What are the major considerations in a rights issue that I need to keep in mind as an investor in equities?

You are holding on to 1000 shares of XYZ Ltd and you have just received an intimation that the company is planning to raise money through a rights issue. Your first question would be; what exactly is a rights issue? In simple terms, a rights issue is a means for a company to raise fresh funds from existing shareholders. Obviously, if the rights are issued are around the market price, then the shareholders may not be too interested since they can anyways buy it in the market at the current market price. That is why rights issues are priced at a discount to the market so that it acts as an incentive for the shareholders to invest in the rights issue.

Rights are normally issued to shareholders in a pre-determined ratio

You would have come across news items like “Company A is issuing rights in the ratio of 3:4 or Company B is issuing rights in the ratio of 2:5”. What do these statements mean? This ratio is referred to as the rights ratio. So a 3:4 rights issue will mean that for every 4 shares held by you, you will get 3 new shares and hence your shareholding will go up to 7 shares. A ratio of 2:5 means that you will get 2 shares for every 5 shares held. That means y our 5 shares will now become 7 shares.

In our above illustration of XYZ Ltd. what happens if the company comes out with a rights issue in the ratio of 1:2. That means for every 2 shares, the investor will get 1 additional share. That means for 1000 shares held by him, he will get an additional 500 shares and now his shareholding will go up to 1500 shares. Normally, these rights issues are priced at a discount to the market price as rights lead to dilution of equity. But how do you decide which shareholders get the rights shares?

Like in the case of dividends, bonus and stock splits, the logic of record date applies here also. All shareholders whose names appear as on the end of the record date will be entitled to the rights shares. Shareholders who want to purchase the shares to be eligible for the rights will have to do it before the Ex-Rights date. If the record date for the rights is on 20^th May then shares will start trading ex-rights on 19^th May and hence shareholders will have to buy the shares by 18^th May to be eligible for the rights shares. In case of holidays, this period could get longer.

Why rights issue leads to dilution of equity

Remember, rights issue is a fresh issue of shares to existing shareholders. Hence it will lead to increase in the number of equity shares outstanding. Since the profits will remain the same, the profit will now get distributed across more number of shares and hence the EPS will fall. Of course, the company’s estimate is that it will be able to utilize the funds to substantially increase its profits and thus improve its EPS over time. Here is how the dilution of equity happens.

As can be seen in the above table, the rights issue has actually led to the EPS falling. As mentioned earlier, the company projects that the capital infusion will more than compensate for this fall in EPS.

Did you know that these rights are traded in the market?

As the name suggests, rights shares are like a call option. The shareholder has the discretion to decide whether they want to opt for the rights or not. Like in the case of options, these rights also trade in the stock market with a unique ISIN number. But, how are rights priced?

The rights value of Rs.18.57 will be the base on which the actual market price of the rights will be determined. Investors who do not want to participate in the rights issue can sell their rights in the market at the prevailing price.

Remember, rights are different from stock splits and bonus issues

Many investors tend to confuse rights with bonus issues and splits. There are some basic differences here. Both bonus and splits are value neutral but rights are not value neutral because the investor benefits to the extent the rights are at a discount to the market price. Secondly, neither bonus issues nor stock splits are EPS dilutive while rights are necessarily EPS dilutive. That is because in a rights issue, there is fresh flow of funds into the company and new shares being issued. Over the last many years, rights have been a popular means of financing for Indian companies.