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Know your rights

In the first of a series on the basics of stock market investments, John Andrew explains how rights issues work
Is it an offer too good to be true? You have shares in a company and you are offered more at a discounted price. In stock market parlance this is a rights issue. However, it does not necessarily mean that you are being offered a bargain.

Rights issues are an exclusive share offer to existing shareholders, with new shares being offered in a fixed proportion to current holdings - for example, one new share for each 10 currently held. However, why offer the share at a discount to the current market price?

Imagine that a company with shares currently trading at pounds 5 wants to raise pounds 10m. It could issue two million shares at pounds 5; or four million at pounds 2.50 and so on and fulfil its objective with each combination.

It is unlikely that a company would wish to offer new shares at the current market price. This is because it would want a "safety net" against a general decline in the stock market, or against its own shares weakening after the announcement.

Whatever the level of discount, providing all other factors remain unaltered, the value of an investor's holding after the rights have been taken up will theoretically equal the value of the shares before the issue, added to the cash paid to buy the new shares. This is because after the issue, the shares will settle at a level which is proportional to the amount at which the new shares were issued.

Sounds complicated, but an example can make it clear.

Suppose an investor has 1,000 shares which before a rights issue trade at pounds 5 each. If the company has a one-for-five rights issue at pounds 4, the investor may purchase 200 new shares for pounds 800.

After taking up the rights the shareholder will have 1,200 shares. Theoretically this will be worth pounds 5,800 (pounds 5,000, the pre-rights value, plus the pounds 800 cost of the new issue). This means that after the rights, providing nothing else has altered, each share will be worth pounds 4.83 (pounds 5,800=1,200 shares).

If a shareholder is theoretically no better off after a rights issue, it is tempting to ask why anyone bothers taking up rights. Of course in reality, if a company puts the money to good use, it will increase the value of its business and the value of its shares and dividends paid will eventually rise.

"Investors should examine why a company is raising new capital," says Michael Savoury, of Midland Stockbrokers. "Some need it to finance sound business expansion, while others are simply paying off old debts and could fail if the money is not forthcoming. Shareholders should therefore not assume that all rights issues are worth taking up."

So how do you know if a rights issue is worthwhile? The company will advise shareholders why it wants to raise capital. It will also send an allotment letter giving the terms of the offer. Every situation has to be assessed on its merits and your cash flow. Comment will appear in the financial press and you can also consult your financial adviser. If the issue is well received, the rights will have a value. The choices open to you are:

Take up all the rights. Simply return the allotment letter, duly completed, with your cheque, by the deadline;

Sell all the rights through a stockbroker. Remember, a commission will be charged. If your holding is small, this may not be an economical proposition;

If you do nothing, or miss the deadline, the company will sell the rights to which you are entitled and send you the net proceeds. The advantage of this route is that your share of the selling costs will be minimal, but the sale may not be at the most favourable time;

Take up part of the rights and use the proceeds of the remaining to fund the transaction.

When one of the companies in which you have shares has a rights issue, the most important thing to remember is that "discount" is not synonymous with "bargain"n