However, corporate expansion necessitates appropriate finance, so corporations face rights issues.
What is a rights issue?
A rights issue is a prevalent form of corporate action where the company invites existing shareholders to buy additional shares in the company at a discounted price within the said period (the cut-off date).
Now, as existing shareholders of the company, you do not have an obligation to buy additional shares. If you think the company has a flourishing business, you can apply for the rights issue and increase your stake within the company.
Is expansion the only reason why companies come up with rights issues?
Well, that’s not the case. Many companies come up with rights issues to become debt free. Recently,
came up with a rights issue with the motive of repaying outstanding borrowings availed by the company.
Understanding rights issue
If we take the example of Energy’s rights issue, the issue price was set at Rs 5 per share while the share was trading around Rs 8. The issue size was Rs 1,200 crores. You can buy five shares for every 21 equity shares held at a discounted price.
What must an investor do?
You can either buy the rights or let the rights lapse. When you get to know that the company you have invested in is coming up with a rights issue, do your homework.
Read the letter of offer of the rights issue provided by the company and understand the motive behind raising capital. The company may use it for the expansion of business or towards debt repayment, or partly towards both.
Now, if the company is raising funds for the expansion of business, then it’s a positive prospect for the investors. You will also get a share in the company’s profits when the business grows.
But, if the company is using capital to repay the debt, it is not great news for shareholders as the accumulated capital will not generate profits for you.
Benefits and drawback of rights issue for shareholders
The company offers you an opportunity to buy more shares and increase your stake at a discounted price.
But, there is a significant drawback if you don’t exercise your right. The rights issue will lead to a dilution in the value of shareholders’ holdings. For example, you hold a 3% stake in a company before the rights issue.
If you buy the rights issue, your stake post-rights issue will be the same. But, if you do not purchase the rights and the offer lapses, your stake in the company will fall as other shareholders may exercise the right.
With the rights issue, the number of outstanding shares increases; hence, your holding proportion dilutes, and the earnings per share decrease.
To sum up, the rights issue is an excellent opportunity for shareholders to increase their stake in the company.
But one must not get lured by discounts. Always do your research and check the fundamentals of the company and the aim behind the rights issue.
(The author is Founder, TejiMandi. Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)