A rights issue is an equity issue in which existing shareholders are allowed to subscribe for new shares based on, and in proportion to, the number of shares they already own, generally at a discount to the current market price.
There is no absolute limit on the size of rights issues, so they are the standard method of raising large amounts of equity in many countries.
Pricing and Structure of a Rights Issue
The shares in a rights issue are almost always priced at a significant discount to the market price of the existing shares. Discounts for traditional rights issues have typically ranged from 10% to 25%, but for ‘deep discount’ issues can be significantly greater (25% or more).
The shareholders who take up the rights shares will retain the same proportionate interest in the company after the rights issue.
An economic effect of the discount is to protect underwriters against a fall in the share price during the rights issue period and, therefore, to reduce underwriting costs. This is illustrated below.
Example: Rights Issue
ABC company seeks to raise Rs 25 Million through a rights issue. Currently, the number of shares in the issue is 60 Million, and the current share price is Rs 2.50. Assume the rights issue neither creates nor destroys value for shareholders. What is the impact if the discount is (I) 20% or (II) 50%?
Solution
| (i) Discount of 20% | Number of shares | Share Price (Rs) | Total value (Rs) |
| Existing position | 60,000,000 | 2.50 | 150,000,000 |
| Rights issue | 12,500,000 | 2.00 | 25,000,000 |
| New position | 72,500,000 | 2.4137931 | 175,000,000 |
This is a ‘five for twenty-four’ rights issue. This means that five new shares can be bought at a discount for every 24 shares currently held, i.e.
Rights Issue / Existing Position
12,500,000/60,000,000
=125/600
=5/24
| (ii) Discount of 50% | Number of shares | Share Price Rs | Total value Rs |
| Existing position | 60,000,000 | 2.50 | 150,000,000 |
| Rights issue | 20,000,000 | 1.25 | 25,000,000 |
| New position | 80,000,000 | 2.1875000 | 175,000,000 |
This is a ‘one for three’ rights issue, i.e.
Rights Issue / Existing Position
=20,000,000/60,000,000
=200/600
=1/3
Cum and Ex Rights
The share price with the rights attached is known as the ‘cum rights’ price, while it is the ‘ex-rights’ price without the rights. The company’s total value plus shareholder cash before and after is the same in both cases; the only difference is the number of shares in issue, which impacts the share price. For example, if a shareholder started in each case with 600 shares, their position would be as follows:
| (i) Discount of 20% | Number of shares | Share Price (Rs) | Total value (Rs) |
| Existing position | 600 | 2.50 | 1,500 |
| Rights issue | 125 | 2.00 | 250 |
| New position | 725 | 2.4137931 | 1,750 |
| (ii) Discount of 50% | Number of shares | Share Price (Rs) | Total value (Rs) |
| Existing position | 600 | 2.50 | 1,500 |
| Rights issue | 200 | 1.25 | 250 |
| New position | 800 | 2.1875000 | 1,750 |
Comparing the two rights issues from the viewpoint of the shareholder:
| New position Post Rights issue | Number of shares | Ex-rights share Price (Rs) | Total (Rs) |
| (i) Discount of 20% | 725 | 2.4137931 | 1,750 |
| (ii) Discount of 50% | 800 | 2.1875000 | 1,750 |
The market value of the shareholders’ holding remains the same in each case. The only difference is the number of shares held and the market value of the individual shares’ post-rights issue.
Immediately after the post-announcement, there is still the original number of shares in issue; but they will be priced in anticipation of the rights issue.
Value of a Right’s Issue
If shareholders do not want to buy new shares, they are entitled to sell their rights. Shares not taken up by existing shareholders are typically sold as a block at the end of the rights issue, and any proceeds are distributed to those who did not take up their rights.
The theoretical value of a right to buy one new share at a discount: = Theoretical market value of share ex-rights Less subscription price
20% discount issue: Rs 2.41- Rs 2.00 = Rs 0.41
50% discount issue: Rs 2.18- Rs 1.25 = Rs 0.93
Looking at the 20% case: The shareholder owning 600 shares (now worth 600 x Rs 2.41= Rs 1,446) would sell their 125 rights for 125 x Rs 0.41 = Rs 51.25, which would compensate him for the fall in share price. (1,446 + 51.25 = 1,497 or approx. Rs 1,500/-)
Alternatively, an existing shareholder may prefer to sell their old shares with the attached rights (the ‘cum-rights’ price).
Effect of a Rights Issue on Share Price
A company’s share price will usually adjust one or two days after the Ex-Date of the rights issue, and this movement would usually be downwards. Therefore, if you do not exercise or sell your rights, i.e., let the rights lapse, you will suffer a loss in the market value of the share. In some situations, this loss may be substantial.