10 Dec 2018 07:14am IST
Neetant D Sinai Shirodkar
Investing in the stock market comes with its own fair share of trials and turbulences. But for those who believing in long term investment in companies with the right fundamentals can surely harvest a rich crop of returns either through capital gains, bonus issues and making use of rights issue whenever the opportunity arises. Through this column let’s understand the lesser known concept of “Rights issue” to benefit from it.
A rights issue is a way by which a listed company can raise additional capital. However, instead of going to the public, the company gives its existing shareholders the right to subscribe to newly issued shares in proportion to their existing holdings. For example, 1:4 rights issue means an existing investor can buy one extra share for every four shares already held by him/her. Usually the price at which the new shares are issued by way of rights issue is less than the prevailing market price of the stock, i.e. the shares are offered at a discount.
Example of a Rights Issue
Let’s say an investor owns 100 shares of Hindustan Lever Limited and the shares are trading at Rs.10 each. The company announces a rights issue in the ratio of 2 for 5, i.e., each investor holding 5 shares will be eligible to buy 2 new shares. The company announces a discounted price of, for example, Rs.6 per share. It means that for every 5 shares (at Rs.10 each) held by an existing shareholder, the company will offer 2 shares at a discounted price of Rs.6.
Investor’s Portfolio Value (before rights issue)
= 100 shares x Rs 10 = Rs 1,000
Number right shares eligible to be received
Price paid to buy rights shares
= 40 shares x Rs 6 = Rs 240
Total number of shares after exercising rights issue
Revised Value of the portfolio after exercising rights issue = Rs 1,000 + Rs 240 = Rs 1,240
Average price per share post-rights issue
= Rs 1,240 / 140 = Rs 8.86
Why does a company go for it?
The basic idea is to raise fresh capital. A rights issue is not a common practise that a corporate organisation resorts to. Ideally, such an issue occurs when a company needs funds for corporate expansion or a large takeover. At the same time, however, companies also use rights issue to prevent themselves from being conked out. Since a rights issue results in higher equity base for the organisation, it also provides it with better leveraging opportunities. The company becomes more comfortable when it comes to raising debt in the future as its debt-to-equity ratio reduces.
What is the effect on the company and what if a shareholder does not exercise his right?
A rights issue affects two important elements of a company, equity capital and market capitalisation. In case of a rights issue, since additional equity is raised, the issuing company’s equity base rises to the extent of the issue. The effect on market capitalisation depends on the perception of the market.
In theory, every new issue has some kind of diluting effect (as shown in the table above) and hence as a result of a fall in the market price in proportion to an increase in the number of shares, the market capitalisation remains unaffected. However, if the market sentiment believes that the funds are being raised for an extremely positive purpose then price of the stock may just rise resulting in an increase in the market capitalisation. If a shareholder does not want to exercise the right to buy additional shares then he/she can sell the right as the rights are usually tradable. Alternatively, investors can just let the rights issue lapse.
What should an investor be careful about in case of a rights issue?
An investor should be able to look beyond the discount offered. Rights issue are different from bonus issue as one is paying money to get additional shares and hence one should subscribe to it only if he/she is completely sure of the company’s performance. Also, one must not take up the rights if the share price has fallen below the subscription price as it may be cheaper to buy the shares in the open market.
Hope this article provides some insight to improve your skills to invest in the stock market, it won’t promise you great returns as it’s only meant to throw light about a concept, but remember nothing in this world is more dangerous than being deliberately ignorant.