2/2/2017 UnderstandingRightsIssues|Investopedia

Understanding Rights Issues

By Ben McClure | Updated December 29, 2015 1:30 PM EST SHARE

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Cash-strapped companies can turn to rights issues to raise money when they really need it. In these
rights offerings, companies grant shareholders a chance to buy new shares at a discount to the
current trading price. Let's look at how rights issue work, and what they mean for all shareholders.

Defining a Rights Issue and Why It's Used

A rights issue is an invitation to existing shareholders to purchase additional new shares in the
company. More specifically, this type of issue gives existing shareholders securities called "rights
"rights",
",
which, well, give the shareholders the right to purchase new shares at a discount to the market price
on a stated future date. The company is giving shareholders a chance to increase their exposure to
the stock at a discount price.

But until the date at which the new shares can be purchased, shareholders may trade the rights on
the market the same way they would trade ordinary shares.
shares. The rights issued to a shareholder have
a value, thus compensating current shareholders for the future dilution of their existing shares'
value.

Troubled companies typically use rights issues to pay down debt, especially when they are unable to
borrow more money. But not all companies that pursue rights offerings are shaky. Some with clean
balance sheets use them to fund acquisitions and growth strategies. For reassurance that it will raise
the finances, a company will usually, but not always, have its rights issue underwritten by an
investment bank.
bank.

How Rights Issues Work

So, how do rights issues work? The best way to explain is through an example.

Let's say you own 1,000 shares in Wobble Telecom, each of which is worth $5.50. The company is in a HOT DEFINITIONS
bit of financial trouble and sorely needs to raise cash to cover its debt obligations. Wobble therefore
announces a rights offering, in which it plans to raise $30 million by issuing 10 million shares to Dodd-Frank Wall Street Reform and
existing investors at a price of $3 each. But this issue is a three-for-10 rights issue. In other words, for Consumer Protection ...
every 10 shares you hold, Wobble is offering you another three at a deeply discounted price of $3. Portfolio Management
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This price is 45% less than the $5.50 price at which Wobble stock trades. (For further reading, see Smart Home
Understanding Stock Splits.)
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Quick Ratio
As a shareholder, you essentially have three options when considering what to do in response to the
rights issue. You can (1) subscribe to the rights issue in full, (2) ignore your rights or (3) sell the rights Sharpe Ratio
to someone else. Here we look how to pursue each option, and the possible outcomes.

1. Take up the rights to purchase in full

To take advantage of the rights issue in full, you would need to spend $3 for every Wobble share that
you are entitled to under the issue. As you hold 1,000 shares, you can buy up to 300 new shares
(three shares for every 10 you already own) at this discounted price of $3, giving a total price of $900.

However, while the discount on the newly issued shares is 45%, it will not stay there. The market
price of Wobble shares will not be able to stay at $5.50 after the rights issue is complete. The value of
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2/2/2017 UnderstandingRightsIssues|Investopedia
each share will be diluted as a result of the increased number of shares issued. To see if the rights
issue does in fact give a material discount, you need to estimate how much Wobble's share price will
be diluted.

In estimating this dilution, remember that you can never know for certain the future value of your
expanded holding of the shares, since it can be affected by any number of business and market
factors. But the theoretical share price that will result after the rights issue is complete - which is the
ex-rights share price - is possible to calculate. This price is found by dividing the total price you will
have paid for all your Wobble shares by the total number of shares you will own. This is calculated as
follows:

1,000 existing shares at $5.50 $5,500

300 new shares for cash at $3 $900
Value of 1,300 shares $6,400
Ex-rights value per share $4.92 ($6,400.00/1,300 shares)

So, in theory, as a result of the introduction of new shares at the deeply discounted price, the value
of each of your existing shares will decline from $5.50 to $4.92. But remember, the loss on your
existing shareholding is offset exactly by the gain in share value on the new rights: the new shares
cost you $3, but they have a market value of $4.92. These new shares are taxed in the same year as
you purchased the original shares, and carried forward to count as investment income,
income, but there is
no interest or other tax penalties charged on this carried-forward, taxable investment income.

2. Ignore the rights issue

You may not have the $900 to purchase the additional 300 shares at $3 each, so you can always let
your rights expire. But this is not normally recommended. If you choose to do nothing, your Trading Center
shareholding will be diluted thanks to the extra shares issued.

3 Sell your rights to other investors

In some cases, rights are not transferable. These are known as "non-renounceable
"non-renounceable rights".
rights". But in
most cases, your rights allow you to decide whether you want to take up the option to buy the
shares or sell your rights to other investors or to the underwriter
underwriter.. Rights that can be traded are
called "renounceable
"renounceable rights",
rights", and after they have been traded, the rights are known as "nil-paid
rights".
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To determine how much you may gain by selling the rights, you need to estimate a value on the nil- Test your forex trading skills in our FX trading simulator
paid rights ahead of time. Again, a precise number is difficult, but you can get a rough value by
taking the value of ex-rights price and subtracting the rights issue price. So, at the adjusted ex-rights Trade like a top hedge fund manager using technical
price of $4.92 less $3, your nil-paid rights are worth $1.92 per share. Selling these rights will create a analysis and double your wealth...
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The Bottom Line
It is awfully easy for investors to get tempted by the prospect of buying discounted shares with a
rights issue. But it is not always a certainty
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you are getting a bargain. But
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ex-rights share price, you need to know the purpose of the additional funding before accepting or
rejecting a rights issue. Be sure to look for a compelling explanation of why the rights issue and Search news, tickers, terms Newsletters
share dilution are needed as part of the recovery plan. Sure, a rights issue can offer a quick fix for a
troubled balance sheet, but that doesn't necessarily mean management will address the underlying
problems that weakened the balance sheet in the first place. Shareholders should be cautious.

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