Rights Issues: Mechanics and Valuation

What is a Rights Issue?

When a public company wants to raise more equity capital, it can offer new shares to the public in what's known as a seasoned equity offering. However, this can dilute the ownership stake of its current shareholders. An alternative is the rights issue, which is an invitation to existing shareholders to purchase additional new shares, in proportion to their current holdings, at a discounted price. This gives them the 'right' to maintain their proportional ownership in the company.

To start, let's get a clear overview of the concept and its purpose.

As the video explains, a rights issue has several key characteristics:

• It's an offer made exclusively to existing shareholders.
• Shareholders receive rights, typically one per share owned, to subscribe to new shares.
• The new shares are offered at a subscription price (or exercise price), which is set below the current market price to incentivize participation.
• The offer is structured as a ratio, for example, a "1-for-4" rights issue means a shareholder can buy one new share for every four shares they already own.

Shareholders who receive these rights have three main choices:

1. Exercise the rights: Purchase the new shares at the discounted price.
2. Sell the rights: If the rights are transferable (renounceable), they can be sold to other investors in the market.
3. Let the rights expire: Do nothing and allow the rights to lapse, which is generally not a financially wise decision as the rights have value.

Calculating the Theoretical Ex-Rights Price (TERP)

The most immediate financial consequence of a rights issue is its effect on the company's share price. Because the new shares are issued at a discount, the overall value per share is diluted. The Theoretical Ex-Rights Price (TERP) is the estimated price of a share after the rights issue is completed.

Essentially, the TERP is a weighted average of the value of the existing shares and the value of the newly issued shares.

The formula can be expressed as:

Your preference for worked examples will be very useful here. The best way to understand this is to walk through a calculation.

Let's replicate the logic from the video with its example:

• Rights Issue: 1 new share for every 4 existing shares (a 1-for-4 issue).
• Current Share Price (Cum-rights price): $10.00
• Subscription Price: $6.50

To calculate the TERP, consider a holding of 4 shares before the issue:

1. Value of existing shares: 4 shares × $10.00/share = $40.00
2. Cost to exercise rights for new shares: 1 share × $6.50/share = $6.50
3. Total value of all shares after exercise: $40.00 + $6.50 = $46.50
4. Total number of shares after exercise: 4 shares + 1 share = 5 shares
5. Calculate the TERP (average price per share): $$\text{TERP}=\frac{\$46.50}{5\text{ shares}}=\$9.30$$

As expected, the theoretical share price falls from $10.00 to $9.30 because of the dilutive effect of issuing new, cheaper shares.

Calculating the Value of a Right

Since the rights allow shareholders to buy shares for less than they are theoretically worth (i.e., less than the TERP), the rights themselves have value. This value can be realized either by exercising them to get cheap shares or by selling them on the market.

The value of the right to buy one new share (also known as the "nil-paid right" value) is simply the difference between the theoretical ex-rights price and the subscription price.

Using our ongoing example:

• TERP = $9.30
• Subscription Price = $6.50
• Value of the right to buy one new share = $9.30 - $6.50 = $2.80

This $2.80 is the profit a shareholder makes by subscribing to one new share. However, we often want to know the value of one single right. Since it took 4 rights (from the 4 shares held) to get this benefit, we divide the total gain by the number of rights required.

In our example (a 1-for-4 issue, so N=4):

This means each individual right is theoretically worth $0.70. A shareholder with 4 shares (and thus 4 rights) holds a total value of 4 x $0.70 = $2.80 in rights, which matches our earlier calculation.

To reinforce these definitions and calculations, the following article provides a concise summary.

Conclusion

In this lesson, we have demystified the process of a rights issue, focusing on the core calculations you need for your exam. We established that a rights issue is a tool for public companies to raise additional capital by offering new shares to existing shareholders at a discount.

Key Takeaways:

• A rights issue allows existing shareholders to purchase new shares to avoid the dilution of their ownership stake.
• The Theoretical Ex-Rights Price (TERP) is the expected, lower share price after the issue, calculated as a weighted average of the old and new shares.
• The Value of a Right represents the financial gain embedded in each right, derived from the ability to buy a share at the subscription price, which is below the TERP. The formula is:
  $\text{Value per right}=(\text{TERP}-\text{Subscription Price})/N$.

Having covered pure equity (IPOs, rights issues) and pure debt (bonds), we are now equipped to explore hybrid financing instruments. In our next lesson, we will look at convertible bonds, which blend features of both debt and equity, offering another fascinating area for financial calculation and analysis.