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Methods of raising additional equity finance

The importance of the rights issue price

How important is it that the business gets the price right? In the above example, would

existing ordinary shareholders be worse off, better off or unaffected if the rights issue

price had been, say, £1 per share instead of £1.50?

Obviously, to raise £1.2 million would require issuing 1.2 million shares if the issue

price were to be £1 each. The value of the equity immediately following the issue would

still be £8.4 million, but the market price per share would be £1.615 (£8.4 million/5.2

million). This would put the value of the rights at £0.615 per share. Let us again con-

sider the position of a holder of 100 of the original ordinary shares who chooses to take

up the entitlement of 30 new shares (remember that 1.2 million new shares will now

have to be offered to the holders of the original 4 million shares, that is, 3-for-10).

The value of our shareholder’s increased holding will be £210. Again the increase

from the original value of the holding (£180) is entirely accounted for by the cash that

our shareholder has had to pay. Thus the wealth of the shareholder is not affected by

the price at which the rights issue is made. It can equally well be shown that the share-

holder who chooses to sell the rights will similarly be unaffected.

Businesses typically price rights issues at about 21 per cent below the current pre-

rights share price (Armitage 2000). The rights issue by the Costain Group plc(men-

tioned above) was at a 36 per cent discount on the share price at the time that the

business announced its intention to make the rights issue. As we have seen, doing this

should not really advantage the shareholder. However, since allowing the rights to

lapse disadvantages shareholders, a rights issue priced at a discount puts pressure on

them either to take up the issue or to sell the rights. In either case this is likely to lead

to the issue being successful in terms of all of the shares being taken up and the

desired amount of money being raised.

Another reason for pricing rights issues at a discount is to try to ensure that any

possible fall in the market price of the shares already issued, between the date of the

announcement of the rights issue (and of the rights issue price) and the date of the

issue, still leaves the rights issue price below the market price. If, on the issue date,

shares were cheaper to buy in the capital market than by taking up the rights, the issue

would almost certainly fail.

Factors to consider in respect of rights issues

Rights issues are a relatively cheap way of raising equity finance

It is estimated that the issue costs average 5.8 per cent of the funds raised (Armitage

2000). This estimation was based on an examination of a large number of UK rights

issues during the period 1985 to 1996. Note that many of these issue costs are fixed,

that is, they are the same irrespective of the amount of funds raised by the issue. As a

result, the cost (as a proportion of the value of the funds raised) will be more for

smaller issues and less for larger ones.

Pricing of issues is not a critical factor

As we have seen, shareholders who either sell or take up their rights are left in more

or less the same position as regards wealth irrespective of the issue price.

Rights issues are fairly certain

It is rare in practice for a rights issue to fail. This is an important factor since many of

the issue costs are committed in advance and are lost if the issue fails.