Corporate Finance

Rights issue

A rights issue is the sale of new shares to existing shareholders in proportion to their existing holdings. For companies which already have shares in issue, sales of new shares are required by law to be conducted via rights issue, unless shareholders agree otherwise.

The circumstances in which it would be more beneficial for shareholders to take up their rights rather than sell their option in whole or in part are:

1. Where they have an existing substantial stake in the company with influential voting power which will fall if they do not take up their rights in full.
2. Where favorable forecasts relating to future profits and dividends of the company will result in the market price exceeding the theoretical ex-rights price.
3. In cases where the shareholder has surplus funds for investment and cannot obtain a higher return for them elsewhere with no greater risk.
4. Where funds can be borrowed at a lower rate than the return offered by the rights issued.
5. Where substantial capital gains tax will fall to be paid if any part of the present holding (including the rights) is sold. The option which the shareholder may face is that of having $4 invested in one particular company or only $3 in any other since a certain amount must be paid in taxes on a disposal taking place.

Costs of rights issue

The various types of costs incurred in making a rights issues are:
• Stock exchange listing fees for new securities
• Printing costs for prospectus and share certificates
• Underwriting commission
• Brokers commission
• Issuing house commission
• Legal and accounting fees.

Advantages of rights issues

A. Control: With a rights issue relative control of individual shareholder is maintained provided the rights are not sold.
B. Cost: A full prospectus is not required for a rights issue unlike a public issue. Underwriting costs are also likely to be lower than a public issue.

Disadvantages of rights issues

i. Spread of Ownership: A public ownership will spread ownership more widely (rights issue does not) and so prevents unwanted bidders getting control over a large number of shares.
ii. Fall in price: There will usually be a fall in the share price because of increase in the supply of the shares in the market.

Factors that determine the ex-right price of rights issue in practice:

1. Quantity of Shares Issued: if the issue is large, many shareholders may sell their rights and the additional shares on the market will depress the price.
2. Profitability of the new project: If it is anticipated that the investment of the funds will provide profits for the company greater than its present return, then this will enhance the value of existing capital and the share price will rise. Conversely, if the issue proceeds cannot be invested as profitably, or are needed to overcome liquidity problems, then the price will fall.
3. Ability to maintain the existing dividend: If the company is able to maintain the existing rate of dividend on the increased capital, the share price should rise.
4. Other general factors: Any current political or economic information which may boost or depress share prices generally.

Determinants of the price of rights Issue

• the existing value per share of the company
• the current prices of comparable shares
• the size of the issue and the ability of shareholders to subscribe
• any current government controls.
• the future cost of dividends if the same level of dividends is to be maintained on the enlarged share capital.

Timing of the rights issue

The timing of the rights issue will largely be determined by the following factors:

i. The needs for funds: The most common need for funds is for expansion, whether by organic growth or by acquisition. For example, funds for organic growth may be required fairly quickly if the company is attempting to beat its competitors into a new market but may be less urgent in other cases, for instance if it is intended to take over existing companies.
ii. The current value of the shares: Companies will seek to raise the most cash from the least number of shares. Thus, the most opportune moment for a right issue will be when the market value is high.
iii. It must be emphasized, however, that if the capital market is efficient the above point is completely invalid as the EMH makes us to believe that the timing of new issues is completely irrelevant.
iv. Approval by SEC: Any company wishing to issue any type of security on the stock market has to notify SEC of its intention and is then allocated a place in the issue of would-be users. This system is imposed to ensure that there is a reasonable demand for cash issue.

When considering the relative merits of a rights issue and a public issue of shares, the following points should be considered:

A. Shareholder control: A right issue of shares offers new shares to existing shareholders in proportion to their existing shareholders. This means that providing each shareholder takes up the right offer, shareholder control over the company will remain unchanged. A public issue of shares, on the other hand, will result in the sale of shares to other investors and so some dilution of control for existing shareholders could occur.
B. Issue costs: A public issue of shares is subject to tight regulation and so large legal and accountancy costs may be incurred to ensure compliance. In addition, a public issue will often involve high costs in advertising the issue and in publishing the offer document. A rights issue is not subject to such tight regulation and so compliance costs are not as high as a public issue. In addition, the costs of circulating existing shareholders with details of the offer are usually much cheaper than advertising a public issue.
C. Time taken: The fact that a rights issue is not subject to tight regulation and the circulation of details of the rights issue is a relatively straightforward process means that a rights issue can often be undertaken much more quickly than a public issue of shares.
D. Financing costs: A public issue of shares means that investors are in open competition for the shares on offer. Where there is strong demand, it may be possible to obtain a high price for the shares and this, in turn, will lower the cost of capital. A rights issue, on the other hand, will not result in open competition for the new shares and so the cost of capital may be higher.
E. Share price: New shares are often offered at a discount to the current market price and this will usually depress the price of shares already in issue. In the case of a rights issue, this is not really a problem providing existing shareholders exercise their options. However, when there is a public issue of shares, existing shareholders will be worse off. It is worth mentioning that, in many countries, shareholders have ‘pre-emptive rights’, which means that any new issues of shares for cash must first be offered to existing shareholders.