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Unraveling the rights issue - Views on News from Equitymaster
 
 
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  • Sep 17, 2004

    Unraveling the rights issue

    After trying to unravel the concept of bonus issue and stock split, in this article we try to throw some light on another type of corporate action, i.e. the rights issue. This method helps the company to raise additional capital from shareholders and is generally given effect to in times of firm stock market trends when stock prices are ruling relatively strong.

    Rights issue:
    A rights issue is basically when a company offers existing shareholders a right to purchase additional shares of the company at a given price, which is at a discount to the prevailing market price of the stock, to make the offer enticing for the shareholder and to ensure that the rights offer is fully subscribed to. It must be noted that in case of a rights issue, a shareholder has the option of applying for additional shares also i.e. over and above what he is entitled to. Thus, assuming that some of the shareholders do not exercise their right, the shareholders who have applied for additional shares are allotted the same.

    Since, in the case of a rights issue, additional equity is issued, the issuing company's equity base rises to the extent of the issue. Thus, considering that the number of equity shares of the company has increased, there is a proportionate fall in the stock price of the company reflecting the new adjusted earnings per share (EPS). Here, unlike a stock split, the face value of the stock remains unaltered. Further, the market capitalisation of the stock also remains unchanged as the stock price adjusts (as per the valuation accorded to the stock) to the new EPS. Let us see with an example how the two parties (investor & company) involved are affected.

    An investor: Mr. A had 100 shares of company X at a face value of Rs 10 per share and a total investment of Rs 10,000, assuming he purchased the shares at Rs 100 per share. Assuming a 1:1 rights issue at an offer price of Rs 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 Rs 5,000 in order to acquire the shares, thus effectively bringing his average cost of acquisition for the 200 shares to Rs 75 per share. However, since the new adjusted stock price would be close to the Rs 75 levels, the investor would neither stand to neither gain nor lose in the near-term. Further, considering that the new adjusted price would lead to a higher valuation for the stock, if the business returns (including the new investment) fail to justify the higher valuation, the stock price would correct to original valuations putting the investor at a considerable loss.

    The company: Company X had 100 m outstanding shares of face value Rs 10 each. The share price currently being quoted on the stock exchanges is Rs 100 thus the market capitalization of the stock would be Rs 10 bn (outstanding shares x share price). Further, post the rights issue the company's outstanding shares would increase to 200 m with no change in the face value. However, there would be a change in the market capitalisation of the stock, as with double the equity shares outstanding and the new stock price of Rs 75, the market capitalisation would stand at Rs 150 bn (200 m outstanding shares x Rs 75 per share).

    Why the process of rights issue?
    The basic premise of carrying out rights offers is to raise additional capital. The company raises money from its existing shareholders, who have seemingly posed their faith in the company by virtue of being its shareholders, to invest in expanding capacities or to explore other investment opportunities. This (additional capital) in turn provides the company better leveraging opportunities. A higher equity capital base would assist the company to raise higher debt. This is because a company's debt-to-equity ratio would stand reduced, putting the company in a comfortable position to raise further debt from the market. While some may argue here that the company's return on equity (ROE) would get adversely affected and it would be wise to raise debt from the markets at competitive costs without leveraging on additional equity raised from shareholders, the former argument (debt-equity) cannot be discarded. Apart from this, other advantages of a rights issue is that it leads to increased liquidity and affordability of the stock owing to reduced stock price and higher equity base.

    Conclusion:
    However, investors should treat the rights issue as a fresh equity issue, as they would be increasing their exposure to a company. Therefore, all the necessary precautions of a fresh investment should be taken. They should look beyond the discount being offered in the rights issue and rather concentrate on the manner in which the company would utilize the money. Investors must remember that if the company fails to meet its growth targets or get substantial returns from their increased investments, the EPS could get hit much harder than otherwise owing to reduced profits and higher equity base. Thus, the general factors like the growth prospects of the company, management capability, business model, etc. should continue to remain the deciding factors while making an investment decision here.

     

     

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