Thursday 23 June 2011

Rights Issue: Good or Bad?

When a listed company declare rights issue, it means that the company wants to raise more money (cash!) by "selling" more new shares to its existing shareholders, not to the non-shareholders. Will it benefit  the existing shareholders?

Whether the rights issue benefit the shareholders depends on the purpose of the rights issue and how the company is going to spend the money raised. If the company is not making profit, has lots of bad debts, is difficult to get loan from banks and wants to get more money from the existing shareholders to pay debt or finance their operation, then this is not good.

If a financially sound company wants to get the money to expand its business or acquire other company's stake, then it should be good to shareholders.

Anyway, when the rights issue is exercised, total outstanding shares of the company will increase and the earning will be diluted.

The new shares issued usually will come at a "discount" price. Existing shareholders are given the option whether to buy it or not. Even if the shareholders buy the new shares at that "discount" price, it doesn't mean that they will gain anything, because the new share price after the rights issue will be adjusted.

For example:

Mr A has 1000 shares of company X at RM1.00. (total capital RM1000)

Company X declares rights issue of 1 new share for every 2 existing shares at RM0.50 each (50% discount!).

Since Mr A has 1000 shares, he is entitled to purchase 500 new shares at RM0.50 each.

If he decides to exercise his rights, then he needs to pay company X RM250 to buy this 500 shares at RM0.50.

So now Mr A has 1500 shares in company A that cost him RM1250 in total.

After the ex-date for the rights issue, the share price of the company will start at RM0.833, down from RM1.00 before ex-date.

As 1500 shares x RM0.833 = RM1250., Mr A does not gain or lose money from the rights issue. What has changed is that Mr A now has more shares in company X.

If Mr A decides not to buy the new shares, he can sell his rights of 500 new shares at RM0.334 per share and gain a net cash of RM167. After the ex-date when the share price falls to RM0.833, his existing 1000 shares will give him RM833, which is lower than his initial investment capital of RM1000. However, since he already gains RM167 from the sale of rights, in the end he also does not gain or lose money from the rights issue (RM833 + RM167 = RM1000).

Sometimes a company will give "free" warrants together with the rights issue. In the end, the final share price will also be adjusted and we can't earn any money from it. So the "free" and "discount" here are actually not really free and discount. There is no free lunch.

After the rights issue, the earning per share is diluted but it does not really affect the shareholders who buy the new shares under rights issue as their total shares also increase. For those who do not exercise their rights, their shareholding in the company will be diluted.

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