Understanding Rights Issues

What Is a Rights Issue?

A rights issue is an invitation from a company to its existing shareholders to purchase additional shares in the company. This type of issue offers these shareholders securities called rights.

In these rights offerings, companies grant shareholders the right, but not the obligation, to buy new shares at a discount to the market price up to a stated future date.

Cash-strapped companies can turn to rights issues to raise money when they really need it.

Understanding a Rights Issue

Until the date on which the new shares can be purchased, shareholders may trade the rights in the market the same way that they would trade ordinary shares.

The rights issued to a shareholder have value, thus compensating current shareholders for the future dilution of their existing shares' value. Dilution occurs because a rights offering spreads a company’s net profit over a larger number of shares. In turn, the company’s earnings per share, or EPS, decreases.

Purpose of a Rights Issue

Companies commonly issue a rights offering to raise additional capital. A company may need extra capital to meet its current financial obligations. Troubled companies typically use rights issues to pay down debt, especially when they are unable to borrow more money.

However, not all companies that pursue rights offerings are in financial trouble. Even companies with clean balance sheets may use them. They are a way to raise extra capital to fund expenditures designed to expand the company's business, such as acquisitions or new facilities for manufacturing or sales. 

If the company is using the extra capital to fund expansion, it can eventually lead to increased capital gains for shareholders despite the dilution of the outstanding shares caused by the rights offering. 

Example of a Rights Issue

Let's say you own 1,000 shares of Wobble Telecom, each of which is worth $5.50. The company is in financial trouble and needs to raise cash to cover its debt obligations. Wobble, therefore, announces a rights offering through which it plans to raise $30 million. It will issue 10 million new shares to existing shareholders at a price of $3 each.

This issue is a three-for-10 rights issue. In other words, for every 10 shares you hold, Wobble is offering you another three at the deeply discounted price of $3. This price is 45% less than the $5.50 price at which Wobble stock trades.

As a shareholder, you have three options with a rights issue. You can:

1. Subscribe to the rights issue in full
2. Ignore the rights issue
3. Sell your rights to other investors

1. Subscribe to the Rights Issue in Full

To take advantage of the rights issue in full, you would need to spend $3 for every Wobble share that you are entitled to purchase under the issue. As you hold 1,000 shares, you can buy up to 300 new shares (three shares for every 10 you already own) at the discounted price of $3 for a total price of $900.

However, while the discount on the newly issued shares is 45%, the market price of Wobble shares will not be $5.50 after the rights issue is complete. The value of each share will be diluted as a result of the increased number of shares issued. To see if the rights issue does, in fact, give a material discount, you need to estimate how much Wobble's share price will be diluted.

Estimate the Dilution

In estimating this dilution, remember that you can never know for certain the future value of your expanded shareholding since it can be affected by business and market factors. But the theoretical share price that will result after the rights issue is complete—which is the ex-rights share price—is possible to calculate.

This price is found by dividing the total price you will have paid for all your Wobble shares by the total number of shares you will own. This is calculated as follows:

So, in theory, as a result of the introduction of new shares at the deeply discounted price, the value of each of your existing shares will decline from $5.50 to $4.92.

But, the loss on your existing shareholding is offset by the gain in share value on the new rights. That is, the new shares cost you $3, but they have a market value of $4.92.

These new shares are taxed in the same year as you purchased the original shares and carried forward to count as investment income. However, no interest or other tax penalties are charged on it.

2. Ignore the Rights Issue

You may not have the $900 to purchase the additional 300 shares at $3 each, so you can always let your rights expire. But this is not normally recommended. If you choose to do nothing, your existing shareholding will be diluted thanks to the extra shares issued by the company.

3. Sell Your Rights to Other Investors

In some cases, rights are not transferable. These are known as non-renounceable rights. But in most cases, your rights allow you to decide whether you want to take up the option to buy the shares or sell your rights to other investors or the underwriter. Rights that can be traded are called renounceable rights. After they have been traded, the rights are known as nil-paid rights.

To determine how much you may gain by selling the rights, you can estimate the value of the nil-paid rights ahead of time. Again, a precise number is difficult, but you can get a rough value by taking the value of the ex-rights price and subtracting the rights issue price.

At the adjusted ex-rights price of $4.92 less $3, your nil-paid rights are worth $1.92 per share. Selling these rights will create a capital gain.

The Bottom Line

Investors may be tempted by the prospect of buying discounted shares offered by a rights issue. But it is not always certain that you will get a bargain.

In addition to figuring the ex-rights share price, you should investigate the purpose for the additional funding before accepting or rejecting a rights issue. If a company is in real trouble, you may not wish to invest any more in it (even at a discounted price).

So be sure to look for a compelling explanation of why the rights issue is necessary. A rights issue can offer a quick fix for a troubled balance sheet, but that does not mean that management will address the underlying problems that weakened the balance sheet in the first place. Shareholders should be cautious.