Introduction

In the stock market, companies often require additional capital to expand operations, repay debts, or invest in new projects. One way they raise this capital is through a rights issue. But what exactly is a rights issue, and how does it work?

A rights issue of shares refers to the process where a company offers existing shareholders the opportunity to buy additional shares at a discounted price. Unlike other fundraising methods, rights issues give preferential treatment to current shareholders, maintaining their proportional ownership in the company.

The idea of a right share issue is rooted in fairness, allowing loyal shareholders to benefit from discounted prices. This move can help the company raise funds without diluting the ownership stakes of existing shareholders too much.

How Does a Rights Issue Work?

A rights issue involves offering additional shares to existing shareholders at a discounted price. This fundraising strategy enables companies to raise capital quickly and efficiently while giving existing shareholders an opportunity to maintain their proportional ownership. Here’s a detailed breakdown of how the process works:

1. Announcement of the Rights Issue

The first step is the company’s announcement, which serves as a formal notification to shareholders and the public. This announcement includes critical information such as:

• Rights Issue Price: The discounted price at which the new shares will be offered.
• Entitlement Ratio: The ratio determining how many additional shares shareholders can purchase in relation to their current holdings (e.g., 1:4 or 1:3).
• Record Date: The date on which a shareholder must own shares to qualify for the rights issue.

This announcement not only outlines the terms of the offer but also serves as a signal of the company’s intent, whether it is to strengthen its balance sheet, fund new projects, or address financial challenges.

2. Record Date Determination

The record date is a critical aspect of the rights issue process. It determines shareholder eligibility to participate in the offer. Only those who own shares on or before the record date are entitled to subscribe to the additional shares.

Why the Record Date Matters:

• It ensures only current shareholders benefit from the offer.
• It provides clarity for investors, enabling them to make informed decisions about their participation.

Investors who buy shares after the record date are not eligible for the rights issue, even if they own shares during the subscription period.

3. Entitlement Ratio

The entitlement ratio dictates the number of additional shares a shareholder can purchase relative to their current holdings. For example:

• 1:4 Entitlement Ratio: A shareholder can buy 1 additional share for every 4 shares they own.
• 1:3 Entitlement Ratio: A shareholder can buy 1 additional share for every 3 shares they own.

The entitlement ratio ensures proportional allocation of shares to maintain shareholder ownership structure. Companies use this ratio to strike a balance between raising the required funds and not overly diluting existing share value.

4. Subscription Period

Once the rights issue is announced, there is a specific subscription period during which shareholders can decide to:

• Exercise their rights to purchase the shares.
• Sell their rights on the stock exchange (if they are tradable rights).
• Ignore the offer, which results in their entitlement lapsing.

Shareholders need to act promptly, as the subscription period is typically limited to a few weeks. After this period, the company may offer unsubscribed shares to other investors.

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Rights Issue Calculation

To fully understand the financial impact of a rights issue, let’s explore an example in detail:

Example Scenario:

A company announces a 1:3 rights issue at a discounted price of ₹50 per share. The current market price of the stock is ₹75 per share. A shareholder owns 300 shares.

Here’s how the calculation unfolds:

Step 1: Calculate Number of Shares Offered

Since the entitlement ratio is 1:3, the shareholder can purchase 1 additional share for every 3 shares they own:

 300 shares 13=100 additional shares.

Step 2: Determine the Cost of Buying Rights Shares

The cost of purchasing the additional shares at the discounted price is:

 100 shares 50 ₹/share=5,000₹

Step 3: Calculate Total Shares After the Rights Issue

The total number of shares the shareholder will own after exercising their rights is:

300 existing shares +100 additional share=400shares.

Step 4: Adjust the Average Share Price (Theoretical Ex-Rights Price or TERP)

Theoretical ex-rights price is calculated to reflect the adjusted average price of shares post-rights issue:

TERP = (30075) + (10050)400=22,500 +5,000400=68.75 ₹/ shares.

This calculation demonstrates that the average price per share decreases (from ₹75 to ₹68.75), benefiting the shareholder by lowering their cost of ownership while maintaining proportional value.

Advantages and Disadvantages of a Rights Issue

Advantages for the Company

Cost-Effective Fundraising:

Rights issues are less expensive compared to public offerings, as they don’t require extensive underwriting.

Retains Control:

Unlike external fundraising methods, the company ensures existing shareholders retain voting rights and proportional ownership.

Faster Process:

The streamlined process allows the company to raise funds quickly, addressing immediate financial needs.

Advantages for Shareholders

Discounted Prices:

Shares are offered below market value, providing a profit opportunity for shareholders.

No Ownership Dilution:

Shareholders who participate maintain their proportional ownership in the company.

Disadvantages

Pressure to Invest More:

Shareholders may feel compelled to invest additional money to maintain their ownership stake.

Share Price Volatility:

Market sentiment can lead to fluctuations in share price, especially if investors view the rights issue as a sign of financial weakness.

Risk of Undersubscription:

If the rights issue is undersubscribed, the company may fall short of its fundraising goals.

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How to Participate in a Rights Issue

Participating in a right share issue involves the following steps:

Step 1: Check Eligibility

Verify you were a shareholder on the record date. Only eligible shareholders can subscribe to the rights issue.

Step 2: Review the Offer Document

Carefully read the company’s offer document for details about the:

• Entitlement ratio.
• Rights issue price.
• Subscription process.

Step 3: Decide Whether to Subscribe

Shareholders have three choices:

• Exercise Rights: Purchase the additional shares.
• Sell Rights: Trade your rights in the open market (if tradable).
• Ignore Rights: Let your rights lapse (not recommended if you want to maintain ownership).

Step 4: Make Payment

Pay for the shares you wish to purchase before the subscription period ends.

Real-World Examples of Rights Issues

Example 1: Reliance Industries (India)

In 2020, Reliance Industries launched India’s largest rights issue, raising ₹53,124 crores. The issue price of ₹1,257 per share was significantly lower than the market price of ₹1,450, encouraging participation from shareholders.

Example 2: HSBC Holdings (UK)

During the 2008 financial crisis, HSBC raised ₹53,124 crores through a rights issue. While initially perceived as a sign of financial strain, the move helped the bank stabilise and recover.

Impact of Rights Issues on Stock Market Performance

Dilution Effect:

Shareholders who don’t participate may see their ownership stake diluted, impacting earnings per share (EPS).

Market Sentiment:

Rights issues can signal financial challenges, causing short-term declines in stock price. However, successful utilization of funds can lead to long-term growth.

Adjusted Share Price (TERP):

After the rights issue, shares trade at an adjusted price reflecting the dilution and discounted offering.

Conclusion

A rights issue is a strategic way for companies to raise capital while offering shareholders the chance to invest at a discounted price. However, careful evaluation of the company’s financial health and the purpose of the rights issue is crucial before participating.

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