Rights issue is yet another way using which companies raise additional capital from the public. In a rights issue, the company offering these rights gives its existing shareholders a right to buy new shares of the company at a discount from its current market price at a specified future date. The right works just like an option, so the investor getting the right can choose to exercise it or not.

The rights issues are generally used by companies that are in urgent need of money and want to raise capital quickly to ease their financial burden. Many companies use the additional capital raised to clear the debt they are finding difficult to service.  Some healthy companies also use the rights issues to fund acquisitions or pursue other growth opportunities.

How it works?

Let’s take an example to understand how a rights issue works. Let’s say you hold 100 stocks of a company. The current market price of the stock is $10. The company is undergoing some financial trouble and comes out with a rights issue to raise additional capital. Under the rights issue, the company is raising $80 million by issuing 10 million new shares at a price of $8 per share. The rights issue is described as a 1-for-4 rights issue. This means that for every four shares of the company that you hold you get the right to buy one more stock at a discounted price of $8. This is a discount of 20% on the market price.  Since you have 100 shares of the company, you are eligible to buy 25 shares under the rights issue.

The shareholder can make one of the following choices:

1. Exercise the right to buy

Under this option you get the maximum benefit from the rights issue. You decide to exercise your right and buy 25 additional shares at a price of $8 per share, spending a total of $200. Note that once the new shares have been issued, your existing shares would have diluted and their market price will fall. Even though the market value of stock can change for many reasons, we can still estimate how much its value will drop just because of the rights issue. The maths is explained below:

Value of existing 100 shares at $10 each = $1000

Value of new 25 shares at $8 each = $200

Value of 125 shares = $1,200

Ex-rights value per share = $1,200/125 = $9.6

We can say that theoretically the new value of each share will be $9.6. This also means that the new shares that you are buying at $8 each will have a market value of $9.6.

2. Sell the rights to someone else

Since it’s a right, you can always ignore it and not do anything. But that does not help because the value of your existing shares will still dilute. To compensate for the dilution factor, the rights themselves also have some value.  The holder of the rights, therefore, has the choice of selling these rights to someone else at a price. Such rights are called renounceable rights and can be sold at a price called nil-paid rights. Theoretically this price will be equal to ex-rights price of $9.6 minus $8 = $1.6. The actual price is slightly difficult to estimate but this is a good estimate. The gain from sale of rights is considered capital gain and taxed accordingly.

Rights issues are generally not preferred by the investors because they need to buy more shares to avoid any loss due to dilution. Also, these rights give the investors signs of increasing financial troubles in the company. It is important that investors appropriately assess the reasons for the rights issue and only then take any action.