RIGHTS ISSUE
Normally, whenever an existing company makes a fresh issue of equity capital or convertible debentures the existing shareholders or convertible debenture holders have the first right to subscribe to the issue in proportion to their existing holdings. Only what is not subscribed to by the existing shareholders can be issued to the public. Thus, an issue offered to the existing shareholders or convertible debenture holders as their right is known as rights issue, as opposed to an issue open to the public at large, in which case we call it a public issue. An investor may exercise this right to subscribe to the offered issue, or he may sell the rights separately in the market. The rights have a market value only when the issue is made below the market value of the security. When this happens, as can be expected, the market price drops a little. The price of the security before the rights issue is known as the cum-rights price. The difference between the cum-rights and ex-rights price is a measure of the market value of a right, through increase in shares prices.
IS THE PRICE AT WHICH THE RIGHTS ARE ISSUED IMPORTANT:
The price at which a rights issue is made is irrelevant. In order to understand this, consider the example of a company, which has 100000 ordinary shares outstanding with a market price of Rs.40 per share. This is the cum-rights price. The total market value of the shares (also known as market capitalization) at this stage is Rs.4000000 (Rs.40 x 100000). Let us assume that this company needs to raise another Rs.500000 for sustaining its operations and so makes a rights issue of 25000 shares, i.e., at a ratio of 1:4, at Rs.20 each. Thus, after the rights issue is made, the number of shares outstanding increases to 125000. Assuming that the purpose for which the additional capital is being raised is not likely to affect the overall profits of the company significantly (in other words, everything else remains the same), the ex-rights price of the share should drop to about Rs.36 { Rs. (4000000 + 500000) / 125000). In this case, the value of a right is Rs.4 and one requires four rights in order to procure one share at Rs.20, and the ex-rights wealth of the shareholders works out to about Rs.4500000 (Rs.36 x 125000). If on the other hand the company were to decide to raise the additional Rs.500000 by issuing 12500 shares at Rs.40 each, the ex-rights price of the share would remain unchanged at Rs.40 (4500000 / 112500). Also, one who buys four rights for Rs.16, and acquires one share at the issue price of Rs.20, eventually ends up paying Rs.36, which is the same as the ex-rights price. In this case once again, the ex-rights wealth of the shareholders is about Rs.4500000 (Rs.40 x 112500).
Thus, it can be seen that no matter at what price the rights issue is made; the ex-rights wealth of the shareholders subscribing to the rights issue (ex-rights price multiplied by the number of shares outstanding including the rights issue) remains more or less the same. This was not so in the case of public issues. A public issue made blow the market price, we noticed, resulted in a transfer of wealth form the existing shareholders to the new shareholders. Needless to say, no issue, whether rights or public, will be subscribed to by a rational investor at a price higher than the prevailing market price, as the investor can always buy that the share from the secondary market rather than subscribe to the issue.