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Similar to a stock split, a right issue is also a part of corporate action. Let us learn everything about rights issues in this section.
What is a Right Issue?
A right issue is basically a way through which a listed company raises additional funds from existing shareholders. Rights Issues are primary market activity. The company implementing the rights issue is offering additional and/or new shares but only to existing shareholders. Existing shareholders are given the right to purchase or receive these shares before they are offered to the public.
A rights issue takes place in a form wherein the existing shareholders are given the right to subscribe to additional shares normally at a discount to the prevailing market price of the stock. The shareholders receive this right by virtue of being stakeholders in the company. They can also sell their rights for a consideration to others if they do not wish to subscribe for additional shares. In essence, rights are freely traded & transferrable.
A rights issue is contemplated by equity shareholders in the view that it is a way to raise money from the market via equity dilution. Shareholders must carefully examine the purpose behind raising funds and whether or not promoters/promoter groups are subscribing to the issue.
Let’s understand this concept better with the help of an example –
Reliance Industries Ltd. has proposed the right issue in the ratio of 1:15.
This means Reliance Industries Ltd.’s shareholders can subscribe to 1 equity share for every 15 equity shares held by eligible shareholders as on the record date. The right issue price is ₹1257. It is about a nearly 14% discount on the company stock’s price of ₹1466 as of April 30, 2020.
Let us suppose investor A currently holds 90 shares of Reliance Industries, which were brought at a price of ₹1,400
The company set a conversion rate of 1:15, meaning that investor A can buy 1 discounted share for every 15 that he owns on the record date. As a result, the investor could buy 6 (90/15) more shares for ₹ 1257.
So now his cost for a total of 96 shares would be:
(90*₹1400) + (6*₹1257)
= ₹ 1,33,452
Cost of one share: 1,33,452/96
Now, his actual cost price for 90 as well as other shares comes to ₹1,391 Vs the closing price at ₹1,466.
Should you Invest in the Rights Issue of Shares?
Continuing with our previous example, Investor A is entitled to subscribe for 6 right shares in lieu of his shareholding. Investor A’s demat account will be credited for 6 RE’s (Rights Entitlement) as a proof of ownership. Now, let us look at the three alternatives available to the investor:
First case – One can exercise his rights by subscribing to additional equity shares of Reliance Industries.
Second Case – One does not want to apply for the rights issue so he/she does not exercise his rights.
Third Case – One can renounce his/her rights by selling his Rights Entitlement (RE) in the open market within a stipulated time period. The base price aka the minimum price below which the value of RE must not fall is the PV(Market Price of stock-Rights Issue Price)
Other market participants who do not own equity shares of the company, can participate in the rights issue by purchasing RE’s from the open market.
Why do companies go for Rights issue?
Companies go for the rights issue of shares to raise funds for:
1. Growth and Expansion.
2. Launching new products.
3. Paying off debt.
4. Taking over another company (Acquisition).
An investor should check out the reason for the rights issue before opting for it. He should also make sure the company has strong earnings visibility coupled with visionary management.
Advantages of rights issues:
- The shares are offered to the shareholders at a discounted price. So, it is an opportunity for the existing shareholders to increase their stake in the company at a lower price thus decreasing their holding price average for the company.
- For the company, the Right issue is one of the best ways to raise capital without incurring additional debt from the banks on high-interest rates thus cutting on the Finance cost for a Company.
Disadvantages of rights issues:
- If the shareholders do not subscribe to the rights issue, then the company may fail to achieve its target.
- Promoters can raise more money from an FPO as they can raise rights only in proportion to their existing Equity value.
- If a stronger Balance Sheet company is going for the right issue of the shares, then it goes on to create a negative market sentiment for that particular company. It is assumed that the company is struggling to run its business operations smoothly.
- Due to rights issue dilution of Equity happens thus ones who do not want to subscribe to the rights find their percentage of holding getting reduced due to allotment of new shares.
- There is a time lag between rights shares issued and transferred to holders' accounts thus the same percentage of discount might not be available while selling the rights shares.
How do you apply for a rights issue?
There are two ways to apply for a rights issue:
1. If your bank supports ASBA (Application Supported by Blocked Amount), you can apply online just like an IPO.
2. If your bank doesn’t support ASBA, then you would have received a courier of the Composite Application Form (CAF) from RTA (Registrar and Transfer Agent) of the company.