New shares - or rights - for shareholders
A company that wants to raise additional capital will sometimes offer new shares to current shareholders. This is called a rights issue. The company issues the rights in proportion to existing holdings. So, for example, in a one-for-two rights issue, shareholders will be offered one new share for every two they hold. The new shares are generally offered at a significant discount to encourage take-up.
As a shareholder, you are not required to take up these new shares or rights, but if you waive them you risk diluting your existing holding as the total number of outstanding shares increases. It is often possible to sell your rights on the open market to others.
You might also consider buying additional shares in a rights issue if the issuing corporation absorbs any brokerage fees. However, the main consideration should be the ability of management to use the capital raised for the benefit of the corporation.
Although you will get new shares at a discount, this may prove a false saving if the company's strategy is misguided, and this will ultimately be reflected in the share price. In this case, by taking up your rights you may be increasing your investment in a poor stock.
Shareholder options
When a company makes a rights issue, as a shareholder you have three options. You can:
- take up your rights and maintain your proportionate ownership of the company
- sell your rights in the open market
- do nothing and let the underwriter send you the value of your rights minus charges
If you are thinking about taking up your rights, make sure you are happy with the performance of the company. Ask your broker for advice or do some independent research to help you make your decision.
If you do not want to take advantage of the rights issue but you want to sell your rights, you may find it difficult to find a broker who is willing to act on your behalf since private investors usually deal in small amounts of stock. Also, don't forget that brokers usually take commissions. These will be deducted from the value of your rights.
Calculating the value of your right
It's easy to work out the value of your right. Let's look at the example a one-for-five rights issue. The current market price is £2 per share. To attract take-up, the company proposes a discount subscription price of £1 per share. Let's calculate the value of the right for an investor who has five shares.
Current holding: Five shares @ £2 per share = £10
Rights Issue: One share @ £1 per share = £1
Total value of holding after rights issue = £11
So, if six shares have a total value of £11.00, then the theoretical value of one share after the rights issue will equal £1.83. The value of a right per share equals £2.00 minus £1.83, or £0.17.
If the holding was larger, you would simply multiply the value of a right per share by the total holding to see how much your rights are worth.