies that have clean balance sheets also go for the rights By approaching the existing shareholders they raise the capital they need for their growth and expansion.
How do rights issue work?
In this section, we will understand how rights issue shares work from a company’s point of view. We will take another example to illustrate this.
Let’s say that Grand Power Ltd. is strapped for cash. They’re in debt and they can’t go out and get another debt as of now. So they thought that the best way to remain afloat is to issue right shares. They decided that they will issue right shares to the existing shareholders at $35 per share when the market price of their shares is $50 per share. Every right issue share will be issued for 3 existing shares.
At this juncture, existing shareholders have three options –
- They can choose to buy the right shares: This is what the company expects from the existing shareholders. If more existing shareholders buy the right shares, they will raise more capital.
- They can choose to ignore the right issue shares: Many existing shareholders ignore the idea of buying any more shares if particularly the company isn’t doing well financially. Why buy from a company that is deeply in debt?
- They can choose to buy the shares and sell them off: Many shareholders can buy the right issue shares and can sell off the shares to other investors. As a result, they can make profits on the right shares and the company will also be able to raise the required capital.
So what Grand Power Ltd. should do? Should they go about issuing right shares? Would it be beneficial?
The answer is they should definitely go for issuing right shares. But before they ever decide to issue right shares, they need to be clear on how they will utilize the capital raised. Would they pay off the debt? Would they invest in a new project to generate more cash-flow? Or would it be a good idea to buy a new company/expand?
Once they’re clear about what they want to do with the money, they can set a goal and issue right shares accordingly.
Market price after right issue
There are many factors that are responsible for market price. For example, we can talk about the general outlook for the industry the particular company is in, or the outlook of the company, the market trends, the market price of the competitors etc.
Thus, it’s difficult to say what would happen to the market price after the rights issue. But it can be easily said that the existing shareholders may always not get the benefit as mentioned post rights issue.
What is the ex-rights price?
The ex-rights price is the average of the market price per share after the rights issue.
- Let’s say that Ramesh owns 100 shares of $10 each. He has bought 50 right issue shares at $7 each.
- Now after the rights issue, the average market price per share would be = ($10 * 100) + ($7 * 50) / 150 = $1000 + $350 / 150 = $9.
- $9 is the ex-rights price.
Why knowing the ex-rights price is important? Because it tells us what the shareholders actually get instead of what the company promised. In the above example, the company offers 30% discount on the rights issue, but actually, the shareholder has got a 10% discount overall.
As mentioned in the previous sections, many factors determine whether the shareholders will get the mentioned benefit or not. Sometimes, the shareholders don’t get any benefit if the market price drops post rights issue.
This has been a guide to What are Rights Issue? Here we discuss rights issues examples, how does it work, why companies issues right shares and ex-right prices. You may also have a look the following recommended articles to learn more –