What to do with a rights issue

One of the main reasons companies list on stock exchanges is so they can raise money by selling newly created shares when they need to. One way to do this is to give existing shareholders the right to buy new shares at a discount to the existing share price a rights issue.

Yet the mere words rights issue' often send a shiver down shareholders' spines. Rights issues are often associated with desperate, cash-strapped companies. Another issue is that shareholders like to keep hold of their share of the company's profits. Any new shares that come on to the market might jeopardise that.

Mothercare has just announced a rights issue and there are rumours that Tesco and Sainsbury's might follow suit. But are rights issues really that bad? And how do you work out what they mean for your investment in a company?

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What is a rights issue?

A rights issue gives existing shareholders the right to buy new shares in a company in proportion to the size of their existing shareholding. So a two for one rights issue gives you the right to buy two new shares for each existing share you own.

To encourage shareholders to subscribe for new shares, they will usually be offered at a discount to the current share price. As a rule of thumb, the more desperate the company is for cash, the bigger the discount.

A rights issue will usually be underwritten by a stockbroker who will buy up any unused rights so the company raises all the money it needs to. So how do you weigh up the impact of a rights issue and what are your options?

Let's take Mothercare's recently announced rights issue as an example.

It is a nine for ten rights issue at a price of 125p compared with its current share price of 266p. This means that, after the new shares are paid for and start trading on the stock exchange, the share price will inevitably be lower. The first thing to do is calculate what is known as the theoretical ex-rights price (TERP) as shown below.

So the price of the shares will fall from 266p to 199p.

As a shareholder you have three practical options:

Take up your rights in full.

Sell your rights.

Sell some of your rights and take upthe others.

How to take them up

If you decide to take up your rights in full, you will need to find £11.25 to buy nine new shares for every ten that you already own. But does the maths make sense? Your ten existing shares will fall in value from 266p to 199p a loss of 67p per share or £6.70 in total.

However, you are also buying nine new shares for 125p that will have a value of 199p a gain of 74p per share or £6.66 in total. That means you are not really any better or worse off, which is how it should be.

When you decide whether you want to take up your rights, it's a good idea to focus on why the company wants to raise cash. Paying down debt can be a good idea, as it will make your shareholding less risky, which should be positive for its value. It's even better if the cash will be used to invest in a profitable new business.

However, on the downside, rights issues are often used to pay for restructuring a poorly performing part of a business. If this is the case, then check that the management's turnaround plan is credible and doable. If it isn't, then you may be throwing good money after bad.

You might decide that you don't want to buy any more new shares. If so, then instead of letting the rights lapse before a predetermined date, you can sell them, or get your stockbroker to. If you do this, you are selling the rights nil paid' because you haven't paid anything for them. The value of the rights in the Mothercare example is 74p per share. It is simply the TERP less the rights issue price (199p less 125p).

Issues for Isas

If you own shares within an individual savings account (Isa), a rights issue can trigger a practical challenge. The problem comes when you have already paid the maximum amount of cash into your Isa for the year. (Currently that maximum is £15,000.) In this situation, you can't pay in any extra money to buy your rights.

Thankfully, there is a way around this. You can sell some of your rights to raise some cash, which you can then use to buy some new shares. To calculate the number of rights you need to sell to buy the maximum number of shares, you can perform the following calculation:

(Rights x subscription price)/TERP = (9x125p)/199p = 5.65 or five shares.

You need to round down to the nearest whole share. So selling five shares at

74p nil paid would raise 370p. That would leave you 5p short of the money needed to buy three new shares at 125p. This means you could only buy two new shares at nil cost.

Are rights issues a buy signal?

Possibly. Share prices may fall in anticipation of a rights issue, but may do well afterwards if the issue has placed the company on a firmer footing which allows it to recover. It all depends on the price of the rights issue and whether a company can turn itself around. So, rights issues are worthy of further research: see if you can pick up a bargain.