CIMA F3 Syllabus B. Sources of long term funds - Rights issue - Notes 2 / 3
Issue of shares for cash
A rights issue is an issue of shares for cash.
The cash received leads to an increase the working capital of a company.
It also increases the share premium account whereas a bonus issue is likely to reduce it.
These shares are usually issued at a discount to the current market price. The discount offered influence the number of shares issued, the earnings per share and the cost of underwriting.
The 'rights' are offered to existing shareholders, who can sell them if they wish.
This formulae is given in the exam:
Legend
N = number of shares required to buy 1 share
Cum rights price = the market value before the rights issue is made
Illustration 1 - TERP
Cow Co. makes a 1 for 4 rights issue, at $3 (MV before issue made $5)
What is the theoretical ex-rights price?
Solution
TERP
= 1 / (4 + 1) x [(4 x 5) + 3]
= $4.60
Illustration 2
Cow Co. makes a 1 for 3 rights issue, at $5 (MV before issue made $6)
What is the theoretical ex-rights price?
Solution
TERP
= 1 / (3 + 1) x [(3 x 6) + 5]
= $ 5.75
Advantages
Raises cash
Reserves are available for future dividend distribution
Disadvantages
If a shareholder sells his rights, he will be losing (diluting) his control in the company
Illustration 3
Cow Inc. currently has 9 million $1 shares in issue with a market value of $4 per share. The directors of Cow Inc. have decided to raise additional capital through a 1-for-3 rights issue.
What is the amount of new finance raised by Cow Inc. if the theoretical ex-rights price per share is $3.70?
Solution:
A 1 for 3 rights issues will mean 3 million new shares will be issued. This will mean there will be 12 million shares in total after the rights issue
If the TERP is $3.70, the total value of the company after the rights issue will be 12 million × $3.70 = $44.4 million
The value of the company cum‐rights was 9 million × $4 = $36 million
The value of finance raised must therefore be $44.4 million – $36 million = $8.4 million