What is Rights issue?

Savvy investors are well aware about genius way used by corporate to raise funds. Very recently Reliance Industries (RIL) successfully concluded rights issue worth Rs 53,124 crore by offering one share for every 15 shares held at Rs 1,257.
RIL intends to use three-fourth of the proceeds of its mega rights issue for repayment of some of its borrowings.
There are several reasons for the fund raising exercise carried out by a company.
Cash-strapped companies can turn to rights issues to raise money when they really need it. In these rights offerings, companies grant shareholders the right, but not the obligation, to buy new shares at a discount to the current trading price.

Companies most commonly issue a rights offering to raise additional capital. A company may need extra capital to meet its current financial obligations. Troubled companies typically use rights issues to pay down debt, especially when they are unable to borrow more money.
Let us understand how rights issues work and what they mean for the company and its shareholders.

Defining rights issue:
A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. This type of issue gives existing shareholders securities called rights. With the rights, the shareholder can 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.

A listed company can raise additional capital. However, instead of going to the public, the company gives its existing shareholders the right to subscribe to newly issued shares in proportion to their existing holdings.
For example, 1:4 rights issue means an existing investor can buy one extra share for every four shares already held by him/her. Usually the price at which the new shares are issued by way of rights issue is less than the prevailing market price of the stock, i.e. the shares are offered at a discount.

Reason for rights issue:
The basic idea is to raise fresh capital. A rights issue is not a common practise that a corporate organisation resorts to. Ideally, such an issue occurs when a company needs funds for corporate expansion or a large takeover. At the same time, however, companies also use rights issue to prevent themselves from being conked out.
Since a rights issue results in higher equity base for the organisation, it also provides it with better leveraging opportunities. The company becomes more comfortable when it comes to raising debt in the future as its debt-to-equity ratio reduces.

The effects of rights issue on the company and shareholders:
A rights issue affects two important elements of a company equity capital and market capitalisation. In case of a rights issue, since additional equity is raised, the issuing company���s equity base rises to the extent of the issue. The effect on m-cap depends on the perception of the market.
In theory, every new issue has some kind of diluting effect and hence as a result of a fall in the market price in proportion to an increase in the number of shares, the market capitalisation remains unaffected. However, if the market sentiment believes that the funds are being raised for an extremely positive purpose then price of the stock may just rise resulting in an increase in the market capitalisation. If a shareholder does not want to exercise the right to buy additional shares then he/she can sell the right as the rights are usually tradable. Alternatively, investors can just let the rights issue lapse.

Precautions to be taken by an investor:
An investor should be able to look beyond the discount offered. Rights issue are different from bonus issue as one is paying money to get additional shares and hence one should subscribe to it only if he/she is completely sure of the company’s performance.
Also, one must not take up the rights if the share price has fallen below the subscription price as it may be cheaper to buy the shares in the open market.

Investors may be tempted by the prospect of buying discounted shares with a rights issue. But it is not always a certainty that you are getting a bargain. In addition to knowing the 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 share dilution are necessary as part of a company’s strategic plan. A rights issue can offer a quick fix for a troubled balance sheet, but that does not mean that management will address the underlying problems that weakened the balance sheet in the first place. Shareholders should be cautious.

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