Introduction to Rights Issues
Welcome to one of the most practical chapters in your F3 studies! As a company grows, it often needs more cash to fund new projects, pay off debt, or expand into new markets. One of the most popular ways to do this is through a Rights Issue. Think of this as a "VIP Sale" where the company offers new shares to its existing owners before offering them to anyone else. By the end of this section, you will understand how these issues work, how to calculate the new share price, and why companies choose this path.
What is a Rights Issue?
A Rights Issue is an offer to existing shareholders to purchase additional new shares in proportion to their current holding. These are a primary source of long-term equity finance.
The key concept here is Pre-emptive Rights. In many countries, the law protects shareholders by saying: "If the company wants to issue more shares, they must offer them to the current owners first." This prevents the current owners' control from being "diluted" (weakened) without their permission.
Key Characteristics:
• Discounted Price: To make the offer attractive, the new shares are usually offered at a price lower than the current market price.
• Pro-rata: Shares are offered in a ratio, such as "1-for-4." This means for every 4 shares you currently own, you have the "right" to buy 1 new share.
• Tradable: These "rights" have a value of their own and can often be sold to other people if the shareholder doesn't want to use them.
Quick Review: A rights issue is a way to raise equity from current owners, usually at a discount, while respecting their right of first refusal.
Why Choose a Rights Issue?
Why would a Finance Director choose a rights issue over other methods like a public offer?
1. Lower Cost: It is much cheaper than a public offer because you don't need expensive advertising or as much "underwriting" (insurance against the shares not selling).
2. Control: Since shares go to existing owners, the balance of power (voting rights) stays the same.
3. Success Rate: Because the shares are offered at a discount, shareholders are very likely to take them up.
4. Signaling: It can signal that the company has great new projects that it wants its current owners to benefit from.
Analogy: Imagine you own a small slice of a local bakery. If the bakery wants to expand, they ask you first if you want to buy more "ownership" at a discount before they ask a stranger. This keeps the "bakery family" in control.
Calculating the Theoretical Ex-Rights Price (TERP)
This is a classic exam favorite! When a company announces a rights issue, the share price will eventually settle at a new level. We call this the Theoretical Ex-Rights Price (TERP).
Don't worry if this seems tricky at first! It’s really just a weighted average. We take the value of the old shares and add the cash coming in from the new shares, then divide by the new total number of shares.
The Formula:
\( TERP = \frac{(N \times P) + (n \times S)}{N + n} \)
Where:
N = Number of existing shares in the ratio
P = Current Market Price (also called the Cum-Rights Price)
n = Number of new shares in the ratio
S = Subscription price (the discounted price of the new shares)
Example Walkthrough:
Company X has a current share price of $5.00. It announces a 1-for-4 rights issue at a price of $4.00.
Step 1: Value of 4 existing shares = \( 4 \times \$5.00 = \$20.00 \)
Step 2: Value of 1 new share = \( 1 \times \$4.00 = \$4.00 \)
Step 3: Total value of 5 shares = \( \$20.00 + \$4.00 = \$24.00 \)
\nStep 4: TERP = \( \$24.00 / 5 = \$4.80 \)
\nThe new "theoretical" price is $4.80.
The Value of a "Right"
A "Right" is a piece of paper that allows you to buy something for $4.00 when the market thinks it's worth $4.80. That piece of paper clearly has value!
Formula:
\( Value\ of\ a\ Right = TERP - Subscription\ Price \)
In our example above:
\( \$4.80 - \$4.00 = \$0.80 \)
\nSo, each right to buy a new share is worth $0.80.
Did you know? In the real world, you can actually sell these rights on the stock exchange. If you don't want to buy the new shares, you can sell your "rights" to someone else and keep the cash!
The Shareholder's Four Options
When a shareholder receives a rights offer, they have four main paths to choose from:
1. Exercise (Take up) the rights: Pay the cash and get the new shares. Their percentage ownership in the company stays the same.
2. Sell the rights: Sell the "right to buy" to someone else. They get cash now, but their percentage ownership in the company will drop.
3. Do nothing (Lapse): This is the worst option! The rights expire, and the shareholder loses the value. Most companies will sell the rights on the shareholder's behalf if they forget, but it's not guaranteed.
4. Tail-swallow: This is a clever trick! The shareholder sells just enough rights to raise the cash needed to "buy" the remaining rights. This means they get some new shares without spending any of their own "fresh" cash.
Key Takeaway: In theory, the shareholder's total wealth should remain the same whether they take up the rights or sell them (ignoring taxes and transaction costs).
Impact on Financial Ratios
In F3, you must understand how a rights issue affects the company’s financial position:
Earnings Per Share (EPS): This usually decreases. Why? Because there are now more shares in issue, and the new cash hasn't started generating profits yet. We also have to adjust previous years' EPS using a "bonus factor" to make them comparable.
Gearing (Debt-to-Equity): This usually decreases. Since the company is raising equity, the "Equity" part of the balance sheet goes up, making the debt look smaller in comparison.
Cash Flow: The company receives a large inflow of cash which can be used to reduce debt or invest in projects.
Common Pitfalls to Avoid
• Confusing the Ratio: In a "1-for-4" issue, the total number of shares becomes 5, not 4. Always add the two numbers together for the denominator.
• Price Confusion: Use the Cum-Rights price (the price before the issue) for the calculation of TERP, and the Subscription Price (the offer price) for the cash injection part.
• Wealth Impact: Remember that while the share price drops from the Cum-Rights price to the TERP, the shareholder isn't "poorer"—they either have more shares or the cash from selling the rights to make up the difference.
Summary Table
Concept: Rights Issue
Source: Long-term Equity Finance
Price: Usually at a discount to market price
Key Calculation: TERP (Weighted average price)
Impact on Shareholder: Wealth stays neutral; ownership stays same if rights are exercised.
Impact on Company: Cash increases, Gearing falls, EPS may be diluted.