2009 has been the year of the rights issue. A huge amount of new equity capital has already been raised through rights issues and placements and the capital raisings keep coming. With so many companies putting their hand out for cash, should I or should I not, take up my rights?

Each situation needs to be analysed on its own merits, but more often than not the answer will be ‘yes’.

The first question is, are the rights renounceable or not. Renounceable rights are transferable and usually able to be sold on the share market. This means an investor may choose not to take up their rights but can still realise some value by selling them on market. With non-renounceable rights, the only option is to take them up or let them lapse worthless.

If an investor decides not to take up their rights their stake in the organisation is going to be diluted. For small shareholders, the fact that their voting rights decline from 0.01 per cent to 0.005 per cent may not be of great concern, but their share of earnings and dividends will also decline. For example if a stock normally pays a 50cent dividend and then does a one for one rights issue, all else being equal it will pay a 25cent dividend going forward. If an investor elects not to take up their rights, the dollar amount of the dividend they have been receiving will be halved.

The most pressing question is: will taking up the rights prove to be a profitable transaction. Under normal circumstances, the answer should be yes. Rights issue are offered at a discount to the prevailing price and the theoretical value after the ex-rights date will be higher than the rights offer price. In theory rights should always be taken up to take advantage of this discount.

In August 2009, Australand (ALZ) had a 7:10 rights issue, with an offer price of $0.40. The cum-rights share price for ALZ was $0.50.

Assume an investor owns 10,000 shares.

Current value 10,000 ALZ @ $0.50 = $5,000
Rights entitlement @ 7:10 = 7000 stapled securities
Cost of new securities 7000 @ $0.40 = $2,800
Total investment = $7,800
New number of shares 10,000 + 7,000 = 17,000
Ex rights value per share = total investment/new shares
= $0.46

The theoretical value of ALZ stock after the rights issue is $0.46. If an investor decided not to take up the rights, the value or their existing shareholding would fall by 8 per cent.

Some investors may recognise they will sacrifice value but do not have the funds to seize the opportunity. One possible solution is to sell the amount of shares they are entitled to once the shares have gone ex-rights and use the proceeds to take up their entitlement.

In the Australand example above, the securities traded at a high of $0.48 on the day they went ex-rights. Our investor could have sold 7,000 shares realising $3,360 then used the proceeds to buy their rights at $0.40, thereby maintaining the number of shares they hold and pocketing $560 profit. They will still suffer a dilution of future dividends, but the cash profit will help to compensate. (Tax implications need to be considered as well.)

The biggest risk for an investor is that the stock price may fall below the rights offer price, in which case they would be better off buying on market (or avoiding it altogether). The window between when the application is submitted and the new shares issued is the most vulnerable time. If the price falls rapidly the investor could be out of pocket.

Other than in a quickly falling market, rights issues offer nimble investors a simple way to make some short term gains. This then begs the question: why do some investors still choose to let rights lapse?

Chris Batchelor is senior technical writer for Kaplan Professional.

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