What it means
A rights issue lets a company raise money by offering existing shareholders the chance to buy new shares, usually at a discount to the market price. Each existing share carries a right, and a set number of rights allows the holder to buy one new share at the subscription price.
Because the subscription price is below the market price, each right has real value. The calculation differs before and after the cut-off date.
While the shares trade "rights-on", meaning a buyer still receives the rights, the share price includes the value of the right. Once the shares trade "ex-rights", meaning the buyer no longer receives them, the share price falls by roughly the value of the right.
Managers use the figure to decide whether to take up the offer, sell the rights or let them lapse. A shareholder who ignores a rights issue suffers dilution, which means a smaller percentage ownership and a lower per-share value.
Selling the rights or exercising them keeps the shareholder broadly whole. The word "theoretical" is important, because actual rights trade in a market and their price moves with supply, demand and sentiment.
The formula assumes the market price after the offer reflects the average of old and new capital, and it ignores transaction costs and taxes. In practice, quoted rights can trade slightly above or below the calculated figure.
For a finance novice, the useful point is that a rights issue transfers value rather than destroying it. The price drop after the cut-off date is offset by the value of the rights received, so a shareholder who acts is not worse off.
Those who do nothing, however, quietly give that value away.
In practice
Real-world examples.
Example
A listed retailer announces a rights issue to fund new stores at a subscription price well below its market price. An investor holding 1,000 shares works out the value of her rights before the cut-off date. She sells half of them on the market and uses the proceeds to take up the rest.
Example
A pension fund manager holds shares in a regional bank that has launched a rights issue after a loss. The manager uses the theoretical value to compare the quoted rights price with the calculated figure. When the quoted price is clearly below the calculation, the manager buys more rights.
Example
A small family shareholder in a manufacturing company has no spare cash to subscribe. Rather than letting the rights lapse, the family sells them through its broker on the last trading day. The sale proceeds offset the fall in the share price after the cut-off date.
Formula
Calculation
Rights-on: Value of one right = (Market price - Subscription price) / (Number of rights needed per new share + 1)
Ex-rights: Value of one right = (Market price - Subscription price) / Number of rights needed per new share
Suppose a company's shares trade rights-on at $50, and shareholders may buy one new share at $40 for every four shares held, so four rights are needed. Value of one right = (50 - 40) / (4 + 1) = 10 / 5 = $2. The theoretical ex-rights price is 50 - 2 = $48. Check: four old shares at $50 plus one new share at $40 gives 200 + 40 = $240 for five shares, and 240 / 5 = $48. Once the shares trade ex-rights at $48, the same formula gives (48 - 40) / 4 = $2, which agrees.Case study
Seen in the real world.
Meridian Textiles is an illustrative, fictional listed company that needed $20,000,000 to pay down debt. The board offered existing shareholders one new share at $20 for every five shares held, when the market price was $26.
The finance team published a worked example showing the theoretical value of a right as (26 - 20) / (5 + 1) = $1. The theoretical ex-rights price was therefore $25, and the team explained that shareholders who sold or exercised their rights were protected from the fall in price.
The illustrative offer was well subscribed, partly because the explanation was clear. The finance director observed that most complaints in earlier rights issues had come from small holders who had not understood that the price fall was matched by an asset they could sell.
Watch out
Common mistakes.
- Using the ex-rights formula while the shares still trade rights-on, which overstates the value of each right.
- Treating the price fall after the cut-off date as a loss, when the right received offsets it.
- Assuming the theoretical value is the price a right will trade at, when supply and demand can move the market price away from it.
Questions
People also ask.
Why is the divisor one higher before the cut-off date?
Because the rights-on share price still contains the value of the right, so the calculation must spread the discount over the existing shares plus the new one.
What happens if I do nothing?
The rights lapse or are sold on your behalf in some markets, and you suffer dilution if you receive no value in return.
Does the formula include dealing costs and tax?
No, it ignores both, so the real gain or loss from selling or exercising a right will differ slightly.
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