What is Rights Issue? | How it works? | Do's and don'ts during a Rights Issue

Rights issue is a means through which companies can raise money from its existing shareholders by giving them the right to buy additional shares of the company at a discounted price (at least 20%).

You can only buy a limited number of additional shares in accordance to the ratio at which the company is bringing rights issue.

For example, if a company is bringing rights issue at a ratio of 3:10 that means you can buy 3 additional shares for every 10 shares you hold. 

In a rights issue, a shareholder has the right but is not obligated to buy the additional shares. However ignoring a rights issue is not recommended, you will get to understand the reason in this article afterward.

 

Let’s see how Rights issue works and how a smart investor should play it:

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 issue

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

Average price per share                                              = Rs959

Price of share in the open market                               = Rs968.6

*Your holding 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 the 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 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.