A rights issue is a way in which a company can sell new shares in order to raise capital. Shares are offered to existing shareholders in proportion to their current shareholding, respecting their pre-emption rights. The price at which the shares are offered is usually at a discount to the current share price, which gives investors an incentive to buy the new shares — if they do not, the value of their holding is diluted.
A rights issue by a highly geared company intended to strengthen its balance sheet is often a bad sign. Profits are already low (or negative) and future profits are diluted. Unless the underlying business is improved, changing its capital structure achieves little.
A rights issue to fund expansion can usually be regarded somewhat more optimistically, although, as with acquisitions, shareholders should be suspicious because management may be empire-building at their expense (the usual agency problem with expansion).
The rights are normally a tradeable security themselves (a type of short dated warrant). This allows shareholders who do not wish to purchase new shares to sell the rights to someone who does. Whoever holds a right can choose to buy a new share (exercise the right) by a certain date at a set price.
Some shareholders may choose to buy all the rights they are offered in the rights issue. This maintains their proportionate ownership in the expanded company, so that an x% stake before the rights issue remains an x% stake after it. Others may choose to sell their rights, diluting their stake and reducing the value of their holding.
If rights are not taken up the company may (and in practice, in many markets, does) sell them on behalf of the rights holder.
Because the rights are usually worth enough to cover the price differnce between the market price of the shares and the exercise price of the rights (because of the law of one price), shareholders do not lose if the rights are issued at a steep discount. It is therefore usual for the discount to be large (especially of the share price is volatile) to ensure that the rights are exercised.
It is possible to sell some rights and exercise the remainder. One possibility is selling enough rights to cover the cost of exercising those that are not sold. This allows a shareholder to maintain the value of a holding without further expense (apart from dealing costs). This does not mean that a shareholder can entirely neutralise the effect of a rights issue, only the element described by the formula below.
As with a scrip issue, the price before the rights are issued needs to be adjusted for the rights issue. The calculation is a little more complicated as the new shares are paid for. Before comparison with share prices after the rights issue, prices before the shares went ex-rights need to be multiplied by:
((m ×y) + (n ×x) ) ÷(m ×(x + y))
where x is the number of new shares issued for every y existing shares
m is the closing price on the last day the shares traded cum-rights and
n is the price of the new shares
The same adjustment needs to be made to per share numbers such as EPS if they are to remain comparable, for example, when looking looking at growth trends. However, a large rights issue is often associated with other changes that will distort these numbers or change trends such as paying off debt, expansion, etc.
This calculation makes the assumption that all rights will be exercised. This is usually an acceptable assumption as it is usual for a rights issue to be priced at a steep discount to the share price to ensure that the rights will be exercised.
In the interval between the shares going ex-rights and the rights being exercised, if the share price falls low enough for the rights to have significant option value, then an adjustment may have to be made for this. This happens very rarely.