Chapter 8 • Sources of long-term finance
Once the business has decided on the amount of finance it needs and has set a price,
it simply offers shares to existing shareholders. The number of new shares that any
individual shareholder has the rightto take up depends on the number of shares
already owned.
If the shareholder wishes not to take up this entitlement, the rights may be sold to
someone who does wish to take them up (irrespective of whether or not the buyer is
an existing shareholder). Usually rights may be sold in the capital market. Their buyer
acquires the same right to take up the shares as did the shareholder to whom they
were originally granted.In Example 8.3, the value of the entire equity of the business immediately before
the rights issue was £7.2 million (4 million ×£1.80). Immediately following the issue,
this should rise by £1.2 million (the amount of new money raised). The total value
of the equity should then be £8.4 million (4 million +800,000 =4.8 million shares) or
£1.75 per share (£8.4 million/4.8 million).
This is the price at which the shares should trade immediately following the
rights issue, assuming that everything else remains equal. Thus the value of the right
to buy one share is likely to be £0.25, that is, the difference between the rights issue
price and the ex-rights price. Market forces would tend to ensure that this is broadly
true, since if it were not, it would imply that it is possible to make abnormal gains
by buying rights, on the one hand, or that no one would be prepared to buy them,
on the other.
Let us consider a shareholder who starts with 100 ordinary shares and as a result is
offered 20 new shares in the rights issue. This person has three choices:
l Pay £30 (20 ×£1.50) to the business and take up the entitlement. If this is done, the
value of the shareholding will go up from £180 (100 ×£1.80) to £210 (120 ×£1.75).
This increase of £30 is exactly the amount that has just been paid to take up the
rights, so the rights issue leaves the shareholder neither richer nor poorer than
before.
l Sell the rights, presumably for £5 (20 ×£0.25). This would leave a shareholding
worth £175 (100 ×£1.75) and £5 in cash, a total value of £180, once again leaving the
shareholder neither better nor worse off.
l Allow the rights to lapse, in which case the value of the shareholding will fall from
£180 to £175. Thus the shareholder will lose wealth by failing to act either to take up
the rights or to sell them within the time allowed by the business to do so. In prac-
tice, however, the business will typically sell the rights, on the shareholder’s behalf,
and pass on the proceeds, if the rights look likely to lapse.A business has 4 million ordinary £1 shares whose current market price is £1.80 each. It
wishes to raise £1.2 million by a rights issue at £1.50 per share. The number of shares to be
issued will be £1.2 million/£1.5, that is, 800,000 shares. These will, therefore, be offered on
a 1-for-5 basis to existing ordinary shareholders. For example, a shareholder owning 200
shares will be given the right to buy an additional 40 shares.Example 8.3