Rights issue: How to decide to apply in the rights issue?
Have you ever wondered about the methods through which a company may raise funds apart from IPOs and bank loans? Many Indian companies like L&T finance holdings Ltd, PVR cinemas and Reliance Industries Ltd raised funds through a rights issue in the middle of the Covid-19 pandemic. And today in this article we will get into the details of what a rights issue is and its impact on the company and its shareholders.
Let’s begin by understanding what a rights issue means.
A rights issue is essentially an invitation to existing shareholders to buy more shares of the company in addition to the shares they already hold. What sets them apart is that shareholders can purchase these additional shares at a discount on the market price. The shareholders are granted a right to exercise this purchase, however, they are not obligated to do so; they can decide to ignore it altogether.
But before this, you need to be eligible to get the rights. The company issuing rights announces an Ex Right date well in advance, before which you need to be a shareholder of the company. You become a shareholder of a company when you have its stock in your demat account.
If you become a shareholder of the company or purchase the company’s shares after the ex-date, then you will not be eligible to receive additional shares through the rights issue.
Shareholders get to purchase these rights in proportion to the shares they already possess. If the company announces a rights issue in a ratio of 2:5, then the shareholders can buy 2 additional shares for every 5 shares they already own, at a discounted rate put-forth by the company.
Additional Read: Can I apply for IPO without a demat account?
These rights can either be fully-paid or partly paid. In a fully paid rights issue, applicants are required to pay the entire amount at the time of application and in partly paid rights issue, applicants only need to pay a partial amount, the remaining amount is then paid when subsequent calls are made by the company issuing the rights.
Rights can also be either renounceable or non-renounceable. Renounceable rights can be sold to other investors in the market and non-renounceable rights cannot be sold. You need to either buy these additional shares or ignore them.
Now as we know that shareholders aren’t obligated to buy these additional shares, they get 3 choices once a company announces a rights issue.
Firstly, they can oblige and buy these additional shares, which is what the company expects the shareholders to do as they are being offered at a discounted rate on the market price.
Secondly, they can ignore the rights issue altogether. As we discussed previously, shareholders are not obligated to buy these rights.
And thirdly, they can choose to sell the issued rights to others if the rights happen to be renounceable. SEBI recently introduced the Rights Entitlement platform, where eligible shareholders can sell their Rights Entitlements to others on the stock exchange like shares.
Let’s now decode the reasons for which a company decides to issue rights.
The primary reason is to raise funds. But you may be thinking about why the company can't go to the public again to raise the capital via an FPO (Follow on Public Offer). There are two simple reasons: one is to reward existing shareholders by offering shares at some discount and secondly to avoid the lengthy FPO process, which is similar to an IPO.
The funds raised through a rights issue can then be redirected to accomplish certain objectives.
One of these objectives can be to improve their debt-to-equity ratio by using the funds raised by the rights issue to clear some debt.
Also companies which are running low on cash and are in need of some capital but do not want to increase the burden of debt by taking a loan can raise some funds through a rights issue.
Or if a company needs to expand its operations by acquiring new companies, or ramping up its output by buying up new manufacturing facilities, they can generate the capital required to do so through a rights issue.
Let’s now talk about the impact a rights issue has on the stock price of the company.
As we now know that in a rights issue, existing shareholders get additional shares in proportion to the shares they already hold. This resultantly increases the number of outstanding shares in the market and theoretically should dilute the share price. However, this dilution in the price may be temporary and depends heavily on the market sentiment and company performance depending on which price may bounce back up to its pre-issue value or higher.
Before we get to the benefits, let’s get familiar with some factors and risks which need to be acknowledged before you go ahead and buy these additional shares.
Firstly, do not get tempted by these additional shares which are being offered to you at a discounted price of the current market value, it may not always be a bargain for you. You need to check the future growth prospects and possibilities of an increase in the share price from its current level.
You also need to figure out the real reason due to which the company had to announce a rights issue, as it can reflect the financial health and the future growth outlook of the company and its stock.
If the company says that they are running low on cash and need some funds as they cannot take more debt, you need to evaluate the impact of this move on the future trajectory of the company’s profitability.
Or suppose they plan to use the funds for opening up new facilities or acquire a competitor. In that case, you need to analyse how well this will integrate with the company and add value to its profitability.
Many broking companies or publications also come up with review of rights issues and you may also want to understand their view before you subscribe to a an issue.
And finally, let’s talk about the benefits a rights issue delivers, both to the company and its shareholders.
For companies, issuing rights is one of the fastest methods of raising capital. They also get to save-out on some expenses on advertising and underwriting fees which are incurred while raising capital through FPO (Follow on Public Offer).
And most importantly, companies get to raise additional funds without increasing debt.
As for the shareholders, they get to increase their stake in the company by purchasing these additional shares at a price lower than the current market price of the shares. And since they aren’t obligated to do the same, they can even sell these rights to other investors given that the offered rights are renounceable in nature, which usually is the case.
Let’s now take a look at the largest ever rights issue in India, carried out by Reliance Industries Ltd back in May 2020. Their aim was to redirect the funds raised by this issue towards eliminating debt.
The issue price was Rs. 1,257 per share, offered at a discount of Rs.200 from the market price at that time of Rs. 1,458. Shareholders were offered 1 share for every 15 shares they already held at this discounted price. The issue was oversubscribed by 1.6 times and they ended up raising around Rs. 84,000 crores. After the issue opened, the stock price also witnessed an increase which proved that shareholders were confident about the company’s future growth prospects.
Additional Read: 7 things to know about a demat account
To conclude, a rights issue can be potentially beneficial both for the company issuing it and its shareholders who choose to partake in it, given that the company uses the funds raised to drive future growth.
On and ending note, let’s summarize everything we discussed:
- In a rights issue, you’re offered additional stocks in proportion to your present holding at a discounted price against the market rate.
- Rights can either be renounceable or non-renounceable, which means that they can either be sold to others in the market or cannot be sold to others respectively.
- The main objective behind companies issuing rights is to raise additional funds so that they can clear out some debt or use these funds for purpose of expansion.
- For companies, this is one of the fastest methods of raising capital without increasing the debt burden and the shareholders also get the opportunity to increase their stake in the company at a discounted price.
- It may not always be profitable for you to purchase these rights. It would help if you did your research before applying for a rights issue.
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