During a Rights Issue the shares of that particular company are available at a discounted price to their existing shareholders. What we need to understand here is that the discounted price is just an illusion to attract their shareholders to raise money from them.
Now you may be thinking that how the discounted price is an illusion if you are getting additional shares cheaper than the price at what it is available on the market.
The answer to this question is that, after the Rights Issue, whether you participate in it or not, your shareholding will get diluted and the shares of that company will be available at a new price (cheaper than before) on the market.
Let’s understand this process through a simple example and let’s see what you should do during a rights issue :
Let’s suppose there is a company ‘ABC’ with 1crore outstanding shares and the price of each share is Rs1000, hence the market cap of ‘ABC’ is Rs1000crores (outstanding shares X share price).
You are an investor in ‘ABC’ and you hold 100 shares of this company which you bought at Rs1000 each, making your total investment in the company to be Rs1lakh.
Assuming since the day you have bought the shares, the price has not moved from Rs1000.
This company ‘ABC’ decides to raise Rs55crores through a rights issue at a proportion of 1:10 (1 share for every 10 share you hold) at an offer price of Rs550 (45% discount).
Now according to the situation, you can take action in three possible ways:
1. Subscribe for the offering
Let’s suppose everyone including you subscribes to the rights issue. Now you have acquired 10 additional shares of ‘ABC’ at Rs550 each i.e. you increased your investment in the company by Rs5,500.
Now you have a total of 110 shares and a net investment of Rs1,05,500 in ‘ABC’, bringing down your average cost of each share to Rs959 (total investment – total shares).
As the company has now raised Rs55crores by allotting 10lakh new shares to its existing shareholders, the market cap of ‘ABC’ has now become Rs1055crores (Old market cap + money raised through rights issue) and the outstanding shares also increased to 1.1crore (Previous outstanding shares + New allotted shares).
So after the rights issue, your holding will get diluted and the shares will be available at a new price in the market i.e. Rs959 (New market cap / Total outstanding shares after rights issue).
Now if the company uses the raised money to clear off its’ debts, it is not increasing the company’s revenue in any way, which will bring down the company’s EPS(Earning Per Share) by 9%. But instead, if the company uses the raised money to expand its operation or to acquire another company, it will eventually balance out the EPS or you may also witness an increase in the EPS with time.
2. Do nothing
Let’s assume another situation where 25% of shareholders choose not to apply for the rights issue and you are among those 25% people.
Still, the company will be able to raise 75% of 55crore (The amount they wanted to raise) from the rest 75% shareholders who subscribed for it i.e. the company will be able to raise 41.25 crores by allotting 7,50,000 new shares.
Then the revised market cap and the share price of the company will be 1041.25crores and Rs968.6 respectively. Anyhow your holding got diluted.
*Let’s see what would have happened in this situation if you were among the 75% who subscribed for the rights issue.
Total shares you will have
|
110
|
Total investment in the company
|
Rs1,05,500
|
Total investment in the
company
|
Rs959
|
Price of share in the open market
|
Rs968.6
|
*Your shareholding got even more diluted when you chose not to participate in it.
3.Trade your rights
Although in some cases rights are not tradable but most of them are, so you can also choose to sell your rights in the market like any other share i.e. the person who buys the rights can then buy the shares of that company at a discounted price.
Now in the above scenario, instead of not doing anything, if you choose to sell your rights in the market you can make an estimated profit of Rs418.6 (Revised share price after the offering – offer price of rights issue) per share.
The rights that you trade in the market are also known as nil paid rights because you haven’t paid for them.
Conclusion:-
1. From the above example it is clear that not doing anything during a rights issue is not smart as it will eventually dilute your shareholding in the company. Because of its dilutive nature most investors don’t like companies which bring rights issue more often, which may hurt its share price. That’s why most companies see the rights issue as their last alternative for raising money.
2. Before taking any action it is very important that you should know the company’s motive behind the rights issue. Whether the company is raising money to clear off its debts or to expand its operation or acquire a company.
3. In case, if the company’s motive is to clear off its debts and according to your analysis you don’t think the company has a good future then the smartest action will be to trade your rights in the market.
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