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What’s a rights issue?
A Rights
Issue is a way by which a listed company can raise additional capital. However,
instead of going to the public, the company gives its existing shareholders the
right to subscribe to newly issued shares in proportion to their existing
holdings. For example, 1:4 rights issue means an existing investor can buy one
extra share for every four shares already held by him/her. Usually the price at
which the new shares are issued by way of rights issue is less than the
prevailing market price of the stock, i.e. the shares are offered at a discount.
Why does a company go for it?
The basic idea is to raise fresh capital. A rights issue is not a common
practice that a corporate organisation resorts to. Ideally, such an issue occurs
when a company needs funds for corporate expansion or a large takeover. At the
same time, however, companies also use rights issue to prevent themselves from
being conked out. Since a rights issue results in higher equity base for the
organisation, it also provides it with better leveraging opportunities. The
company becomes more comfortable when it comes to raising debt in the future as
its debt-to-equity ratio reduces.
What is the effect on the company and what if a shareholder does not exercise
his right?
A rights issue affects two important elements of a company - equity capital
and market capitalisation. In case of a rights issue, since additional equity is
raised, the issuing company’s equity base rises to the extent of the issue. The
effect on m-cap depends on the perception of the market. In theory, every new
issue has some kind of diluting effect and hence as a result of a fall in the
market price in proportion to an increase in the number of shares, the market
capitalisation remains unaffected.
However, if the market sentiment believes that the funds are being raised for an
extremely positive purpose then price of the stock may just rise resulting in an
increase in the market capitalisation. If a shareholder does not want to
exercise the right to buy additional shares then he/she can sell the right as
the rights are usually tradable. Alternatively, investors can just let the
rights issue lapse.
What should an investor be careful about in case of a rights issue?
An investor should be able to look beyond the discount offered. Rights issue
is different from bonus issue as one is paying money to get additional shares
and hence one should subscribe to it only if he/she is completely sure of the
company’s performance. Also, one must not take up the rights if the share price
has fallen below the subscription price as it may be cheaper to buy the shares
in the open market.
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