Rights issue

From Wikipedia, the free encyclopedia

When doing a Secondary Market Offering of shares to raise money, a company can opt for doing a rights issue to raise capital. With the issued rights, existing shareholders have the privilege to buy a specified number of new shares from the firm at a specified attractive price within a specified time. A rights issue is offered to all existing shareholders individually and may be rejected, accepted in full or (in a typical rights issue) accepted in part by each shareholder. Rights are often transferable, allowing the holder to sell them on the open market.

Rights can be renounceable (can be sold separately from the share to other investors during the life of the right) or non-renounceable (shareholders must either take up the rights or let them lapse. Once the rights have lapsed, they no longer exist).

To issue rights the financial manager has to consider:

Subscription price per new share
Number of new shares to be sold
The value of rights
The effect of rights on the value of the current share
The effect of rights to existing and new shareholders

A right to a share, generally issued on ratio basis (e.g. one-for-three rights issue). Because the company is getting the shareholders' money in exchange for issuing rights, a rights issue is a source of funds for the company issuing it.

Rights issues may be underwritten. The role of the underwriter is to guarantee that the funds sought by the company will be raised. The agreement between the underwriter and the company is set out in a formal underwriting agreement. Typical terms of an underwriting require the underwriter to subscribe for any shares offered but not taken up by shareholders. The underwriting agreement will normally enable the underwriter to terminate its obligations in defined circumstances. A sub-underwriter in turn sub-underwrites some or all of the obligations of the main underwriter; the underwriter passes its risk to the sub-underwriter by requiring the sub-underwriter to subscribe for or purchase a portion of the shares for which the underwriter is obliged to subscribe in the event of a shortfall. Underwriters and sub-underwriters may be financial institutions, stock-brokers, major shareholders of the company or other related or unrelated parties. The Panel’s guidance covers both non-underwritten and underwritten rights issues.

[edit] Basic example

An investor: Mr. A had 100 shares of company X at a face value of $10 per share and a total investment of $10,000, assuming he purchased the shares at $100 per share.

Assuming a 1:1 rights issue at an offer price of $50, Mr. A will have the option to subscribe to additional 100 shares of the company at the offer price. Now, if he exercises his option, he would have to pay an additional $5,000 in order to acquire the shares, thus effectively bringing his average cost of acquisition for the 200 shares to $75 per share. Although the price on the stock markets should reflect a new price of $75 (see below), the investor is actually not making any profit nor any loss.

The company: Company X had 100 m outstanding shares of face value $10 each. The share price currently being quoted on the stock exchanges is $100 thus the market capitalization of the stock would be $10 billion (outstanding shares x share price).

Further, post the rights issue the company's outstanding shares would increase to 200 million with no change in the face value. The market capitalization of the stock would increase to $15 billion (previous market capitalization + cash received from owners of rights converting their rights to shares), implying a share price of $75 ($15 billion / 200 million shares). If the company were to do nothing with the raised money, its Earnings per share (EPS) would reduce by half. However, if the equity raised by the company is used to increase profits (e.g. acquisition of a company), the EPS impact will reflect that.