Is Rights Issue A No-Win Situation For Investors?

Foreword from ShareInvestor

This article “Is Right Issue A No-Win Situation For Investors?” by Mindy Tan was first published in The Business Times on 03 Oct 2011 and is reproduced in this blog in its entirety.

It depends on whether the investor is looking at it from the profit or control angle, reports MINDY TAN

A rights issue, an invitation to existing shareholders to purchase additional new shares in the company, is an option available to companies when they need to raise cash.

In a rights issue, existing shareholders are given securities, called “rights”, which give shareholders the right to purchase new shares at a discount to the market price on a stated future date.

The Tiger Example

In August, Tiger Airways announced that it was looking to raise $155.2 million in a rights issue to shore up its capital.

The budget carrier proposed issuing 273.42 million new shares at 58 cents apiece, on the basis of one rights share for every two existing shares held by shareholders. The issue price stood at a discount of about 39 per cent to the last traded price of 95.5 cents per share.

Associate Professor Sundaram Janakiramanan, SIM University’s head of programme for finance, explains: “Suppose you are a shareholder of Tiger Airways and hold 1,000 shares, you would receive 500 rights and if you exercise the rights, you can buy additional 500 shares of Tiger Airways at 58 cents per share.

“In this example, the shares outstanding will increase by 50 per cent after the new issue of shares and if an existing shareholder who owns 10 per cent of the shares before the new issue decides not to exercise his rights and these shares are taken up by others, the ownership percentage will drop 6.7 per cent.”

Control vs Profits

While some people would argue that a rights issue is basically a no-win situation for investors who are either forced to invest more in the company to ensure they do not experience share dilution, or not invest and experience share dilution, Prof Janakiramanan says it depends on which angle you take it from.

From the control angle, the investors’ main purpose of investing in a company is to stay in control of the company. Thus, the said investor would probably fully subscribe to the rights issue, ensuring he remains a majority shareholder.

From a participation in profits angle, an investor needs to take into account a variety of factors:

Share of profits (profits divided by number of shares outstanding)

Let us assume that Company X has profits of $273.42 million, and issues 273.42 million new shares on the basis of one rights share for every two existing shares held by shareholders. This would translate into earnings per share (EPS) of 50 cents, given that the company currently has 546.84 million shares.

After the additional 273.42 million shares are issued (through the rights issue), the number of shares outstanding will increase to 820.26 million. As such, EPS will fall to 33 cents. Sounds simple? It’s slightly more complicated.

Forecasting future earnings

In the earlier calculation, we assumed that profits would remain stagnant, which is never the case.

Instead, investors should ask themselves: what is Company X going to do with the funds raised and how will this impact future earnings?

Assume that the funds will be used to expand Company X’s operations and earnings increase to $820.26 million (again, for the sake of simplicity).

In this case, EPS will remain at $1 even after the issue of new shares. If on the other hand earnings increase beyond $820.26 million, EPS would be higher than $1.

Thus, the most important aspect to look at is the forecast of future earnings, says Prof Janakiramanan.

Stock price post rights announcement

Given the difficulty in forecasting earnings of a company, Prof Janakiramanan says that the best way for an investor to gauge a company would be via their stock price, post rights announcement.

“When any new information about the company including rights issue arrives, a number of analysts will look at the prospects of the company to arrive at new forecasts of earnings and then suggest what the fair value of the stock is likely to be.

“The price in the market is based on the consensus of the analysts. If the stock price increases upon the announcement of rights issue, this means that the analysts are optimistic about the future of the company. In case there is a decrease in price, the prospects for the company can be considered as poor,” he says.

Shareholder’s Options

Until the date at which new shares can be purchased, shareholders may trade the rights on the market the same way they would trade ordinary shares.

The price of the right will be determined in the market based on the demand and supply of these rights. If a large number of investors are willing to buy Company X’s shares and very few of the existing shareholders are willing to sell the rights, the right price can be high (and vice versa), says Prof Janakiramanan. “The liquidity of the rights market would depend on the demand for the rights.”

Assuming an investor is investing in the company in order to hold a controlling stake, the investor should subscribe fully to the rights issue.

On the other hand, if the investor is looking at a company from the profit angle, he needs to look at the rights issue very carefully.

The rights issue helps this investor because he has the right to invest and no obligation to buy additional shares, says Prof Janakiramanan.

“If an investor is not sure whether the share of profits will be higher or lower, he can sell the rights and take that as gain. Moreover, if an investor is holding a diversified portfolio, exercising the rights would increase the percentage holding in that stock in the portfolio owned and in that case, selling the rights would be a better option.”