Rights issues

There are three main sources of equity finance  :

• internally-generated funds - retained earnings
• rights issues
• new external share issues - placings, offers for sale, etc.

Rights issues

A rights issue is an offer to existing shareholders to subscribe for new shares, at a discount to the current market value, in proportion to their existing holdings.

This right of pre-emption:

• enables them to retain their existing share of voting rights
• can be waived with the agreement of shareholders.

Shareholders not wishing to take up their rights can sell them on the stock market.

Advantages and disadvantages of rights issues

Advantages:

• it is cheaper than a public share issue
• it is made at the discretion of the directors, without consent of the shareholders or the Stock Exchange.
• it rarely fails
• existing shareholders' equity stakes are not diluted, provided they take up their rights.

Disadvantages

• there is a limit to how much can be raised through this method as existing shareholders are only willing to invest so much. A rough rule of thumb is that a rights issue could raise up to 25% of the existing equity value of the firm.
• If shareholders do not take up their rights, then their shareholding will be diluted.

Shareholders' options

The shareholder's options with a rights issue are to:

(1)take up his rights by buying the specified proportion at the price offered

(2)renounce his rights and sell them in the market

(3)renounce part of his rights and take up the remainder

(4)do nothing

Further calculations

The theoretical ex-rights price (TERP) of a share

The new share price after the issue is known as the theoretical ex-rights price and is calculated by finding the weighted average of the old price and the rights price, weighted by the number of shares.

The formula is:

The value of a right

To make the offer relatively attractive to shareholders, new shares are generally issued at a discount on the current market price.

 Value of a right = theoretical ex rights price - issue (subscription) price

Since rights have a value, they can be sold on the stock market in the period between:

• the rights issue being announced and the rights to existing shareholders being issued, and
• the new issue actually taking place.

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Tags:	rights issue;pre-emption rights;TERP;equity finance;equity