This post is a continuation of the previous post discussing rights issues.
Before we go into some mathematical aspects of rights issues, it is good to go through a couple of terms that we commonly see.
Renounceable – A renounceable rights issue allows for shareholders to sell away their rights. A non-renounceable rights, on the other hand, cannot be sold.
Underwritten – A rights issue that is underwritten ensures that all the required funds are received regardless of the number of subscriptions by the shareholders. The underwriter will have to subscribe to any leftover rights. In return for this risk, a fee has to be paid to the underwriter. In cases where an underwriter cannot be found, it is common to get a majority shareholder to agree to subscribe to the excess rights. Another way is to allow for all shareholders to subscribe to the excess rights.
Now, let us go on to some maths using the recent DBS rights issue as an example. Letters in parenthesis will be used to show a general formula. 🙂
Last traded price (before announcement of rights) : $9.85 (M)
Theoretical ex-rights share price: $8.37 (X)
Subcription price: $5.42 (S)
1 rights given for every 2 (N) shares owned
To make things simpler, let’s consider an investor John who owns 2000 shares of DBS bought at a price of $9.85.
After the ex-rights date, he owns 1000 rights which he duly uses to subscribe to DBS shares.
All in all, his total outlay for his DBS shares is 2000×9.85+1000×5.42=$25120
Therefore, his weighted average cost per share becomes 25102/3=$8.37 which is actually the theoretical ex-rights share price.
A rights issue is not supposed to create or reduce shareholder’s wealth, so it makes sense that the value of the DBS shares to an investor is the same after the ex-rights date.
The trading price of the rights (R) would be based on (ignoring the option value):
R + S = X
which works out to be 8.37-5.42= $2.95
So, if John does not want to subscribe to the DBS shares, he can sell his rights for $2.95. His total investment in DBS shares becomes 2000×9.85-2950=$16750
His weighted cost per share then becomes 16750/2=$8.37
which works out to be the same as the case if he had subscribed to the shares.
On the surface, a lower weighted average cost of your shares might seem like a sure-win deal. This is not really the case. The theoretical ex-rights price is just a useful way of telling you your weighted average cost of your shares. It is important to realise that we do not use it as a parameter for the valuation of your shares.
Remember you have to take into account the share dilution.
Let’s say you use PE/share as the basis to determine the fair value of DBS shares. Based on your analysis, you decide that $9.85 (pre ex-rights) is a fair value for DBS.
After the rights issue, if you use the same yardstick to determine the fair value of DBS shares, you would arrive at $6.57 (remember there is now 50% more shares in circulation). Of course, this is taking a very simplistic approach. It doesn’t consider the fact that the capital raised from the rights issue can be used to reduce expenses or increase the revenue.
Personally, I do not like those rights offering with very low ratios (N) for the rights entitlement:
eg. 1 for 1 or even 2 for 1
It is like asking existing shareholders to top up a significant amount of capital compared to their original investment.
Suppose you bought some shares of a company at $0.12 (which to you was a very good price) and then suddenly they announced a 1 for 1 rights issue at $0.09.
If you take up the rights, your cost of investment (for the same percentage shareholding) would have increased to $0.21, almost double your original investment. Among other things, this can mess up your original asset allocation plan.
I think at the end of the day, whether to take up any rights offer or not boils down to one fundamental question:
Are you willing to commit more capital to the company and believe the capital will be useful (essential) to them to grow the business?