Is a Rights Share Issue right?

When a company wished to raise additional capital one way of doing so without diluting the existing shareholders is via a Rights Share Issue. When a company makes such an offer it essentially gives the existing shareholders a chance to buy new shares at a discount to the current trading price.

Why It’s Used

Unlike a new issue of shares, the Rights Share Issue (the ‘rights’) themselves are usually a tradable commodity because the company is giving shareholders chance to acquire the stock at a discount price. It is this discount that is usually used to entice shareholders to invest more in the company that needs cash because the discount reduces their risk. The ‘rights’ issued to a shareholder have a value and hence compensate current shareholders for the future dilution of their existing shares’ value.

How a Rights Share Issue Works

Let’s say you own 1,000 shares in TradeMe Limited, each of which is worth £5. TradeMe intends to raise £3 million by issuing 1 million shares to existing investors at a price of £3 each. But this issue is a 3-for-10 rights issue. In other words, for every ten shares you hold, TradeMe is offering you another three at a deeply discounted price of £3. This price is 40% less than the £5 price valuation of TradeMe.

Your Rights

As a shareholder, you have three options when considering what to do in response to the Rights Share Issue.

(1) subscribe to the rights issue in full,

(2) ignore your rights, or

(3) sell the rights to someone else.

Here we look how to pursue each option, and the possible outcomes.

1. Take up the share rights issue to purchase in full.

To take advantage of the Rights Share Issue in full, you would need to spend £3 for every TradeMe share that you are entitled to under the Rights Share Issue. As you hold 1,000 shares, you can buy up to 300 new shares (three shares for every ten you already own) at this discounted price of £3, giving a total purchase price of £900.

However, the share valuation of TradeMe shares will stay at £5 after the Rights Share Issue is complete as the value of each share will be diluted as a result of the increased number of shares issued.

The theoretical share price that will result after the rights issue is complete (the ex-rights share price) is possible to calculate. This price is found by dividing the total price you will have paid for your entire TradeMe shares by the total number of shares you will own. This is calculated as follows:

1,000 existing shares at £5 £5,000
300 new shares for cash at £3 £900
Value of 1,300 shares £5,900
Ex-rights value per share £4.54 (£5,900/1,300 shares)

In theory the value of each of your existing shares will decline from £5 to £4.54. But the loss on your existing shareholding is offset exactly by the gain in share value on the new rights: the new shares cost you £3, but they have a market value of £4.54.

These new shares are taxed in the same year as you purchased the original shares, and carried forward to count as investment income, but there is no interest or other tax penalties charged on this carried-forward, taxable investment income.

2. Ignore the Rights Share Issue.

You may not have the £900 to purchase the additional 300 shares at £3 each, so you can always let your rights expire. But this is not normally recommended. If you choose to do nothing, your shareholding will be diluted due to the extra shares issued.

3 Sell the right to your Right Share Issue to other investors.

In some cases, rights are not transferable. These are known as “non-renounceable rights”. But in most cases, your rights allow you to decide whether you want to take up the option to buy the shares or sell your rights to other investors or to the underwriter. Rights that can be traded are called “renounceable rights”, and after they have been traded, the rights are known as “nil-paid rights”.

To determine how much you may gain by selling the rights, you need to estimate a value on the nil-paid rights ahead of time. Again, a precise number is difficult, but you can get a rough value by taking the value of ex-rights price and subtracting the rights issue price. So, at the adjusted ex-rights price of £.54 less £3, your nil-paid rights are worth $1.54 per share. Selling these rights will create a capital gain for you.

A Warning

It is easy for investors to get tempted by the prospect of buying discounted shares. However it is not always a certainty that you are getting a bargain. The most important consideration is to understand the purpose of the additional funding before accepting or rejecting a rights issue. After all, why would a company offer shares at a discount if it were capable of offering them to new shareholders as a fresh issue?

Usually a rights issue can offer a quick fix for a troubled balance sheet, but that doesn’t mean management will address the underlying problems that weakened the balance sheet in the first place.