We often keep on hearing about companies coming out with a rights issue or bonus issue. Both sound similar but are, in fact, worlds apart. We need to clearly understand what differentiates a rights issue from a bonus issue. After all, not everything falling from the sky is a blessing in disguise. Once we understand the difference, we can better evaluate our options. Be it rights or bonus, we should know what lies underneath.
Johnny: Let’s start with rights issue. Can you tell what it is?
Jinny: We often hear about companies coming out with a rights issue. What this actually means is that the company is providing an opportunity to its existing shareholders to subscribe for additional shares of the company at a price usually lower than the current market price. The shareholders can purchase additional shares in proportion to their existing shareholding. A rights issue of “5 for 10” means that you can subscribe for five more shares for every 10 shares held. So if you are holding 100 shares in total, you can subscribe for 50 additional shares. This kind of proportional distribution ensures that after a rights issue, shareholders continue to enjoy the same percentage of shareholding as before.
A shareholder with a 10% stake in a company would continue to hold 10% shares even after the rights issue. In other words, rights issues enable companies to raise additional money without disturbing the existing shareholding pattern. However, it is not compulsory for the existing shareholders to subscribe to the rights issue. In case the shareholder chooses not to subscribe, the percentage of his shareholding comes down after the issue. In a way, a rights issue is all about providing rights without any obligation.
Johnny: How could a rights issue affect the value of our investments?
Jinny: That’s something you need to assess carefully. At first look, it might seem as if you were getting an opportunity for quick profits. But in reality, a rights issue might not always work to your advantage. Let’s take an example. Suppose you hold 10 shares that are currently trading at a price of Rs5 per share and the company is offering you “one for one” additional shares at a price of only Rs3 per share. It means that you can acquire an additional 10 shares by paying Rs30 whereas the value of your existing shareholding is Rs50 at the current market price. Looks good moneywise, but the overall market equation leaves no scope for a free lunch. After the rights issue is complete, your shares might not keep on trading at a price of Rs5 per share. The increase in the number of outstanding shares after the rights issue leads to a decrease is earnings per share unless the company is able to commensurately increase its profit. The market would find a new equilibrium price after taking into account the increase in the number of shares floating in the market. Leaving aside other market factors, the price adjustment is such that you would neither earn nor lose any money. The gain made by subscribing for new shares at a lower price is just offset by the loss on existing shares due to decline in current price. Theoretically speaking, the market price should move towards the average value of new shares and your already existing shares, which would be Rs4 per share in the present case.
Johnny: How is a rights issue different from a bonus issue?
Jinny: In a bonus issue, the company allots additional shares to its existing shareholders, but the biggest difference lies in price. Unlike a rights issue, the bonus issue comes absolutely free. You get additional shares without paying anything. In fact, by declaring a bonus issue, the company is rewarding its existing shareholders. Not every company can do so. For rewarding its shareholders, the company, first of all, must have accumulated some profits over the years. The company has the option of distributing the accumulated profits as a dividend in the form of cash or as additional bonus shares in which case the company converts the accumulated profits into the company’s capital. In the whole process, the money sitting in one corner of the balance sheet shifts over to another. But leaving aside the accounting part, any bonus issue of shares brings gains for existing shareholders. They can very well sell their bonus shares and take home the money. So finally, the difference between a rights issue and a bonus issue lies in terms of money. A company comes out with a bonus issue when it is sitting on piles of money whereas it comes out with a rights issue when it dearly needs money.
Johnny: That’s something which sets the record straight. A bonus should be worth more than 100 rights.
What:In a rights issue, a company provides opportunity to its shareholders to subscribe additional shares at a price usually lower than the market price.
Why: Companies come out with a rights issue when they are in need of money and they come out with a bonus issue when they wish to distribute accumulated profits.
How: Bonus shares are distributed free of cost, and a shareholder can realize his gain by selling them in the secondary market.