CHAPTER 7
RIGHTS ISSUES
1. Rights issues
Introduction
If you were going to borrow money from somebody, would you ask a friend, or
would you pick a person in the street at random and see if they could lend you a £5?
Sometimes, using similar logic, entities may choose to raise equity finance from
existing shareholders, rather than trying to find new ones through any of the
methods we just saw.
There can be lots of reasons for this. For instance, it may be existing shareholders are
familiar with the entity and are therefore more willing to provide extra finance. A
successful rights issue can really help reduce the entity’s financing headaches!
However it's not always plain sailing. Banco Popular was the sixth largest bank in
Spain when in May 2016, struggling under the aftermath of the global economic crisis
and continued low interest rates, the bank offered a rights issue. Share prices
immediately dropped 20%. The need to raise funds was an indication to the market
that the bank was in trouble so that was one reason.
However, share prices almost always drop following a rights issue – to what is known
as the theoretical ex-rights price, and so there's a more theoretical explanation too.
We'll learn how to calculate this theoretical price in this chapter – something which
would have helped distinguish between what was expected and what was just a
market reaction to the news.
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Rights Issues
What is a rights issue?
As we now know, a rights issue is an issue of additional shares to existing
shareholders by an entity to raise funds. A rights issue is formally defined as:
“The raising of new capital by giving existing shareholders the right to subscribe to
new shares in proportion to their current holdings. These shares are usually issued at
a discount to market price. A shareholder not wishing to take up a rights issue may
sell the rights.”
(CIMA Official Terminology)
The ‘rights’ (know as pre-emption rights) let existing shareholders buy a specified
number of new shares from the entity at a specified price within a specified time.
They enable existing shareholders to avoid dilution on their stake in the entity.
The formal definition of dilution is:
“A dilution is the reduction in the earnings and voting power per share caused by an
increase or potential increase in the number of shares in issue.”
(CIMA Official Terminology)
Essentially, dilution is the extent to which shareholder power is decreased by
additional shares becoming available to investors.
For example: Joe Bloggs' shares in Fox's Fireworks are shown in turquoise on the pie
charts below both before and after the company release additional shares in an IPO.
We can see that because Fox's issued more shares for sale in 20X6, although Joe
owns the same number of shares as he did in 20X5, his stake has been diluted.
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Rights Issues
This could have been prevented by a rights issue, as Joe and other shareholders
would have had an option to buy more shares, and Joe could protect his stake from
dilution.
In a rights issue, the issue price is often set below the current market price. Let's say
the current market price is £3 per share, the rights issue might be agreed at £2.50 per
share. This encourages investors to take up the share offer.
How it works
Target shareholders
A rights issue is directly offered to all existing shareholders. The shareholder has
the choice whether to exercise the right in full, partially or not at all. As such, if the
company offers Joe Bloggs a 2:1 subscription right he is being offered 1 share for
every 2 he already owns.
As such, if Joe owns 500 shares, he can claim an additional 250 shares under the
rights issue, but can also claim any number up to 250 shares. This would be
exercising the right partially.
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Rights Issues
Selection of an issue price
The rights are usually offered at a discount to the current share price, which will
be lower than the current market value, in order to make them attractive and
encourage take up. In practice the issue price is often set at a 20% discount to the
current market price.
As such if shares in Fox's Fireworks are currently worth £10 on the market, they
would be offered to Joe Bloggs for approximately £8.
Selection of an issue quantity
A rights issue to shareholders is generally made on a ratio basis in proportion to
the existing shareholding. For example, a 1:3 rights issue allows the purchaser to
purchase 1 new share for every 3 existing shares they own.
Provision of shareholder options
Subscription rights may either be transferable, which means that the subscription
rights holder can sell them privately, on the open market or not at all. Trading them
on the open market is known as renouncing rights. This means that the rights
holder can benefit from selling their rights, even if they do not want to purchase the
underlying shares.
For example, if Joe Bloggs is offered a subscription right of 2:1 on his 500 shares in
Fox's Fireworks he is able to purchase an additional 250 shares for £8.
Given that shares are currently trading for £10, this gives him a total saving of £500
on the purchase of 250 new shares because 250 x (£10-£8) = £500. As such, if Joe
doesn't want to use his rights, he could still sell them for up to £500, with the buyer
then able to purchase the shares for £8 each and still make a saving on the market
price of £10.
Underwriting
Rights issues can be underwritten by major banks in the same way as shares in
an IPO. It provides insurance to the entity that they will receive all expected funds, in
exchange for the underwriter’s fee.
As was the case with an IPO, the role of the underwriter is to guarantee that all of
the funds sought by the entity will be raised. The agreement between the
underwriter and the entity is set out in a formal underwriting agreement. A typical
underwriting requires the underwriter to pledge to buy all shares that were offered
but not taken up by shareholders.
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Considerations
There are five main issues the financial manager has to answer when undertaking a
rights issue:
Does the company engage a broker to manage the offering
processes?
Companies do this to guarantee selling a high enough proportion of the shares
offered in a rights issue. If the offering company don't use a broker to place the
shares, they might not sell all of the offering, and the rights issue would not be worth
pursuing.
What should the subscription price per new share be?
The price is often at a discount to current prices to encourage shareholders to take
up their rights. That said, too low a price will raise less finance and be seen to
undervalue the company which may impact market perceptions. This was seen in the
stock market flotation of Royal Mail in October 2013, where the initial share price
was so low that the shares were purchased rapidly, leading to accusations that the
government could have made more money selling the company by charging a higher
share price.
How many shares should be sold?
This relates to the amount which needs to be raised; the more you need to raise, the
more shares you issue!
What effect will the rights issue on the value of the current
shares?
This will depend on the discount offered – the bigger the discount the greater the
dilution in price of all shares after issue. For example, if Fox's Fireworks have 100,000
shares in issue worth £10 each, and release 50,000 shares at £10, there would be no
dilution, because the share price has not been adjusted at any point. If the new
shares are issued at £9, however:
(£9 x 50,000) + (£10 x 100,000)
New Share Price = = £9.67 per share
150,000 (total number of shares)
This price is known as the theoretical ex-rights price.
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As such, the net result for existing shareholders will be a loss of value of 33p per
share!
2. Implications of a rights issue
A rights issue also has implications for both shareholder and the entity. These are
detailed below.
From a shareholder perspective:
In a rights issue, shareholders get the option to buy shares at a discounted
price.
They also have the opportunity to cash-in by selling their rights.
The relative voting position and ownership of the shareholder are
maintained by exercising the rights, but are lessened if they do not due to
dilution. Just to remind ourselves, exercising the right means purchasing the
shares which are offered!
From the entity's perspective:
A rights issue is relatively cheap and straightforward to implement.
It has a comparatively good chance of success because rights issues are
normally 'fully subscribed' due to the discount. This means that all offered
shares are sold.
A rights issue raises the profile of an entity as a result of favourable
publicity – shareholders who are eager to buy additional shares seemingly
showcases how happy they are with their investment.
Example – rights issues from the investor's
perspective
Let's look at another example of how to calculate the TERP or Theoretical Ex Rights
Price of shares as a result of a rights issue. The TERP is a way of working out the
hypothetical value of every share in a company following a rights issue, and as
we will see, this is greatly affected by the issue price used in the rights issue.
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Let's imagine that Joe Bloggs also has shares in Spaniel Sparklers, which also
manufactures fireworks (Mr Bloggs likes fireworks a lot). Joe had 100 shares in
Spaniel Sparkler's at a total investment of $40,000:
He purchased the shares at $400 per share
The share price has not changed between the purchase date and the date at
which the rights were issued
Rights have been issued to shareholders in SS at a rate of 1:1 and an offer price of
$200.
1. Calculate the theoretical ex-rights price of shares if Joe buys in the rights issue.
2. Calculate the value of the purchase and the value of the right.
Theoretical ex-rights price (TERP)
The subscription right of 1:1 means 1 'new' share will be sold at $200 for every 1
current ('old') share owned. Mr. Bloggs will be notified by a broker that he has the
option to subscribe for an additional 100 shares of the company at the offer price.
If he exercises his option, the value of his portfolio of shares would be:
100 'old' shares @ $400 = $40,000
100 'new' shares @ $200 = $20,000
Therefore, his average price per share (as given by the TERP) will be:
Total Cost $40,000 + $20,000
Share Price = Total Number of Shares = 100 ('old')+ 100 ('new') = $300
This is the theoretical ex-rights price (TERP), which is the theoretical price of all of the
shareholder or company's shares after a share issue.
Was the purchase profitable?
Although the price on the stock market should reflect a new price of $300, the
investor is actually not making any profit nor any loss as their total investment
has been $60,000, which matches the current value of their shares:
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They have spent $60,000 and gained 100 shares, for a total of 200 shares:
$60,000
200 = $300 per share
As such, they have paid the new market value for their shares.
In the real world, the value after the rights issue will depend on how well the
market believes the new investment will be used. For example, if the market
believes the money will give a strong return above the company’s cost of capital
giving positive NPV, the value of shares will rise above $300. This is due to the
additional value from the positive NPV projects and means that Joe will make a
profit.
Value of a right (per existing share)
If you are asked in the exam to calculate the value of a right, without a specification
of per existing share or new share, you should assume that it is per existing
share.
The right to buy shares in a rights issue can be traded at an exchange, meaning the
shareholder does not have to buy the shares themselves. This might be useful if they
had limited cash flow!
In this example, the price of the right, when sold on the market, should in theory be
$100. This may seem logical, but we need to go into more detail. Let's start with the
formula for calculating the value of a right per existing share:
TERP – Rights issue price
Value of a right per existing share =
N
Where N is the number of existing shares required to purchase one additional share
under the rights issue.
Let's work through this using our example:
We know our equation is:
TERP – Rights issue price
Value of a right per existing share =
N
We know that the TERP is $300 and the rights issue price is $200, but what about N?
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This rights issue was issued on a 1:1 subscription rights basis, meaning only 1 existing
share was required to purchase 1 new one. These means N = 1 and our equation
becomes simpler!
TERP – Rights issue price
Value of a right per existing share =
1
Value of a right per existing share = $300 - $200 = $100
Why is this? Well, if someone buys the right and exercises it, they will pay $200 per
share. However, its price after the rights issue should be $300, so they will make $100
per share, which in a free efficient market should equate to the price of the right. Of
course, if the market is not efficient, the purchaser may make marginally more or less
than this.
Remember to divide by the number of shares required to purchase a share whenever
the subscription rate is not 1:1! If you require 2 shares to purchase one new share, for
instance, you will divide by 2.
Value of a right per new share
If asked to calculate the value of a right per new share, we simply do:
Value of a right = TERP – Rights issue price
This is because, regardless of the subscription rate, we always assume a result of one
new share being issued.
Example – Value of a right (number of shares not
given)
Spaniel Sparklers' shares are worth $400. Based on this, the company offers a rights
issue at a subscription rate of 1:4, meaning that an investor must own four shares in
order to purchase one new one.
What is the value of a right per new share and per old share if new shares are
available at $300?
Answer
Firstly, we need to calculate the theoretical ex-rights price of a share, which is
calculated as:
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Total Cost
TERP =
Total Number of Shares
We are not given a specific number of shares in this question, so for the sake of
simplicity later on, we'll assume four existing shares priced at $400. This implies one
additional share at $300:
(4 x $400) + (1 x $300)
TERP =
4+1
$1,600 + $300
TERP =
5
$1,900
TERP =
5
TERP = $380
In theory, each existing share falls in value by $20 from $400 after the rights issue.
Given that we now have our TERP, we can calculate the value of a right per new share
very easily:
Value of a right = TERP – Rights issue price
Value of a right = $380 - $300
Value of a right = $80
This can then be used to calculate the value of a right per existing share:
TERP – Rights issue price
Value of a right =
n
From the subscription rate of 1:4 we know that it took 4 existing shares to purchase
one new one. This means n = 4. We have also just calculated TERP – Issue price as
$80.
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As such:
TERP – Rights issue price
Value of a right =
n
$80
Value of a right =
4
Value of a right = $20
This means that each right is effectively worth $20 each, and suggests that the
shareholders should go ahead and take up the rights issue to avoid losing this
benefit.
The rights associated with shares in a rights issue can be traded in the market and so
the shareholder may alternatively wish to sell the right to the market. The price
should theoretically be $20 per right, although in reality that will be determined by
the long term potential the market sees in the company after the funds have been
raised and invested.
Example – Rights issue from the entity's perspective
We are going to continue looking at our example of Joe Bloggs and his investment in
Spaniel Sparklers.
Spaniel Sparklers has 100,000 shares in issue at present. The share price currently
quoted on the stock exchange is $400. Thus, the market capitalisation, which is the
total market value of all the company’s shares, would be $40 million:
Outstanding shares of 100,000 x share price of $400 = $40 million
Market capitalisation post-rights issue
So, what happens if Spaniel Sparklers offer a rights issue for 100,000 additional
shares?
If all the shareholders of the company choose to exercise their stock option and
purchase the shares they have been offered, Spaniel's outstanding shares would
increase by 100,000. The market capitalisation of the stock would increase to $60m
as shown:
100,000 'old' shares @ $400 = $40m
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100,000 'new' shares @ $200 = $20m
This implies a share price or TERP of $300 ($60m/ 200,000 shares).
You'll notice that the TERP is the same as when we calculated Joe Blogg's TERP, as
the ratio has not changed. What we mean, is that the ratio is still 1:1 and each
shareholder can buy one share for every one they own.
Earnings per share impact
If the company were to do nothing with the money raised by the rights issue, its
earnings per share (EPS) would be reduced by half. This is because there would be
twice as many shares but no extra earnings, due to no new investments, to reward
shareholders with!
However, if the equity raised by the company is reinvested (e.g. to acquire another
company), the EPS may change depending upon the outcome of the reinvestment.
For example, if SS purchased another firework company and this resulted in
increased in earnings quadrupling, this would lead to EPS doubling!
This is because EPS is calculated as:
Earnings
Number of shares
Whilst earnings have quadrupled, the number of shares has doubled, hence:
4
=2
2
EPS will double!
3. Yield adjusted ex-rights price
In the calculation of a theoretical ex-rights price (TERP), it is assumed that the
additional funds raised will generate the same rate of return as the existing
funds. For example, if Fox's Fireworks currently make $1 on every $2 which they
invest, we have so far assumed they will make $1 on every $2 they invest from the
rights issue.
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If, however, an entity expects the new funds will earn a different return (i.e.
higher) than at current, then a 'yield-adjusted' TERP should be calculated. This
represents the company's expectation of the impact that investments as a result of
the rights issue will have on shares' market value.
Yield-adjusted TERP is calculated as:
[ ] [ ]
N Yn
Yield-Adjusted TERP = CRP x + Issue Price x
N+1 N+1 Yo
Where:
Yn is the yield on new funds
Yo is the yield on existing funds
N is the number of shares which are needed to purchase one additional share under
the rights issue
CRP is the cum rights price, which means the actual market price of the shares
BEFORE the rights issue (i.e. the fair value). This is normally given in the question
Example (yield-adjusted TERP)
We're going to continue with our earlier example of Spaniel Sparklers, looking at it
from Joe Bloggs' perspective. He wants to know the effect the issue will have on his
investments!
So, we know that shares are being offered for $200 per share when they are actually
valued at $400 per share. One new share is offered for each one owned. He also
knows that the yield on new funds will be 12% rather than the 8% on old funds!
So, if we remember our TERP formula:
N Issue Price Yn
Yield-Adjusted TERP =
[ CRP x
N+1 ] [ +
N+1
x
Yo ]
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We can input the values we know:
Yn 12
Yo 8
N 1
CRP $400
Rights Issue price $200
1 $200 12
Yield-Adjusted TERP =
[ $400 x
1+1 ] [
+
1+1
x
8 ]
1 $200 12
Yield-Adjusted TERP =
[ $400 x
2 ] [
+
2
x
8 ]
$400 $200 3
Yield-Adjusted TERP =
[ 2 ] [ +
2
x
2 ]
$400 $300
Yield-Adjusted TERP =
[ 2 ] [ +
2 ]
$700
Yield-Adjusted TERP =
2
Yield-Adjusted TERP = $350
Notice that the Yield-Adjusted TERP is higher than the non-adjusted one which we
calculated earlier as $300. Why? Well, the funds from the share issue have been
invested at 12%, higher than our previous 8% returns on existing funds.
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