Rights Issue Learning objective After completing this chapter you will be able to answer to these questions:
What is rights issue? What are the reasons for such rights/ Under what circumstances the company shall decide on rights issue? What are the hazards in case of rights issue? How the company should approach to price the rights/ shares conversion ratio? What are the strategic points worth considering while formulating the company’s strategy on rights? Chapter Content 1. Definition 2. Features 3. Conditions to be satisfied by the firm 4. Impact on price of existing equity 5. Impact on shareholders’ wealth 6. Pricing of rights
2 What is Rights Issue? An existing company which has already gone for an IPO has a base of its own stockholders. If the company has been doing quite well and its stockholders are happy with its performance, it can approach the existing equity shareholders for further finance in case of necessity like expansion and launching new projects. Who could be a better choice than its satisfied owners? The company has to make least efforts to sell its equity in terms of marketing. It has very little to prove before its own shareholders who are with them for quite some time. Both the issue cost and time cost of the issue would be less than the cost had the company gone for another public issue. And offering shares to existing shareholders is called Rights Issue. The nomenclature Rights is because under the company law in case of all the subsequent public issues after the IPO, a company has to offer first to its existing stockholders. Thus this is a right to the stockholders given by law. That is why such an issue is called a Rights Issue. Rights are not an Indian typicality only. Almost in every country similar law exists. However, the stockholders themselves can relinquish this provision by a passing a resolution that effect in a general meeting of the company. In that case the company would not be allowed to go for a Rights Issue. The shareholders can also relinquish their rights even by part.
3 What is ‘Rights’? Popularly, shares issued through a Rights Issue are called rights shares. In fact, there is a difference between rights and what is referred to as rights shares. A shareholder is entitled to rights equal to the number of equity shares he is holding. That is the number of rights is exactly equal to the number of shares held by the investor. These rights are converted into equity shares at the conversion ration as decided by the management of the company. Rights are negotiable and tradable like shares. This indicates that the rights in the market has a price. Although it is difficult to measure the possible market price of a right, on the basis of the assumption that a shareholder’s wealth position can hardly be affected by a Rights Issue, we may calculate some indicative price of rights. The assumption of no change in shareholders’ wealth position is quite rational. When the shares are offered only to the existing shareholders, the pre-issue and post-issue holders remain the same. That is the demand side of the rights also remain the same, while the supply side has gone up since the stockholders are in possession of more shares from the same company. This must logically bring the share price down in the market. The erosion in price should be exactly to the extent of the so called extra benefit afforded to the existing stockholders. Thus the wealth position of the stockholders maintains a status quo. This also implies that if one existing stockholder does not subscribe to the rights issue, his wealth position is bound to erode since he will be left with the same holding, but at a lower market price.
In reality this may not be the case. Since the rights are tradable and having a market of their own, the market price of rights are likely to be determined by the market forces of demand and supply. The rights are derived from the shares. But it would not be always practical to link rights with the movements of the underlying security. The price may be influenced by many factors like the individual investors’ personal finance at the moment and their preferences that vary too widely. Thus there are possibilities of different kinds of situational movements resulting in rights being priced in sharp difference to the indicative theoretical value of rights. Moreover, rights declaration may also sometimes create a positive or negative vibe in the market. The price of rights would be influenced by that too. Rights are exercisable within a specified period of time, generally up to thirty days. The shareholders can also sell either in full or in part the rights they are allotted to. Selling the rights would save them from the possible ex-rights downfall in the price of the shares. How to price a Rights Issue? Pricing the issue seems to be not that important in case of rights as
in case of IPO. Only thing to ensure is that it should be substantially underpriced. If the subscription price is not considerably below the market price, the shareholders would not be motivated to buy it. But how much underpricing should be done is not that material an issue
5 here, since any dilution of price would be borne by the existing shareholders only as they are the main buyers. The only thing is to take note of is to see that the subscription price is attractive enough for the target investors. The success of the rights issue largely depends on how low the subscription price is.
Why Rights Issue is done by a company? Rights Issue is done by a company for many a reason. The first major one is it is far easier to sell the issue to the existing stakeholders than to anybody else. Second, unlike public issue Rights Issue does not have the possibility of control dilution. The success of any issue much depends on the company’s consistent track record. But in Rights Issue some extra protection is enjoyed by the company since it is targeted to it own shareholders. company has an edge in capitalizing the market through Rights. In general, never the existing stockholders of a company would welcome another issue of equity because rationally they do not like at all their wealth and ownership to be divided with newcomers. But if it is a Rights Issue they do not have to worry since both these are well protected. Rights issue is a weapon too in the hands of the company management to avoid the dilution of control whenever the company decides to raise finance through equity. Particularly, in case of a closely held company it saves prevents the company to be taken over So the
6 in the days of corporate predation. The company as a defence against a hostile takeover bid may decide to go for a huge rights issue. The ex-rights price would go down then substantially keeping the company control intact. This is expected that this would discourage the predating company from its takeover bids. This is a proven device and popularly called as poison pills. The practice is that the shareholders are issued long-dated rights which do not come in effect immediately. They are automatically exercised when, during a hostile takeover a company or an investor acquires a certain percentage of shares, thereby diluting the takeover bid. In fact, many a company has taken to the poison pill so far.
Market Value per share after the rights issue (ex- rights): Value of one share after the rights issue (ex- rights): (nMPS0 + SP)/ n +1, Where, N= no. of rights required to subscribe to one share MPS0= market price per share before rights issue (cum-rights) SP=Subscription price per share for rights issue Theoretical value of one right then would be= (MPS0-SP)/ n+1 The price advantage thus is being distributed among all the shares the investor is going to have immediately after the rights issue (ex-rights holding).
The shareholder however neither gains nor loses through rights issue. He has three options: 1. Exercising his rights by buying additional shares; or, 2. Selling his rights and get cash; or, 3. Allowing his rights to expire by doing nothing. In the first two cases he is not likely to either gain or lose. By either of these he is able to maintain his position. If he exercises his rights, he will be in possession of additional shares. But due a fall in ex-rights market price of shares, the value of his shareholding is likely to remain the same. In case he sells his rights, his holding size remains the same and due to reduced ex-rights market price the value of his holding would come down. But the loss incurred would be compensated by the cash he has received from the sale of rights.
But in case he allows his rights to expire, he is neither in possession of additional shares nor he additional cash from sale of rights. Therefore he loses. So, the investors should choose either of the first two options as discussed.
We can take the following example to prove this point. A Ltd. has a capital base of 100 lakh equity shares of Rs. 10 each fully paid. The company’s last balance sheet shows Rs. 6 crore in its general reserve, and Rs. 2 crore in 10% Debentures. It has earned 15% on its total capital employed. The company is in a 40% corporate tax bracket. The company’s shares enjoy a price-earning ratio of 12 in the market. The company now decides to raise finance through a further issue of 40 lakh equity shares of Rs.10 each. The half of the issue will be treated as a rights issue. The subscription price has been determined at Rs.12.
EBIT Interest EBT Tax @40% EAT Number of shares outstanding EPS
Rs.27000000 Rs. 2000000 Rs. 25000000 Rs. 10000000 Rs. 15000000 10000000 Rs. 1.50
Price earning ratio Market price per share
12 Rs. 18
Now, suppose one investor Mr.X is holding 1000 shares in the company. Thus he is entitled to 1000 rights in this case. n will be= 10000000/2000000, or 5. That is he is entitled to 10 equity shares in this rights issue. Value of one right= (18-12)/(5+1)= Re.1 Ex-rights market price per share would be= ((n*MPS0+SP)/n+1) =((5*18+12)/6))= Rs.17
The shareholders position if he exercises rights:
Cum-rights : Investment value(1000 shares @Rs.18 per share) Ex-rights : Size of his shareholding(1000+200) Market price per share Rs. 17 1200 shares Rs.18000
Investment value(1200 shares @ Rs. 20400 Rs.17 per share) Less: His cash outgo for subscribing the additional shares(200 shares @Rs.12 per share) Net value of investment Rs. 18000 Rs. 2400
10 His net gain/ loss Nil
The shareholders position if he sells rights:
Cum-rights : Investment value(1000 shares @Rs.18 per share) Ex-rights : Size of his shareholding Market price per share 1000 shares Rs. 17 Rs.18000
Investment value(1000 shares @ Rs. 17000 Rs.17 per share) Add: His cash income by selling 1000 rights @ Re.1 Net value of investment His net gain/ loss Rs. 18000 Nil Rs. 1000
The shareholders position if he allows his rights to expire: Cum-rights : Investment value(1000 shares @Rs.18 per share) Ex-rights : Size of his shareholding Market price per share 1000 shares Rs. 17 Rs.18000
Investment value(1000 shares @ Rs. 17000 Rs.17 per share)
11 His net gain/ loss Rs. 1000
Can this theoretical value of rights differ from the value in the market? YES, for these two reasons in addition to what we have discussed in some early paragraphs: The value in the market could differ due to the transaction cost in the market; The company’s goodwill in the capital market at that point of time is very important. More reputed the company is, greater would be the demand because non-shareholders would also throng the market for the company scrip. This accelerated demand would move the value of rights upward;
Setting the subscription price for the existing shareholders in case of rights issue:
All the discussion we have done so far on rights simply makes it clear that the subscription price does not matter. The shareholder’s position would be irrespective of the quantum of the subscription price. Whatever may the SP, the shareholders either have to exercise the rights or to sell the rights to maintain the status quo. Either of However, the difference between MPS0 and SP determines a shareholder’s extent of loss if he does not do anything with his rights. His loss will increase if the subscription price is considerably
12 lower than the MPS0. Either of these two activities is rationally expected from the shareholders. No rational investor would allow his rights to expire. In case of any issue of shares, it is imperative to the company to under price the subscription price. This is no exception to the rights issue also. If the subscription price is not lower than the then market price, there would be no reason to buy the share from the open market. So, the success of the rights issue largely depends on how low the subscription price is. But at the same time lower the subscription price is, greater has to be the issue size to collect the requisite funds. Greater the number of shares, harder it would be for the company to maintain its EPS and dividend per share (DPS) level. So, these factors are to be seriously kept in mind while pricing. Some other factors worth considering while setting the subscription price: Is it the right time to approach the market? Choosing the appropriate time to approach the market is very vital. For this a continual close observation is necessary. Generally both the primary and secondary segments of the capital market move hand in hand. So, at the time of overall buoyancy in the market, at least the inclination toward buoyancy, is the clear indicator as to the time to approach market. Is the scrip doing steadily well in the market? No investor would take a long position if the company is not doing well as
13 compared to other firms in the market. If in the investors’ perception the scrip of the company is not an undervalued one with strong potential to go higher and higher, it would certainly not be the right situation for a rights issue. Is the effective control of the company going to be diluted after the issue? As we have already seen that losing control over the company happens to be the least acceptable consequence to the existing shareholders and the company management. There are several devices to avoid dilution of control. In fact a company tries a number of avenues like preferential allotment and private placement with this object in mind. So the management has to estimate the impact beforehand. Rights issue – the merits: 1. It is easier than the public issue in that the company is approaching its own shareholders who already know the company well. Thus lesser efforts are needed for the sale. 2. Therefore the company can either avoid or reduce underwriting because of lesser risk of being under subscribed. A reduction in underwriting commission makes the floatation cost of the issue low. 3. It helps the company to expand its equity base without any dilution in control. Rights issue: the hazards: 1. Existing shareholders may not relish the idea of further investment. Although it has been seen that by exercising rights
14 they can maintain status quo. But they might not feel
comfortable with the idea of spending cash to buy this status quo. In fact, they certainly lose marginally if the opportunity cost of the cash outgo is considered; 2. For a company in which a sizable portion of its shares are held by financial institutions, rights issue may not be a success prove to be Rights issue could also help the company if it is going through a period of financial hardship. Thus the rights issue, at times, should more be viewed as a corporate strategy for preventing control dilution than a method of raising finance. In other words, rights issue is a funding mode to the company that has little threat to company management.