Rights issue

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A rights issue or rights offer is a dividend of subscription rights to buy additional securities in a company made to the company's existing security holders. When the rights are for equity securities, such as shares, in a public company, it is a non-dilutive(can be dilutive) pro rata way to raise capital. Rights issues are typically sold via a prospectus or prospectus supplement. With the issued rights, existing security-holders have the privilege to buy a specified number of new securities from the issuer at a specified price within a subscription period. In a public company, a rights issue is a form of public offering (different from most other types of public offering, where shares are issued to the general public).

A company, abbreviated as co., is a legal entity made up of an association of people, be they natural, legal, or a mixture of both, for carrying on a commercial or industrial enterprise. Company members share a common purpose, and unite to focus their various talents and organize their collectively available skills or resources to achieve specific, declared goals. Companies take various forms, such as:

Equity (finance) difference between the value of the assets/interest and the cost of the liabilities of something owned

In accounting, equity is the difference between the value of the assets and the value of the liabilities of something owned. It is governed by the following equation:

Public company Company that offers its securities for sale to the general public

A public company, publicly traded company, publicly held company, publicly listed company, or public limited company is a corporation whose ownership is dispersed among the general public in many shares of stock which are freely traded on a stock exchange or in over the counter markets. In some jurisdictions, public companies over a certain size must be listed on an exchange. A public company can be listed or unlisted.

Contents

Rights issues may be particularly useful for all publicly traded companies as opposed to other more dilutive financing options. As equity issues are generally preferable to debt issues from the company's viewpoint, companies usually opt for a rights issue in order to minimize dilution and maximize the useful life of tax loss carryforwards. Since in a rights offering there is no change of control and a "no-sale theory" applies, companies are able to preserve tax loss carry-forwards better than via either follow-on offerings or other more dilutive financings. It's one of the types in modes of issue of securities both in public and private companies.

How it works

A rights issue is directly distributed as a tax free dividend to all shareholders of record or through broker dealers of record and may be exercised in full or partially. Subscription rights may be transferable, allowing the subscription-rightsholder to sell them on the open market. A rights issue to shareholders is generally made as a tax-free dividend on a ratio basis (e.g. a dividend of three subscription rights for two shares of common stock issued and outstanding). Because the company receives shareholders' money in exchange for shares, a rights issue is a source of capital.

In economics, capital consists of an asset that can enhance one's power to perform economically useful work. For example, in a fundamental sense a stone or an arrow is capital for a caveman who can use it as a hunting instrument, while roads are capital for inhabitants of a city.

Considerations

In rights issue, the financial manager has to consider:[ citation needed ]

In financial services, a broker-dealer is a natural person, company or other organization that engages in the business of trading securities for its own account or on behalf of its customers. Broker-dealers are at the heart of the securities and derivatives trading process.

Underwriting

Rights issues may be underwritten. The role of the underwriter is to guarantee that the funds sought by the company will be raised. The agreement between the underwriter and the company is set out in a formal underwriting agreement. Typical terms of an underwriting require the underwriter to subscribe for any shares offered but not taken up by shareholders. The underwriting agreement will normally enable the underwriter to terminate its obligations in defined circumstances. A sub-underwriter in turn sub-underwrites some or all of the obligations of the main underwriter; the underwriter passes its risk to the sub-underwriter by requiring the sub-underwriter to subscribe for or purchase a portion of the shares for which the underwriter is obliged to subscribe in the event of a shortfall. Underwriters and sub-underwriters may be financial institutions, stock-brokers, major shareholders of the company or other related or unrelated parties.

Underwriting services are provided by some large financial institutions, such as banks, or insurance or investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liability arising from such guarantee. An underwriting arrangement may be created in a number of situations including insurance, issue of securities in a public offering, and bank lending, among others. The person or institution that agrees to sell a minimum number of securities of the company for commission is called the underwriter.

Over‐subscription privilege

Some rights issues include an "over‐subscription privilege", allowing investors to buy additional shares beyond the number offered with the basic subscription privilege, if those additional shares are available. [1] Typically the number of over‐subscription shares that can be purchased by an investor is capped as no more than the amount of his/her basic subscription. If not all the over-subscription rights can be filled, they will be partially filled on a pro rata basis. [1]

Pro rata is an adverb or adjective, meaning in proportion. The term is used in many legal and economic contexts. It is sometimes spelled pro-rata, but this is technically a misspelling of the Latin phrase. In North American English this term has been vernacularized to prorated.

Basic example

An investor: Mr. A had 100 shares of company X at a total investment of $40,000, assuming that he purchased the shares at $400 per share and that the stock price did not change between the purchase date and the date at which the rights were issued.

Assuming a 1:1 subscription rights issue at an offer price of $200, Mr. A will be notified by a broker-dealer that he has the option to subscribe for an additional 100 shares of common stock of the company at the offer price. Now, if he exercises his option, he would have to pay an additional $20,000 in order to acquire the shares, thus effectively bringing his average cost of acquisition for the 200 shares to $300 per share ((40,000+20,000)/200=300). Although the price on the stock markets should reflect a new price of $300 (see below), the investor is actually not making any profit nor any loss. In many cases, the stock purchase right (which acts as an option) can be traded at an exchange. In this example, the price of the right would adjust itself to $100 (ideally).

The company: Company X has 100 million outstanding shares. The share price currently quoted on the stock exchanges is $400 thus the market capitalization of the stock would be $40 billion (outstanding shares times share price).

If all the shareholders of the company choose to exercise their stock option, the company's outstanding shares would increase by 100 million. The market capitalization of the stock would increase to $60 billion (previous market capitalization + cash received from owners of rights converting their rights to shares), implying a share price of $300 ($60 billion / 200 million shares). If the company were to do nothing with the raised money, its earnings per share (EPS) would be reduced by half. However, if the equity raised by the company is reinvested (e.g. to acquire another company), the EPS may be impacted depending upon the outcome of the reinvestment.

Stock dilution

Rights offerings offset the dilutive effect of issuing more shares. For this reason, stock-exchange rules don't require that shareholders approve rights offerings if the company offers at least 20% of outstanding shares at a discount. [1] :1 However, some investors see rights offers as an "unwelcome choice between stumping up more cash or seeing their existing holding diluted", as a result of which rumors that a company might undertake an offering can hurt its share price. [2] Because rights offerings are unpopular, companies typically choose them as a last resort, [2] perhaps due to insufficient investor demand. [3]

Tax treatment in the United States

If rights are exercised, they aren't taxed. Like with an ordinary security purchase, taxation happens when the security is sold. The cost basis of the shares is "the subscription price plus the tax basis for the exercised rights". [4] The holding period begins at the time of exercise. [4] [5]

If rights are let to expire, they don't count as a deductible loss, [4] as they have no tax basis in this case. [5]

See also

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Security (finance) tradable financial asset

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Warrant (finance) security that entitles the holder to buy stock

In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed price called exercise price until the expiry date.

Corporate action

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Treasury stock

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The underwriting spread is the difference between the amount paid by the underwriting group in a new issue of securities and the price at which securities are offered for sale to the public. It is the underwriter's gross profit margin, usually expressed in points per unit of sale. Spreads may vary widely and are influenced by the underwriter's expectation of market demand for the securities offered for sale, interest rates, and so on.

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References

  1. 1 2 3 Beck, Melissa. "Frequently Asked Questions about Rights Offerings" (PDF). Morrison & Foerster LLP. Retrieved 1 October 2014.
  2. 1 2 Jefferies, Tanya (6 Sep 2013). "How to survive a rights issue: As Barclays cash call deadline looms, what are investors' options?". This is Money. Retrieved 1 October 2014.
  3. "Oversubscription Privilege". Investopedia. Retrieved 1 October 2014.
  4. 1 2 3 "Taxation of Security Transactions" . Retrieved 1 October 2014.
  5. 1 2 IRS Pub. 550