Understanding Rights Issues in Corporate Finance

Hariharan Ganesan • March 9, 2024 | 6 min read • 834 views

In the dynamic landscape of corporate finance, understanding various corporate actions is essential for investors. Among these actions, a rights issue stands out as a fundamental mechanism utilized by companies. In this blog post, we delve into the intricacies of rights issues, shedding light on its significance, features, and implications.

 

What is a Rights Issue?

 

A rights issue is a corporate action through which a company extends the privilege to its existing shareholders to purchase additional shares directly from the company. Unlike transactions in the secondary market, where shares are bought and sold among investors, a rights issue allows shareholders to procure shares at a price typically lower than the prevailing market rate. The allotment of shares in a rights issue is proportional to the number of shares held by each shareholder.

 

Participation in a rights issue is optional for shareholders. Those who opt not to partake can either let the rights lapse or transfer them to another shareholder.

 

Key Features of Rights Issues

 

Understanding the distinct characteristics of rights issues is crucial for investors:

 

  1. Preferential Benefits: Existing shareholders are granted preferential rights to purchase additional shares.
  2. Non-obligatory Participation: Shareholders possess the right, but not the obligation, to subscribe to the rights issue.
  3. Discounted Pricing: Shares are typically offered at a discounted price compared to prevailing market rates.
  4. Cost-Effective Capital Access: Companies can raise capital through rights issues without incurring expenses associated with underwriters or book-running lead managers.
  5. Tradable Rights: Shareholders have the option to sell their rights to other investors, either on the exchange or through off-market transactions.
  6. Potential Dilution: Failure to subscribe to rights can lead to dilution of ownership for shareholders.
  7. Proportional Allocation: The number of shares available for subscription is determined by the shareholder's current holdings.

 

Reasons for Initiating a Rights Issue

 

Companies opt for rights issues for various strategic reasons:

 

  1. Capital Infusion: Rights issues serve as a cost-effective means for companies to raise capital while preserving existing shareholders' voting rights.
  2. Alternative Funding Source: In situations where debt financing is either unavailable or expensive, rights issues offer an alternative avenue for raising funds.
  3. Debt-to-Equity Ratio Management: Rights issues can be employed to optimize the company's debt-to-equity ratio, enhancing financial stability.

 

Example Illustration

 

Consider a hypothetical scenario where a company announces a rights issue at a ratio of 1:4. This implies that for every four shares held by an existing shareholder, they are entitled to purchase one additional share at a discounted price compared to the prevailing market rate. Such initiatives enable companies to efficiently raise capital while providing shareholders with an opportunity for value acquisition.

 

In conclusion, rights issues represent a symbiotic mechanism benefiting both companies and shareholders. While companies gain access to cost-effective capital, shareholders enjoy discounted share prices without dilution of their voting rights. Unlike follow-on public offerings, rights issues offer a strategic avenue for capital infusion while maintaining shareholder integrity.

 

FAQs on Rights Issues

 

What is Right Entitlement?

Right entitlement is a privilege extended to shareholders by companies, entitling them to purchase additional shares at a predetermined ratio based on their existing holdings.

 

How do you trade Right Entitlement?

Right entitlements can be traded on the NSE Equity market trading platform, facilitating seamless transactions in dematerialized mode with settlement guarantees.

 

What happens to unexercised Rights Entitlements (REs)?

Unexercised REs lapse post the issue closing date, resulting in suspension of the associated ISINs.

 

Can non-existing shareholders apply to a Rights Issue?

Yes, non-existing shareholders can participate by purchasing rights entitlement and subsequently subscribing to the rights issue before its closure.

 

What happens if REs are not utilized after on/off-market renunciation?

Unutilized REs lapse, and investors forfeit the opportunity to acquire additional shares.

 

In Which segment do you trade Right Entitlement?

Right entitlements are traded within the Equity market segment of the National Stock Exchange (NSE), providing investors with a designated platform for seamless transactions.

 

What would be the symbol of the RE stock?

 

The specific symbol for the right entitlement stock will be communicated by the Exchange prior to the trading commencement date, ensuring clarity and accessibility for market participants.

 

Would there be e separate ISIN for the RE stock?

 

Yes, a separate International Securities Identification Number (ISIN) will be assigned to the right entitlement stock, facilitating efficient tracking and trading within the market ecosystem.

 

Are the RE stocks available for different market sessions?

 

Right entitlements are accessible for trading across various market sessions, including the pre-open market, normal market (EQ), block window (BL), and post-close market, ensuring flexibility and convenience for investors.

 

How is the base price calculated?

 

The base price for right entitlements is determined through a structured methodology. On the first day of trading, the base price is computed as the difference between the closing price of the underlying stock and the right entitlement price. Subsequently, the closing price of right entitlement trading serves as the base price for subsequent trading sessions, ensuring consistency and transparency in price discovery mechanisms.

 

How does settlement occur for Rights entitlement trades?

All clearing members in the Cash Market (CM) segment are eligible for clearing and settlement of Rights Entitlement. Trades are settled on a T+2 basis, with clearing and settlement executed on a gross basis while funds are settled on a net basis.

 

What is the applicable margin for trading Rights Entitlements?

The applicable margin for trading Rights Entitlements is set at 100% of the Rights Entitlement value.

 

What happens in case of a shortage during settlement of Rights Entitlement trades?

Any shortages in Rights Entitlements are resolved through direct close-out. The shortage is closed out at the highest prevailing price of Rights Entitlement across exchanges from the day of trading until T+1 day or at 20% above the settlement price of Rights Entitlement on T+1 day, whichever is higher.

 

What are the transaction charges associated with trading Rights Entitlements?

Transaction charges for trading Rights Entitlements align with NSE Cash market transaction charges.

 

What is the Securities Transaction Tax (STT) applicable to Rights Entitlement trades?

Trading in dematerialized Rights Entitlements on the Exchange incurs STT as specified in the Finance (No.2) Act, 2004. STT is payable by the seller at a rate of 0.05% of the value at which Rights Entitlements are traded, corresponding to the entry at serial no. 4(a) of the STT Table under Section 98.

Discussion