We know that a company’s management has three key decisions to make for a company to effectively achieve the strategic goals.
These key decisions are Investment, Dividend, and Financing Decisions. These decisions are linked and affect directly each other.
A well planned and a positive NPV cash flow project can yield high profits for the company; a good dividend policy makes company shareholders happy, and so on.
When shareholders put their money in any project or a company they expect good returns from it. A company’s prime objective is to maximize the shareholders’ wealth.
Any firm in order to generate profits and cash streams need profitable projects to invest in.
All projects have costs associated with them; the management may decide to raise these cost needs through bank loans, grants, or from shareholders. In general, a company may raise funds through Debt Financing or Equity Financing.
Debt financiers like banks, investor angels, or institutional investors face less risk as their debt financing is backed up by mortgages.
This makes the debt financing option cheaper, but debt financing is not always available. A new company typically has no assets to mortgage to the bank against a loan facility.
A company may already have exhausted their mortgage and securities options in the past for previous projects.
Other option for the finance management to raise funds is through Equity.
The management decides to issue shares to raise funds, there three common ways to issue new shares:
- Initial Public offerings or the IPO option
- Placing the shares
- Rights Issue of the shares
In Rights Issue; the management offers new shares to the existing shareholders, in proportion to their shareholding size.
“Raising of new capital by giving existing shareholders the right to subscribe to new shares in proportion to their current holdings.
These shares are usually issued at a discount to the market price.” CIMA OFFICIAL Terminology.
If the company decides to issue new shares, its existing shareholders have the “right” to buy those shares prior to the private investors or the public.
The new share issue results in dilution of the shareholding; hence with the “rights issue” of shares, the existing shareholders are protected.
Understanding how a rights issue requires a brief comparison of the other two shares issue options.
In an IPO, new shares are set on offer for sale to the investor through an issuing house (stock Exchange).
The offering is made public with announcements and often offers a set price for the new shares on offer. Generally, these IPO share offers to happen when a large public entity is privatized by the governments.
In Placing of shares, the management decides to approach certain investors privately to obtain finance against share offers.
Large businesses often use this option to attract banks, institutional investors, and wealthy investors to raise funds. This option often signals a negative impact to the common stockholders of the company.
Both IPO and placing might not please large shareholders of the company, the best alternative approach is to first offer the shares to the existing shareholders through Rights Issue.
Like IPO, the management decides the price of new shares on offer so that the shareholders accept it.
As the new shares will dilute the earnings per share (current earnings divided by total new shares), the new share price should not be too low to discourage the shareholders and bad signaling effects.
When companies need to go for a rights issue?
- To raise capital for new projects when there is no cash available
- For acquisition or merger of another entity that can increase shareholders share capital
- To pay off bank loans when the company is cash striped
- Rarely this option can be used as an alternative to dividend payout option
There are certain implications of the rights issue decision both for the company and the shareholders:
- Equity financing is cheaper than debt financing but shareholders expectations will be higher
- Unlike placing or debt financing this option avoids the bad signaling effect
- Shareholders are secured with their voting positions and have the option of keeping the shareholding
- As a dividend alternative, the shareholders may opt to sell the new shares issued.
From the shareholders’ perspective, the rights issue remains a future earning and control of shareholding concern.
The decision likely affects the future earnings per share, dividend ratio, and dividend ratio. If the shareholders decide to adopt the ‘do nothing” approach, they might lose significant control over the company depending upon their existing share percentage.
Rights issue offers many attractive options to the shareholders so it is highly unlikely that shareholders would oppose the rights issue.
The finance management, however, does need to consider manifold implications of the rights issue. Theoretically, the offer price does not pose a problem as far as the total required funding is secured.
However, future EPS and dividend cash needs might need serious consideration before announcing the rights issue.
The Rights issue is offered in proportion to the current shareholders e.g. 1 to 5 or 1 to 4.
EXAMPLE: Let’s suppose Techno Blue Co currently has 1 million, $ 1 ordinary shares issued. The company needs to raise an additional $ 1.5 million for a project.
The management can offer 150,000 new shares at $ 10 or 1.5 million shares at $ 1 to raise the required funds. If the current market price of the shares is $ 7, then both these prices would seem unfair.
As issuing 1.5 million new shares would dilute the shareholding and $ 10 price may seem higher to investors.
An optimum of 250,000 new shares at a price of $ 6 will arrange the required finance and also can be offered as 1 for 4 rights issue as there are 1 million ordinary shares existing.
EFFECT ON MARKET SHARE PRICE:
In theory, when management calculates the rights issue price there should be no effect on the market share price.
However, stock markets react efficiently to financing decisions of the companies hence the share prices fluctuate.
For unquoted companies, the share price also gets affected as the investors react to the financing decision of the company.
Almost certainly the share prices in stock market go down because of the signaling effect that the company does not have cash reserves to finance their projects.
Shareholder future expectations about lower EPS and dividend payout also play a part in declining share prices.
Once the rights issue takes place, the share prices adjust. The management may also calculate the theoretical ex-rights price of the shares TERP as:
Where N = number of rights required to buy 1 share. Cum rights price means before trading new rights issued.
Using our example of Techno Blue Co.
As we can see the Theoretical Ex Rights Prices are slightly different from the management proposed pricing decision of the $ 7 share issue price.
Also, these prices reflect only theoretical prices and the actual variation in share prices happens once the rights issue takes place.
Share prices often fall at first as there are more shares in issue before the market adjusts share prices to demand price in the longer term.
Although Rights Issue is a financing decision it affects shareholders directly in the short term and the company in the longer term.
Companies often opt for the rights issue when in need for a particular project financing needs, as the cost of Equity financing is normally cheaper than the debt financing.
Rights Issue is normally issued at a discount price to the shareholders, which often results in successful finance acquisition.
For quoted companies, however, the share prices fall at first due to signaling effects before they start rising again due to the positive effects of project cash flows or company performance.
Shareholders have many options to react to the management decision of the Rights Issue. Depending on their needs:
- They can decide to “do nothing” if they are not satisfied with the rights issue decision.
- Sell the new rights to another investor
- Buy shares with the rights issued
- Sell a few of the rights to compensate for the dividends
In conclusion, the Rights Issue offers a cheaper financing option for the company to fund its capital needs.
The signaling effect will depend on the financing need of the company; if the company is using the option to pay off the debts it may affect the share prices adversely.
On the other hand, if the company is financing multiple ongoing projects it might give a positive signal to shareholders that can result in higher share prices.
Shareholders, depending on their needs can decide about the best use of the rights issue. A rational shareholder would opt for a mix of buying a few new shares and selling a few of the rights to meet the cash needs.