Things you must know before subscribing to a rights issue

The rights issue of shares is a way through which a listed company raises additional funds from existing shareholders. The new shares are issued in proportion to the existing holding and at a discount to the current market price. As the name suggests, the shareholders have the right but are not obligated to subscribe to the offer.

Let's understand with an example
Let's say an investor, Mr A, owns 500 shares of XYZ Ltd at Rs 80 and the current market price is Rs 100. The company announces a right issue at Rs 90, in the ratio of 2:5, i.e., for each 5 shares held, an investor will be eligible for 2 new shares. Mr A will get 200 new shares at Rs 90 if he subscribes to the offer.

Widespread public perception is that the right issue will always help in decreasing the average holding price but that might not be the case if your buying price is less than the offer price in the rights issue.

From the example stated above, the average holding price will go up since the offered price is more than the buying price of Mr A.

(500*80) + (200*90) = Rs 58,000

58,000/700= Rs 82.9 per share

The average price increases from Rs 80 to Rs 82.9 per share.

Should you subscribe to the rights issue?
The company might raise funds to repay debt, fund capital expenditure, or meet working capital requirements, among other things. Knowing how the company will utilise the raised funds, will help the investor take the right decision.

As an investor you should ideally look for two factors:

• Ensure that for whatever purpose the company is raising money, it should lead to strong earning potential in the future;
• See that the offer price of the rights issue is less or equivalent to the intrinsic value of the share.

Now as an investor, there are three options that you can choose from if you are holding shares in a company that has come up with rights issues.

• Exercise your rights by subscribing to the offer,
• Not exercise your rights so you do not subscribe to the offer, and;
• Sell your rights (to subscribe to the new shares) to someone else by a process called 'right entitlement'.

From the example above, the discount to market price is 10 per cent and you sell your rights to someone else and they are fine with getting the shares at a 6 per cent discount, so you earn 4 per cent on the forgone shares.

So, you earn Rs 720 as a 4 per cent commission on 200 shares applied at Rs 90.

Pros and cons of rights issue
Pros

• If you, as an investor, apply for the issue, you get the shares at a discounted price.
• For the company, this process helps to raise money without incurring underwriting charges and advertising costs.

Con

• If a shareholder does not subscribe to the offer, then his stake will get diluted because of the increased numbers of shares issued.

Suggested read: What are partly-paid shares?