Understanding Rights Issues of a stock

Published in

Stratzy

5 min readMay 4, 2020

What happens when a company has no cash left? What are the options available to the company? The question that comes to our mind is how will the company raise funds and this is when the Rights issue comes into the picture.

What is a Rights issue? When do companies turn towards this saviour? Is this only adopted by cash-strapped companies?

Let’s dive right into this and uncover the secrets behind the recent Rights issue announcement by Reliance Industries. In fact, this is going to be the biggest right issue ever by any Indian Company!

What is a Rights Issue?

When existing shareholders are given an invitation but are under no obligation to buy new shares of the company then this is called a Rights issue.

This is a chance given to existing shareholders to increase their exposure to the company at a discounted price.

Are there different types of Rights issues?

You may ask if people do not exercise their rights then the company may not be able to raise adequate capital. This divides the rights issues into 2 types- namely, direct right offerings and insured/standby rights offerings.

Direct right offerings- here there are no standby purchasers and therefore if people do not exercise their rights then the company may be undercapitalized.

underwrite rights offerings- here the underwriters commit to buy the unexercised rights. This helps the company raise adequate capital even if people do not fully exercise their rights.

But why do companies issue Rights? What is the advantage?

There may be a couple of reasons why companies may decide to issue rights- but the most common reason is to raise capital. They may need capital for paying off debts or to acquire other businesses. There are other benefits also that make issuing rights advantageous for companies and that is — no shareholder approvals are needed, and market interest in the issuer’s common stock increases significantly. It also benefits the shareholder as it allows them to increase their stake in the company for a discounted price.

But it’s not all sweet and good. The rights issue does have a few disadvantages also- For instance, this increases the number of shares available in the market, therefore the profit earned by the company now splits in the hand of more shareholders, therefore the EPS (or the Earning Per Share) may go down.

Let’s see how this rights issue works

Suppose there is person A, he possesses 150 shares of a particular company as of date. Also, assume that person A had bought these shares at a price of Rs. 1000 each and now the price of the discounted shares is Rs. 800 each (i.e a discount of 20% from the market price)

Now according to the terms of the rights issue, you are eligible to buy 1 share at a discounted price for every 15 shares you already hold. That means that person A can buy a total of 10 shares at a discounted price. But he need not buy 10 shares, he need not even buy 1 share because as you might remember, they are only an option, not an obligation. He can buy any number up to 10 shares.

So now A has three options:

1. Take full advantage

He dives right in and buys all 10 shares eligible to him at the discounted price of Rs. 800. Now if he buys then he will have a total 160 shares. However, the value of each share will not remain Rs.1000 but will get diluted due to the rights issue. To actually see whether the rights issue is actually beneficial you will need to know how much the share price will dilute. While estimating, remember you can never predict the future value since it depends on the market conditions. However, an indicative way of estimating the price is described below.

The theoretical price can be calculated by dividing the total price paid for all the shares and then dividing it by the total number of shares you own.

i.e the total price will be Rs.1,000*150 + Rs.800*10 = Rs. 158,000

And the total number of shares is 150 + 10 = 160

Therefore, the price would become = Rs. 158,000/160 = Rs 987.5

So, in theory, as a result of the discounted share, the average cost of acquisition of total new holding will fall from Rs. 1000 to Rs. 987.5 per share.

2. The other option is to let these rights expire.

Is that a good idea? Not really, since your shareholding will get diluted due to the extra share issue. There also may be another situation where you may not have the money to exercise these rights.

3. The third option is to sell the rights to other people.

Sometimes the shares are non- transferrable and are referred to as non-renounceable rights.

However companies, usually, allow shareholders to decide whether they want to buy themselves or want to share their rights with someone else.

But if I am getting shares at a discounted price should I not buy them?

Investors may get all excited to buy shares at a discounted price but the important thing is to analyze whether you are actually getting a bargain. The other thing to pay attention to is how the company plans on utilizing this capital. So one should try finding out why the company is issuing rights and what is their aim to dilute the shareholding of the firm.

The Case of Reliance Industries

Now let us see the rights issue of Reliance Industries, which is set to be the largest ever rights issue by an Indian Company.

Why is Reliance industries issuing rights?

The impending question is why such a big and stable company is issuing rights all of a sudden?

Well, the reason they want to issue rights is because of their commitment to becoming a “net debt-free” (explained below) company by March ’21. They plan to raise about Rs. 53,125 cr. through this rights issue. The rest of the money has come from the recent stake taken by the American giant, Facebook, in the telecom subsidiary of Reliance Industries — Jio. (about Rs.43,000 crore)

Also, this rights issue is to increase investor confidence in the company and show that everything is good and the positive outlook of the promoters in the long-term growth of the company.

What does a net debt-free company mean?

It does not mean that the company no longer has any debt but, what it means is, that the company’s cash reserves are more than the borrowed amount.

The current Rights issue by Reliance

In the instant issue, Reliance is offering 1 share for every 15 shares held by any existing shareholder. The company is giving these rights at a price of Rs. 1257, about 14% discount from the market price of Rs. 1464 as of 3:30 pm on 30 April, ‘20.