What is a rights issue?

As an investor, you need to know the different corporate actions a company can initiate. Among the different non-cash corporate actions possible, a rights issue is one of the most common. What is the rights issue of shares and why does a company opt for it? Here is everything you need to know.

In a rights issue, a company gives its existing shareholders the right to purchase more shares. Since the shareholders get to purchase shares directly from the company instead of the secondary market, the price of the shares is usually set lower than its current market price. The number of shares that an existing shareholder is eligible to apply for is dependent on the number of shares they hold.

Purchasing more shares through a rights issue is not mandatory. For instance, a shareholder who does not wish to subscribe to the issue may choose to either let the right expire or transfer it to another shareholder. Companies issue rights for a number of reasons such as capital requirement for business expansion, debt pay-offs, improving operations and so on. However, every rights issue must be judged for their or demerit as one would not want to invest money in a bad corporate decision.

How does Rights Issue work?

Rights issue usually works in the way mentioned below:

• Announcement by the company
• Proportional allocation to existing shareholders
• Subscription price is set lower than the market price
• Trading rights in some cases for investors to sell to other interested investors
• Exercise period allowing the investors to purchase the new shares

Features of a rights issue

Now that you’re aware of the meaning of the rights issue, let’s take a quick look at some of the unique features of this non-cash corporate action.

• A rights issue gives existing shareholders preferential benefits.
• The existing shareholders only get the right and not the obligation to purchase more shares of the company.
• The shares are generally offered at a discounted price compared to their current market price.
• A rights issue is an inexpensive way for companies to gain access to capital, since they don’t have to pay any fees to underwriters or book-running lead managers (BRLMs).
• A shareholder may choose to sell the rights to other investors through the exchange or via an off-market transaction.
• If a shareholder chooses to let the rights expire, it can lead to a dilution in shareholder’s ownership.
• The number of rights shares that shareholders can apply for is determined by the number of shares they currently hold.
• The announcement of a rights issue can impact the current share price of the company.
• Shareholders can exercise their rights issue partially or fully.

Reasons for a rights issue

A company might opt for a rights issue for several different reasons. Here are some of them.

• When a company needs additional funds but wants to keep the voting rights of existing shareholders intact
• When other sources of funding like debt financing are unavailable or expensive
• When a company wants to improve its debt-to-equity (D/E) ratio
• When a company needs working capital
• When a company wants to grab opportunities due to favourable market conditions
• When the company wants to enter new markets

Example of a rights issue

Let’s assume that a company announces a rights issue at a 1:4 ratio. This means that for every 4 shares owned by an existing shareholder, they’re entitled to purchase 1 share. Now, say the current market price of the same company is ₹1,280 per share, whereas the rights issue may be priced at ₹1,000 per share.

Given these parameters, if you currently own around 2,000 shares of the company, you are eligible for the rights issue at a 1:4 ratio. Here’s how this would work.

The number of shares you’re eligible for = 500 shares (2,000 shares ÷ 4)

The amount that you would have to pay = ₹5 lakh (500 shares x ₹1,000 per share)

The total number of shares that you would own after exercising the rights issue = 2,500 shares

One can calculate the value of right using the following formula: Value of right = [Number of right shares (market price − issue price)]/(Number of existing shares + number of right shares) Let us take another example.
ABC raises capital by issuing 2 shares at ₹ 32 each for every 10 shares held. The market price of the existing shares is ₹40 cum right. Let us calculate the value of right.
Existing number of shares = 10
Market Price = 40
New Shares issued = 2
Issue Price = 32
So, the value of the right is as follows:
2(40−32)/(10+2) = 1.33

Conclusion

A rights issue is beneficial for both the company and its shareholders. While the company gains access to capital via a more inexpensive channel, the shareholders get to enjoy a discounted price on their shares. That’s not all. Unlike a follow-on public offering (FPO), where the voting rights of existing shareholders get diluted, the voting rights remain intact if the rights issue is exercised.