What are Right Issues? And How it affect your investments?
Understanding What are Right Issues: Today if one is to pick up a newspaper he would find the pages riddled with issues on rights i.e. that related to liberty, equality, freedom of expression, opinions, speech, etc. However, you may be surprised that a few flips into the financial section will too include news with regards to the ‘Rights Issue‘. The rights mentioned here similarly outline the entitlement and privilege available but different from those concerned with social issues.
Today, we try and understand the term ‘Rights Issue’ as a corporate action as this would help in making a more accurate decision when offered rights by a company whose shares are held in our portfolio.
What are Right Issues?
A Right Issue is one of the options a company has in order to raise funds. In a Rights issue, the company gives an opportunity only to the existing shareholders to buy additional shares of the company.
The price offered by the company to the existing shareholders is at a discount to the market price. This is done in order to make the offer attractive to the shareholders and at the same time make up for any dilution of capital. A Right Issue also gives an opportunity for the shareholders the opportunity to increase their stake within the company. Shareholders here have a right but are under no obligation to purchase the shares.
— Why do companies go for a Rights Issue?
The nature of a Right Issue also turns the corporate action into a trump card due to its ability to provide companies a shot at raising capital irrespective of the environment they are in. Troubled companies may opt for a rights issue in order to pay off their debts or use it as a means to raise funds for its operations when they are unable to borrow money.
— Is Right Issue a Red Flag that the Company?
A Right Offering is definitely not a red flag. This is because the right offering is also seen as a means to raise additional capital for its expansion and growth needs.
At times when the gestation period of a project undertaken by a company may be too long before it generates profit. In such cases opting for debt would be unwise as they would require regular interest payments even before the project is functional let alone be profitable making debt too expensive. Hence, a Right issue would seem like a Win-Win situation for both the company and the shareholders. This is because the right issue would not require regular servicing as long as the project remains on track to successful completion and future.
In a recent scenario Reliance Industries too opted for a rights issue but this was done in order to rid their balance sheets of all debt and at the same time reward the shareholders.
Can you buy unlimited shares in a rights issue?
Rights issues function differently than an Initial Public Offer(IPO) or a Follow on Public Offer(FPO). In a Right issue, the shareholder will be given the option to purchase rights but only in proportion to the shares they already hold. In the recent issue by RIL, the shareholders were offered shares in the ratio of 1:15. This means that for every 15 shares held one share may be bought in the right issue.
Hence the extent to which the shareholders can purchase shares is limited to the shares they already hold. Investors, however, have the option to sell their right to purchase the shares. The shareholders, however, are free to purchase a right some other investor wants to sell in the market.
Different types of Right Issues
There are two main types of rights issue of shares, which are as follows:
— Renounceable Rights Issue: When Renounceable Rights are offered to a shareholder he has the option to purchase the shares by exercising his right, or ignore the right, or sell his right at the price that the rights are being traded at in the stock market.
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— Non-Renounceable Rights Issue: When Non-Renounceable Rights are offered to a shareholder he only has the option to purchase the shares by exercising his right or ignore the right. When these rights are offered the shareholder cannot sell his right to another investor.
Taking the ‘Right’ decision?
The Right Issue not being an obligation gives the investors the option to buy the shares of the company, ignore the issue, or sell the ‘right’ itself. Now, we take a look at the different options purely on a financial basis.
Example: Say you are holding 1000 shares in the company Pineapple Ltd, whose shares are currently trading at Rs.21 in the market. Pineapple Ltd comes up with a rights issue where the shares are offered at a discount of Rs.15 per share. The right offering is made in the ratio of 2:10. The company already has 100,000 shares issued in its IPO and plans to further raise Rs. 300,000 through the rights issue bringing the total holdings to 120,000 shares.
1. Buying shares through the right issue
Here we look into the consideration of buying the shares. One of the integral portions of a rights issue is the Ex- right price. The Ex-Right price is a theoretical price that will result after the rights issue. Computation of this price helps an investor to take a stand on a financial basis on whether shares should be bought through the right or not. Let’s begin.
- Shares held of Pineapple Ltd – 1000 shares (a)
- The current holdings are valued in the market at Rs.21000.
- The shares made available via. the rights offer is = (1000 x 2/10) i.e. ( shares held x ratio offered) = 200 shares. (b)
- Cost that will be incurred through participation in the bonus issue = 200 x Rs. 15 = Rs 3000.
- Total holdings if post right issue( if successful) = 1000 + 200 = 1200 shares.
- Value of portfolio including investment from rights = 21000+3000 = Rs. 24000.
- Ex Right price ( value per share post issue) = 24000/1200 = Rs. 20 per share
The investment above would prove to be beneficial as even though you have paid Rs.15 per share post the issue, they would theoretically be anticipated to be worth at Rs 20 post the issue.
2. Sell the right itself
The rights that you are entitled to as a shareholder with respect to the privilege to buy shares in a Right issue have an intrinsic value attached and can be traded in the stock market. These are known as Nil Paid Rights.
Above we have already calculated the ex right price. In certain cases, it is profitable if the ‘rights’ are traded at or above a price that is greater than the difference between the offered price and the ex right price.
I.e. (20-15) = Rs 5.
What happens if the shareholder simply gives up the right?
At times the shareholder may also choose to take no action on the right and simply ignore it. It is important for the shareholder to note that the preferential rights given here, come with the risk of dilution if ignored. This is because as discussed earlier, the shares issued derive value from the existing portfolio and investment made through the rights. This will be spread across the whole portfolio post the issue.
Also if we go back to the previous example the shareholder would be left with only 1000 shares post the issue. Say the prices are equal to the ex right price. This would mean that the ex right shares that were earlier valued at Rs. 21,000 would be valued at Rs. 20,000 posts the issue. These would be only the beginning of the effects as the shares will be affected in the future as well eg. income from the company distributed in the form of dividends will now be distributed among 120,000 shares instead of earlier 100,000.
Right Issues in the Covid-19 environment
In the wake of the COVID-19 environment, several companies resorted to raising capital through the right issues. This included companies with strong credentials like Mahindra Finance, Tata Power, and Shriram Transport Finance. These companies have been able to raise a total of 10,000 crores during the pandemic. RIL saw its right issue s oversubscribed by 1.59 times and received applications worth more than Rs. 84,000 crores and raised 53,124 crores through the issue.
The rights issue route was adopted by the companies due to the ease of raising funds. This was because all that is required for the right issue is the board of directors’ approval. Unlike other means that require shareholders’ approval in the shareholders meeting as well which is an added risk in the current environment. In addition to this SEBI also undertook several steps to ease the process of rights issues like reducing the market cap requirements and also the minimum subscription requirements.
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Even though Right issues have been particularly popular during the COVID-19 environment the response has not always been the same. Shareholders were always quick to realize that no matter how democratic the corporate action may seem they still are in a way forced. This is because the threat of their portfolio being diluted always remained.
Despite this, when faced with the choice to participate in a rights issue it is always better to not just rely on the financial aspect. It is also very important to find out what the purpose of the rights issue is. In addition to this, it is also a positive sign if the promoters take part in the rights issue. It shows that they themselves believe in the cause. Happy Investing.
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