Rights issues are a way for companies to raise money

In order to raise extra capital, rather than taking on additional debt, a rights issue involves a company giving existing shareholders the right for a specified period and at a specified (usually discounted) price to subscribe to newly issued shares in proportion to their existing holdings.

In the ‘good old times’, the money raised was used for corporate expansion, such as a large takeover. More recently, however, many fundraisings are used to ‘strengthen the balance sheet’ in order to trade trough the credit crunch or even worse to save a company from going bust. Some sort of corporate activity or explanation will always accompany a rights issue.

What happens if a company launches a ‘rights issue’?

The best way to explain this is by way of an example.

Prior to the announcement of the rights issue, Example Plc has 45 million ordinary shares at £1, which are valued at £3 on the stock market. The company’s market capitalisation therefore amounts to £135 million (multiply 45m times £3).

At some stage, Example Plc announces that it wants to raise £33 million to complete an acquisition based on the following terms:

it is to issue 15 million new £1 Ordinary Shares to existing shareholders for £2.20 cash per share, on the basis of
a “1 for 3” rights issue

A "one for three" rights issue means that an existing investor can buy one extra share for every three currently held.

The price of the newly issued shares is fixed, and is always set below the prevailing market price -in our example £2.20. The main reason is to make the offer relatively attractive to shareholders and encourage them either to take up their rights or sell them so the share issue is "fully subscribed".

How does this effect me?

Suppose you own 3000 shares in Example Plc. You would then be entitled to subscribe for 1000 new shares at £2.20 each, involving a cash payment of £2,200 to the company.

The value of your shareholding before the rights issue is:

3000 shares at £3 = £9,000

If you decide to take up the rights you will have to purchase 1000 new shares at a price of £2.20:

1000 shares at £2.20 = £2,200

As the name implies, the issue gives shareholders the right to buy the additional shares, but not the obligation. The rights can be sold on to others who wish to take advantage of the offer, and hence each right has a value. A shareholder can take up all, some or none of the rights on offer.

If you decide that you do not wish to invest more cash in Example Plc you could sell your rights in the market. The buyer of the rights would then subscribe the required £2.20 per share in order to obtain the new shares.

If I want to sell my rights what would they be worth?

Lets return to our example.

Prior to the announcement of the rights issue, three shares at £3 are worth £9. Following the completion of the rights issue (1 for 3 rights issue at £2.20 per share) four shares should be worth £11.20 (£9 plus £2.20).

Theoretically, the rights per share are therefore worth £0.20 which also equals the £0.80 ‘discount’ (£3 minus £2.20) divided by four shares.

What happens to the share price after the rights issue?

After the shares goes ex-rights (meaning that anyone buying these shares no longer has the right to buy the new shares) the share price, known as the (theoretical) ex-rights share price, can be computed as follows:

divide the total value of your investment by total number of shares held

(£9,000 + £2,200)/(3000 + 1000) = £2.80

All things being equal, that’s very much the theory.

As mentioned before, a rights issue is accompanied by corporate news including the reasons why new cash is being raised. The stock market will take a view regarding the reasoning and usefulness of the rights issue that will influence the actual ex-rights share price. The then prevailing general market conditions may also influence the share price.

If the new money is to be put to good use, then the share price may rise above the theoretical ex-rights share, even though the extra shares will have a dilutive effect. Often the share price will settle above the issue price, in this example £2.20

When not to take part in a rights issue?

If the share price has fallen below the subscription price (in our example £2.20) it would be cheaper to buy the shares on the stock market than to participate in the rights issue.

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