1

Rights Issue

Learning objective

After completing this chapter you will be able to answer to

these questions:

What is rights issue?

What are the reasons for such rights/
Under what circumstances the company shall decide on
rights issue?
What are the hazards in case of rights issue?
How the company should approach to price the rights/
shares conversion ratio?
What are the strategic points worth considering while
formulating the company’s strategy on rights?

Chapter Content
1. Definition
2. Features
3. Conditions to be satisfied by the firm
4. Impact on price of existing equity
5. Impact on shareholders’ wealth
6. Pricing of rights

1
 2

What is Rights Issue?

An existing company which has already gone for an IPO has a base of
its own stockholders. If the company has been doing quite well and its
stockholders are happy with its performance, it can approach the
existing equity shareholders for further finance in case of necessity like
expansion and launching new projects. Who could be a better choice
than its satisfied owners? The company has to make least efforts to
sell its equity in terms of marketing. It has very little to prove before
its own shareholders who are with them for quite some time. Both the
issue cost and time cost of the issue would be less than the cost had
the company gone for another public issue. And offering shares to
existing shareholders is called Rights Issue.

The nomenclature Rights is because under the company law in case of

all the subsequent public issues after the IPO, a company has to offer
first to its existing stockholders. Thus this is a right to the stockholders
given by law. That is why such an issue is called a Rights Issue. Rights
are not an Indian typicality only. Almost in every country similar law
exists. However, the stockholders themselves can relinquish this
provision by a passing a resolution that effect in a general meeting of
the company. In that case the company would not be allowed to go for
a Rights Issue. The shareholders can also relinquish their rights even
by part.

2
 3

What is ‘Rights’?

Popularly, shares issued through a Rights Issue are called rights

shares. In fact, there is a difference between rights and what is
referred to as rights shares.

A shareholder is entitled to rights equal to the number of equity shares

he is holding. That is the number of rights is exactly equal to the
number of shares held by the investor. These rights are converted into
equity shares at the conversion ration as decided by the management
of the company. Rights are negotiable and tradable like shares. This
indicates that the rights in the market has a price. Although it is
difficult to measure the possible market price of a right, on the basis of
the assumption that a shareholder’s wealth position can hardly be
affected by a Rights Issue, we may calculate some indicative price of
rights.

The assumption of no change in shareholders’ wealth position is quite

rational. When the shares are offered only to the existing
shareholders, the pre-issue and post-issue holders remain the same.
That is the demand side of the rights also remain the same, while the
supply side has gone up since the stockholders are in possession of
more shares from the same company. This must logically bring the
share price down in the market. The erosion in price should be exactly
to the extent of the so called extra benefit afforded to the existing
stockholders. Thus the wealth position of the stockholders maintains a
status quo. This also implies that if one existing stockholder does not
subscribe to the rights issue, his wealth position is bound to erode
since he will be left with the same holding, but at a lower market price.

3
 4

In reality this may not be the case. Since the rights are tradable and
having a market of their own, the market price of rights are likely to
be determined by the market forces of demand and supply. The rights
are derived from the shares. But it would not be always practical to
link rights with the movements of the underlying security. The price
may be influenced by many factors like the individual investors’
personal finance at the moment and their preferences that vary too
widely. Thus there are possibilities of different kinds of situational
movements resulting in rights being priced in sharp difference to the
indicative theoretical value of rights. Moreover, rights declaration may
also sometimes create a positive or negative vibe in the market. The
price of rights would be influenced by that too.

Rights are exercisable within a specified period of time, generally up to

thirty days.

The shareholders can also sell either in full or in part the rights they
are allotted to. Selling the rights would save them from the possible
ex-rights downfall in the price of the shares.

How to price a Rights Issue?

Pricing the issue seems to be not that important in case of rights as

in case of IPO. Only thing to ensure is that it should be substantially
underpriced. If the subscription price is not considerably below the
market price, the shareholders would not be motivated to buy it. But
how much underpricing should be done is not that material an issue

4
 5

here, since any dilution of price would be borne by the existing

shareholders only as they are the main buyers. The only thing is to
take note of is to see that the subscription price is attractive enough
for the target investors. The success of the rights issue largely
depends on how low the subscription price is.

Why Rights Issue is done by a company?

Rights Issue is done by a company for many a reason. The first major
one is it is far easier to sell the issue to the existing stakeholders than
to anybody else. Second, unlike public issue Rights Issue does not
have the possibility of control dilution.

The success of any issue much depends on the company’s consistent

track record. But in Rights Issue some extra protection is enjoyed by
the company since it is targeted to it own shareholders. So the
company has an edge in capitalizing the market through Rights.

In general, never the existing stockholders of a company would

welcome another issue of equity because rationally they do not like at
all their wealth and ownership to be divided with newcomers. But if it
is a Rights Issue they do not have to worry since both these are well
protected.

Rights issue is a weapon too in the hands of the company

management to avoid the dilution of control whenever the company
decides to raise finance through equity. Particularly, in case of a
closely held company it saves prevents the company to be taken over

5
 6

in the days of corporate predation. The company as a defence against

a hostile takeover bid may decide to go for a huge rights issue. The
ex-rights price would go down then substantially keeping the company
control intact. This is expected that this would discourage the
predating company from its takeover bids. This is a proven device and
popularly called as poison pills. The practice is that the shareholders
are issued long-dated rights which do not come in effect
immediately. They are automatically exercised when, during a hostile
takeover a company or an investor acquires a certain percentage of
shares, thereby diluting the takeover bid. In fact, many a company
has taken to the poison pill so far.

Market Value per share after the rights issue (ex- rights):
Value of one share after the rights issue (ex- rights):
(nMPS0 + SP)/ n +1,
Where,
N= no. of rights required to subscribe to one share
MPS0= market price per share before rights issue (cum-rights)
SP=Subscription price per share for rights issue

Theoretical value of one right then would be=

(MPS0-SP)/ n+1
The price advantage thus is being distributed among all the shares the
investor is going to have immediately after the rights issue (ex-rights
holding).

6
 7

The shareholder however neither gains nor loses through rights issue.

He has three options:

1. Exercising his rights by buying additional shares; or,
2. Selling his rights and get cash; or,
3. Allowing his rights to expire by doing nothing.

In the first two cases he is not likely to either gain or lose. By either of
these he is able to maintain his position. If he exercises his rights, he
will be in possession of additional shares. But due a fall in ex-rights
market price of shares, the value of his shareholding is likely to remain
the same.
In case he sells his rights, his holding size remains the same and due
to reduced ex-rights market price the value of his holding would come
down. But the loss incurred would be compensated by the cash he has
received from the sale of rights.

But in case he allows his rights to expire, he is neither in possession of

additional shares nor he additional cash from sale of rights. Therefore
he loses.

So, the investors should choose either of the first two options as
discussed.

7
 8

We can take the following example to prove this point.

A Ltd. has a capital base of 100 lakh equity shares of Rs. 10 each fully
paid. The company’s last balance sheet shows Rs. 6 crore in its
general reserve, and Rs. 2 crore in 10% Debentures. It has earned
15% on its total capital employed. The company is in a 40% corporate
tax bracket. The company’s shares enjoy a price-earning ratio of 12 in
the market.
The company now decides to raise finance through a further issue of
40 lakh equity shares of Rs.10 each. The half of the issue will be
treated as a rights issue. The subscription price has been determined
at Rs.12.

EBIT Rs.27000000
Interest Rs. 2000000
EBT Rs. 25000000
Tax @40% Rs. 10000000
EAT Rs. 15000000
Number of shares outstanding 10000000
EPS Rs.
1.50
Price earning ratio 12
Market price per share Rs. 18

8
 9

Now, suppose one investor Mr.X is holding 1000 shares in the

company. Thus he is entitled to 1000 rights in this case.
n will be= 10000000/2000000, or 5. That is he is entitled to 10 equity
shares in this rights issue.
Value of one right= (18-12)/(5+1)= Re.1

Ex-rights market price per share would be= ((n*MPS0+SP)/n+1)

=((5*18+12)/6))= Rs.17

The shareholders position if he exercises rights:

Cum-rights :
Investment value(1000 shares Rs.18000
@Rs.18 per share)

Ex-rights :
Size of his 1200 shares
shareholding(1000+200)
Market price per share Rs. 17
Investment value(1200 shares @ Rs. 20400
Rs.17 per share)
Less: His cash outgo for Rs. 2400
subscribing the additional
shares(200 shares @Rs.12 per
share)
Net value of investment Rs. 18000

9
 10

His net gain/ loss Nil

The shareholders position if he sells rights:

Cum-rights :
Investment value(1000 shares Rs.18000
@Rs.18 per share)

Ex-rights :
Size of his shareholding 1000 shares
Market price per share Rs. 17
Investment value(1000 shares @ Rs. 17000
Rs.17 per share)
Add: His cash income by selling Rs. 1000
1000 rights @ Re.1
Net value of investment Rs. 18000
His net gain/ loss Nil

The shareholders position if he allows his rights to expire:

Cum-rights :
Investment value(1000 shares Rs.18000
@Rs.18 per share)

Ex-rights :
Size of his shareholding 1000 shares
Market price per share Rs. 17
Investment value(1000 shares @ Rs. 17000
Rs.17 per share)

10
 11

His net gain/ loss Rs. 1000

Can this theoretical value of rights differ from the value in the
market?
YES, for these two reasons in addition to what we have discussed in
some early paragraphs:
9 The value in the market could differ due to the transaction cost
in the market;
9 The company’s goodwill in the capital market at that point of
time is very important. More reputed the company is, greater
would be the demand because non-shareholders would also
throng the market for the company scrip. This accelerated
demand would move the value of rights upward;

Setting the subscription price for the existing shareholders in case of

rights issue:

All the discussion we have done so far on rights simply makes it clear
that the subscription price does not matter. The shareholder’s
position would be irrespective of the quantum of the subscription
price. Whatever may the SP, the shareholders either have to exercise
the rights or to sell the rights to maintain the status quo. Either of
However, the difference between MPS0 and SP determines a
shareholder’s extent of loss if he does not do anything with his
rights. His loss will increase if the subscription price is considerably

11
 12

lower than the MPS0. Either of these two activities is rationally

expected from the shareholders. No rational investor would allow his
rights to expire.

In case of any issue of shares, it is imperative to the company to

under price the subscription price. This is no exception to the rights
issue also. If the subscription price is not lower than the then market
price, there would be no reason to buy the share from the open
market. So, the success of the rights issue largely depends on how
low the subscription price is.

But at the same time lower the subscription price is, greater has to
be the issue size to collect the requisite funds.

Greater the number of shares, harder it would be for the company to

maintain its EPS and dividend per share (DPS) level.
So, these factors are to be seriously kept in mind while pricing.

Some other factors worth considering while setting the

subscription price:
¾ Is it the right time to approach the market? Choosing the
appropriate time to approach the market is very vital. For this a
continual close observation is necessary. Generally both the
primary and secondary segments of the capital market move
hand in hand. So, at the time of overall buoyancy in the market,
at least the inclination toward buoyancy, is the clear indicator as
to the time to approach market.
¾ Is the scrip doing steadily well in the market? No investor
would take a long position if the company is not doing well as

12
 13

compared to other firms in the market. If in the investors’

perception the scrip of the company is not an undervalued one
with strong potential to go higher and higher, it would certainly
not be the right situation for a rights issue.
¾ Is the effective control of the company going to be
diluted after the issue? As we have already seen that losing
control over the company happens to be the least acceptable
consequence to the existing shareholders and the company
management. There are several devices to avoid dilution of
control. In fact a company tries a number of avenues like
preferential allotment and private placement with this object in
mind. So the management has to estimate the impact
beforehand.
Rights issue – the merits:

1. It is easier than the public issue in that the company is

approaching its own shareholders who already know the
company well. Thus lesser efforts are needed for the sale.
2. Therefore the company can either avoid or reduce underwriting
because of lesser risk of being under subscribed. A reduction in
underwriting commission makes the floatation cost of the issue
low.
3. It helps the company to expand its equity base without any
dilution in control.

Rights issue: the hazards:

1. Existing shareholders may not relish the idea of further

investment. Although it has been seen that by exercising rights

13
 14

they can maintain status quo. But they might not feel
comfortable with the idea of spending cash to buy this status
quo. In fact, they certainly lose marginally if the opportunity cost
of the cash outgo is considered;
2. For a company in which a sizable portion of its shares are held
by financial institutions, rights issue may not be a success prove
to be

Rights issue could also help the company if it is going through a

period of financial hardship.

Thus the rights issue, at times, should more be viewed as a

corporate strategy for preventing control dilution than a method of
raising finance. In other words, rights issue is a funding mode to the
company that has little threat to company management.

14