Valuation of Rights Issue

In order to make a rights issue the company, when making the offer, must detail the reasons for the issue, the terms of the offer, the capital structure of the company at the time of issue, the future prospects for the company, and forecasts of future dividends. The number of shares needs to buy under the pre-emptive right by the existing shareholders in proportion to their existing shares held is set by the board of directors.

The ratio is determined using a simple calculation:

N = Number of Outstanding Shares / Number of New Shares to be offered

Where, N = Number of rights needed to buy one new share

The rights issue has to be priced in a way to make it attractive to existing shareholders and it must, therefore, be priced below the current market price for the shares. However, the price must not be set too low, due to the adverse effects on earnings per share. Thus in calculating the number of shares to issue to raise a given sum, account is taken of the resulting reduction of earnings per share at various issue prices.

In practice, the most common pricing mechanism is to apply a discount of 15-20% to the current market price. When a rights issue is announced, all existing shareholders have the right to subscribe for new shares, and so there are rights attached to the existing shares.

The shares are therefore described as being ‘cum-rights (with rights attached) and are traded cum rights. On the first day of dealings in the newly issued shares, the rights no longer exist and the old shares are now ‘ex-rights’ (without rights attached).

The theoretical value of the right can be calculated by applying the following formula:

R = M-S/N+1

Where,

R = Theoretical value of Right

M = Market price per share before rights issue (i.e., cum-right market price of a share)

S = Rights issue subscription price per share

N = Number of existing shares required to get a rights share

After the announcement of a rights issue, there is a tendency for share prices to fall, although the extent and duration of the fall may depend on the number of shareholders and the size of their holdings. This temporary fall is due to uncertainty in the market about the consequences of the issue, with respect to further profits, earnings and dividends.

After the issue has actually been made, the market price per share will normally fall, because there are more shares in issue and the new shares were issued at a discount price. The ‘cum-right’ price is higher than the ‘ex- right’ price of the shares since the former includes the ‘value of right’ also.