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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.
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.
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.)
Value
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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.
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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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:
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.
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RELATED FAQS
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rights offering, ... Read Answer >>
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