Companies wanting to raise additional capital sometimes turn to existing shareholders first. There are several reasons for this. The first is obvious: shareholders by definition must like the company, so if it says it can see opportunities for useful investment to allow it to grow but needs additional cash, they are more likely to take a friendly view. Second, it is only fair to allow existing holders to take action against having their holdings diluted by the issue of further shares. Third, the institutions that own most of the shares on issue in Britain are especially insistent on being given the chance to maintain the percentage of the company they have decided was right for that portfolio – this is called their ‘preemption right’.
It is a long and expensive business for a company since it must print extensive literature and post it to all holders, and the merchant banks and accountants cost a fortune in fees. A placing – ringing round funds known to be interested and asking if they would like to buy extra shares – works out a lot cheaper and can be very quick.
The opportunity to buy the new shares is allocated as a ratio of existing shares owned. It is something like the right to buy three new shares for every 11 already held, or some such formula depending on how much the company is trying to raise and how deep a discount it is offering. The issue will dilute the value of the existing shares because profits and dividends will be distributed over a larger number of shares.
Rights issues are normally offered at a discount to the prevailing share price to give people the illusion that they are getting a bargain. So if the shares stand at 200p, the company might offer one new share for every four already held at a price of 150p. So for every four shares, worth £8, they can buy another for £1.50. If investors do buy they have a holding worth £9.50 (assuming the price does not move) and the four continuing shares would be worth £7.60 (four-fifths of £9.50), but on that calculation the right would be worth 40p, so they would be back to the original £8 holding. One complication is that the money received for the rights may be taxable, and another is that the market price will react to the announcement.
Shareholders faced with a rights issue can take it up in full and pay for the new issue of shares. They can sell the nil-paid rights, which have a value on the stock market. Or they can compromise by selling enough nil-paid rights to maintain the value of the portfolio by using the proceeds to buy new shares. The nil-paid price is the difference between the discounted rights issue share price and the ex-rights price.
Source: Becket Michael (2014), How the Stock Market Works: A Beginner’s Guide to Investment, Kogan Page; Fifth edition.
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