14 May 2015
RIGHTS ISSUE: A RIGHT OR A TRAP

by veristrat

Once a simple activity of raising capital has today become one of the most complex and carefully thought decision by corporates, during which everything from the cost of capital, return on equity to credit rating is considered before the particular mode is sought. Companies are often trying to raise capital from least expensive resources and Rights Issue is one of them. A Rights Issue is an invitation to existing shareholders to purchase equity shares in the company at a discount to the market price on a future date.

rights issue

Sometimes investors subscribe to rights issue just to maintain their holdings percentage in the company. Increasing exposure in a growing and profitable company that too at the discounted price, offers a great investment bet. However, investors need to be cautious while exercising their rights, as it can be a camouflaged bet. Some of the key aspects to look into are discussed below:-

Intent of issuance – The purpose of utilizing the proceeds highlights the intent of the issuance. Cash strapped companies typically use rights issue to pay down their debts, especially when they are unable to borrow money from the market. However, other with clean balance sheets utilize the proceeds for growth and acquisition strategies. Companies usually publicises their purpose of issuance, however, one need to read between the lines to understand the intent which can be done through detailed balance sheet and fundamental analysis. Also, retiring the debt from the issuance proceeds cannot be altogether considered as a bad signal, as one needs to consider the implications. Therefore, if proceeds help in lowering interest outgo, enables a better Debt- Equity ratio and a better interest-coverage ratio which help strengthen the balance sheet, it can be considered as a positive sign.

Underwriting the Offer – One need to look if the offer is underwritten by established investment banks as the act of underwriting guarantees the success of fund raising in volatile equity markets. In the process of underwriting the bankers agrees to purchase the stock that remain unsold and in turn bears the risk associated with the issuance. Presence of well-known bankers indicate their confidence in the issue. Another sign to look for is, Promoters eagerness to subscribe for the issuance. If bankers have underwritten the portion apart from promoter’s portion, this suggests that promoter’s intent of maintaining their stake in the company and highlights their confidence in the operations.

Effect on EPS – Rights issuance necessitates adjustment in EPS calculation which occurs due to the equity dilution factor, which in turn is an inherent part of the issuance. In the near term, a decline in projected EPS is observed due to increase in number of outstanding shares. However, judgement is required as to how the top-line would be impacted once the plans are put into action. If the long term outlook looks positive, then there is a possibility that the issue could be EPS accretive.

For Example:-In the recent Rs.7,500 crore rights issuance by Tata Motors, the bankers had underwritten the offer apart from the promoter’s portion where the funds are intended to be utilized for expanding in international markets besides increasing their product portfolio. Analyst observed that further leveraging of the balance sheet was not a good option therefore the company had to resort to raising fund through rights issuance. As a portion of debt would retire, this would lower the interest outgo and would give a better Debt/Equity ratio. It was estimated that the issue would lead to an approximate equity dilution of 5.5% and a decline of 3% in projected EPS for FY 16. However, as per various brokerage firms the outlook over the next two years for the business looked strong making the issue attractive. (Source: Economics Times)

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