Advantages and Disadvantages of Right Issue of Shares

Definition of Right Issue of Shares

A right issue of shares (rights offering) is where a company provides an offer to their existing shareholders to purchase additional shares at a discounted price in a particular ratio proportionate to their present shareholding. Equity capital can be fulfilled using a rights issue.

The rights issue gives the option to the existing shareholders to purchase shares at a lower price on or before a specified date, to retain their existing shareholding percentage.

Advantages of Right Issue of Shares

1. The right issue is a fast source of raising funds

Issuing rights is the fastest method and the cheapest source of raising capital for a firm. Our shareholders can buy new shares at a discount for a certain period on the right issue. The right issue involves less rigorous rules and regulations as it is more of an internal matter in the company.

2. The right issue incurs low cost

A company can initiate the rights issue process to its existing shareholders at indigent times without incurring underwriting fees. The company also saves money that is spent on advertising, underwriting fee, etc. The company does not have to incur such expenses compared with raising fresh equity from an IPO.

3. The right issue provides an option for the shareholders to maintain the same ownership

The number of additional share purchases allowed to an existing shareholder is always in proportion to his existing shareholding. Shareholders have the option to maintain their original proportion of share ownership.

Existing shareholders will have more certainty of getting shares, when a fresh issue is made to the existing shareholders, instead of the general public. The share price of the right issue will be less than the current share price which attracts the existing shareholders.

4. Raise funds without a form of debt

The right issue is a process to raise capital wherein the company can raise capital without any increase in debt. The company can raise the capital from its existing shareholders without altering the shareholder’s holding percentage. The scope of the right issue is purely in the form of equity and it eliminates any scope for debt.

5. The board of directors can not misuse share issuing option

The board cannot misuse the opportunity of issuing new shares at a lower price. The right issue shares offered proportionately to the existing shareholders according to their existing holdings. Directors do not have much control over the right issue.

Disadvantages of Right Issue of Shares

1. The existing shareholding percentage may get diluted

Existing shareholders have the option either to ‘subscribe’ to the right issue or ‘ignore’ to the right issue. If a shareholder ‘ignore’ the right issue then their shareholding percentage will get diluted. This is due to the extra shares issued by the company if it is ‘ignore’ by existing shareholders. If more shareholders ‘ignore’ the right issue then there are chances of stake dilution of the existing shareholders. As the existing shareholder percentage gets reduced with the initiation of new shareholders, it could be a troublesome situation for the existing shareholders.

2. After the right issue share price gets decrease

After the right issue, a certain percentage of shares will be newly introduced at a discounted price. This results in a dilution of the previous share price. Dilution occurs because a new large number share spreads the company’s net profit.

3. Limitation of fund raise

Most of the stock exchanges have put certain limits or restrictions on the amount of a company could raise through a rights issue. This limit is usually decided based on the existing equity value of the firm. The company cannot raise an amount compared to an IPO (Initial Public Offering). Raising funds through the right issue might create pressure on the company if a company has undervalued stocks.

4. The negative effect of the company’s public image

The right issue is an indication of liquidity crises that a company suffers. Generally, companies will practice the right issue option in the case of a financial crisis. The brand name of the company could negatively be effected when the right issue is announced. In another way, the shareholders also could assume that the company is struggling to run its business and could tend to sell their shares, which could then reduce the share price further.

Example of Right Issue

As an example, let’s say Mr. Charles is an existing shareholder of PQR Company. He owns 100 shares. The current market price per share of PQR Company is $500.

PQR Company decided to issue the right shares at a discount of 20% on the market price of the share. Rights issues shares are on 1 for every 4 existing shares. As a result, Charles can buy 25 right-issue shares for $400 each.

Charles can either buy these shares or sell these to another. If Charles buys these shares his shareholding percentage remains the same. But if Charles sells these shares to another, he will get the cash flow, but the shareholding percentage will be reduced.

Why Companies Conduct the Right Issue of Shares?

A rights issue is an additional capital-raising method for companies. A company can raise capital by providing the right for its existing shareholders to subscribe to newly issued shares in proportion to their existing holdings.

Key Takeaways

There are many benefits for the shareholders to subscribe to the rights issue,

Shareholders can keep their percentage of ownership the same.
Shareholders can buy new rights-issue shares for less than the market price of a share.
If a shareholder does not want to exercise the right then it is possible to sell the right. If so, their existing shareholding will be diluted after the right issue of shares.
Existing shareholders can also choose to ignore the rights. Their existing shareholding will be diluted after the right issue of shares.

Learn more about Right Issue of Shares,

Understanding Right Issue of Shares