Rights issue: reasons and advantages

Apr 16, 2022

Level: Beginner

Reading time: 4 min

One of the primary activities the company’s management is liable for is raising funds. In doing so, a listed company engages itself in share-issuing campaigns. This article will discuss one such campaign, the right issue, which gives the existing shareholders a right to purchase the company’s shares lesser than the amount it’s being traded on the stock exchange.

Let’s get started with knowing what the rights issue means.

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What is the rights issue?

The rights issue is a call to shareholders to purchase additional shares in the company. This phenomenon gives existing shareholders the right to buy new shares at a discounted price compared to the market price of the company’s shares.

The premise behind issuing these shares to existing shareholders is to raise additional capital for the company. This added capital is often used for their business’s exponential development and growth, investing in new projects, and fulfilling its financial obligations.

Features of the rights issue

Here are some main features of the rights issue:

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Companies launch rights-issuing campaigns to raise funds for various progressing activities. This process empowers a company to collect funds without incurring an underwriting fee.
Rights-issuing campaign grants the existing shareholders a preferential right, not an obligation, to invest in the company and obtain shares by paying a lower price on or before a specified date.
The shareholders can purchase additional shares based on the proportion of the ordinary shares the existing shareholders already hold.
These shares are traded similarly to the trade of ordinary shares.

Shareholders can also choose not to buy these shares. It is their right. But if they do not buy them, their existing shareholding will be diluted after additional shares are issued.

Reasons for the rights issue

There can be various reasons for a company to issue additional shares. Some of them are:

To expand operations, a company can issue additional shares to raise capital. It is often the right way to raise funds quickly and achieve objectives faster. It saves a company from taking a commercial loan and bearing regular interest payments.
A company may also deem it fit to raise funds via rights issues where debt might be expensive and not an appropriate way to kickstart an expansion.
A rights issue is a corporate strategy where a company intends to improve its debt-to-equity ratio or acquire another company via equity.
At times, companies feeling it tricky to come out of debt can also issue the right shares to pay back the principal and interest payments on the debt.

Note! The stock price will be diluted and likely to go down with the right issue because more shares are issued to the market.

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Example of a rights issue

Suppose an investor owns 1000 shares of Company-Z (the company), and the market price of the shares is $10. The company’s management announces the rights issue in the ratio of 2 for 4 with a discounted price of $5, making every existing shareholder eligible to buy two new shares for every four shares they hold.

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To summarize the example, the company will offer two shares at a discounted price of $5 for every four shares an existing shareholder holds.

Here’s what the calculations will look like:

Shareholder’s portfolio value before the rights issue = 1000 x $10 = $10.000
Number of rights shares to be received = 1000 x 2 / 4 = 500 shares
Cost to buy rights share = 500 shares x $5 = $2500
Total number of shares after the rights issuance = 1000 + 500 = 1500 shares
Revised shareholder’s portfolio value = $10.000 + $2500 = $12.500
It makes the price per share post-rights issue for the existing shareholder to be = $12.500 / 1500 = $8.33

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Now, since the price per share of the existing shareholder’s portfolio is $8.33, if the market price of the shares goes below that price mark, the shareholder will face a loss. On the contrary, the company’s shares are being traded at $10, which already keeps the existing shareholders in a profit of $1.67 per share ($10 – $8.33).

The bottom line

A rights issue is a phenomenal strategy for a company seeking to raise money quickly and efficiently. It’s also a valuable opportunity for existing shareholders to hop into investing in the company’s shares at a lower price than the market.

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