Rights Issue Calculation

In the world of corporate finance, companies frequently encounter situations where they need to raise additional capital to fund a variety of projects or business operations. These needs might include financing expansion plans, paying off existing debt, or securing working capital to cover day-to-day expenses. Publicly listed companies have multiple methods at their disposal to raise the necessary funds, one of which is the issuance of new shares through a rights issue. A rights issue is a straightforward and effective way for a company to raise capital by offering new shares to existing shareholders on a pro-rata basis, often at a price lower than the current market price.

The primary aim of a rights issue is to raise funds without seeking capital from external investors or institutions, which may involve more complex negotiations and potentially dilute the control of the company. A rights issue, by contrast, allows companies to tap into their existing shareholder base, offering them an opportunity to maintain their proportional ownership in the business. This approach to raising capital can have significant consequences for both the company and its shareholders, as it provides much-needed funds but can also present risks if not executed carefully.

The concept behind a rights issue is relatively simple. The company issues new shares to its existing shareholders in proportion to the number of shares they already own. This ensures that the existing shareholders are given the first opportunity to buy additional shares before they are offered to external investors. The number of shares a shareholder is entitled to purchase is determined by a predetermined ratio, which may vary depending on the company’s capital needs and the decision of its management team. For example, in a 1:5 rights issue, shareholders are offered the right to buy one new share for every five shares they already hold. This means that shareholders can increase their ownership stake in the company by purchasing additional shares at a set price.

The key feature of a rights issue is that the new shares are offered at a discounted price. Typically, this price is lower than the current market value of the shares, providing an incentive for existing shareholders to take part in the offering. The price discount is a crucial element in the success of a rights issue, as it makes the offer more attractive to shareholders who may otherwise be reluctant to invest additional capital. By offering the shares at a price lower than the market value, the company increases the likelihood of existing shareholders choosing to take up their rights.

In addition to the discount on the price of the shares, shareholders are typically offered the right to buy the shares in proportion to their current holdings. This pro-rata allocation ensures that no shareholder is unfairly diluted by the issuance of new shares. If a shareholder does not wish to purchase the new shares, they can choose to sell their rights on the open market if the rights are transferable. Alternatively, shareholders can choose to let their rights expire, though this will result in a loss of the opportunity to purchase additional shares at the discounted price. If the rights are transferable, they may be sold to other investors who are interested in buying the shares.

For companies, the benefits of conducting a rights issue are clear. First and foremost, it provides an efficient means of raising capital. Unlike other forms of fundraising, such as debt issuance or borrowing, a rights issue does not increase the company’s liabilities. This is particularly appealing to companies that are looking to reduce their debt levels or avoid taking on additional financial obligations. A rights issue also allows the company to tap into its existing shareholder base, which can make the process quicker and more cost-effective. The company does not need to conduct a lengthy marketing campaign or negotiate with external investors, as the shareholders are already familiar with the company and its operations.

Moreover, a rights issue can help a company raise capital while maintaining control over its ownership structure. If a company were to seek external investors or issue shares to the public, it could dilute the control of existing shareholders, particularly the founding members or management team. By offering the shares only to existing shareholders, the company minimizes the risk of losing control to new investors who may seek a larger influence in the company’s decision-making process. This control over the ownership structure can be a key consideration for companies that prioritize maintaining the stability and direction of their business.

While the benefits of a rights issue are significant, it is important to recognize that the process also carries risks, both for the company and its shareholders. One of the primary risks for the company is that it may not be able to raise the full amount of capital it needs through the rights issue. While the offer is extended to all shareholders, not every shareholder may choose to participate. If a significant portion of shareholders does not take up their rights, the company may not be able to meet its capital-raising targets, potentially leaving it with insufficient funds to meet its objectives. Furthermore, if the company is in financial trouble or facing challenges in its operations, shareholders may be hesitant to participate in the rights issue, fearing that the company’s prospects may not improve in the long term.

Another risk for the company is the potential for negative market reactions. Even though rights issues are a common and accepted method of raising capital, investors may interpret a rights issue as a sign of financial weakness or instability. If the market perceives that the company is struggling to secure funding through other means, it could lead to a decline in the stock price, making the rights issue less effective in raising the necessary capital. A poorly timed or poorly executed rights issue can thus have unintended consequences, leading to a drop in shareholder confidence and a reduction in the company’s market value.

For shareholders, the risks associated with a rights issue primarily stem from the potential for dilution and the impact on the value of their investment. If a shareholder does not participate in the rights issue, their percentage of ownership in the company will be diluted, as the number of outstanding shares will increase. This dilution can reduce the value of their existing shares, particularly if the new shares are offered at a significant discount. Additionally, if the company’s performance does not improve after the rights issue, shareholders may find that the new shares they purchased at a discount do not generate the expected returns, leading to a decrease in the value of their investment.

There is also the risk that shareholders may not have the funds available to participate in the rights issue. While the discounted price of the shares makes the offer more attractive, it still requires shareholders to make a financial commitment. Shareholders who are unable to invest additional capital may find themselves missing out on the opportunity to maintain their ownership stake in the company, or may face the dilution of their holdings if they choose not to participate.

In conclusion, a rights issue is a widely used financial instrument that offers companies an effective way to raise capital while allowing existing shareholders the opportunity to maintain their proportional ownership. By offering new shares at a discounted price, the company incentivizes shareholders to participate in the offering, while also providing a means of securing the funds necessary for expansion, debt reduction, or other corporate needs. However, rights issues are not without their risks, and both companies and shareholders must carefully consider the potential implications before proceeding. When executed properly, a rights issue can provide significant benefits, but it requires careful planning and communication to ensure that it meets the company’s capital-raising goals without alienating or disadvantaging existing shareholders.

Learn how to calculate rights issue with the following example:

HK Ltd has the following balances in its balance sheet:
1,000,000 $1 ordinary shares    $1,000,000
Bank                                          $70,000
The company decided to make a rights issue of 3 ordinary shares for every 10 ordinary shares held. The new shares are issued at a price of $1.50 each.

Solution:
Rights issue = 1,000,000 * 3/10 = 300,000
The new shares are issued at a premium of = 1.50 - 1 = $0.50
Share premium = 300,000 * 0.50 = $150,000
The company will receive = 300,000 * $1.50 = $450,000

After the rights issue, the company will have the following balances:
1,300,000 $1 ordinary shares $1,300,000
Share premium                       $150,000
Bank  (70,000 + 450,000)     $520,000