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How to spot a bargain in a rights offer

the stock market
Shareholders need to be careful when a company offers new shares at seemingly discounted prices. John Andrew explains why.

"The company is having a sale of its shares!" You can imagine the reaction of a new shareholder receiving a letter offering more shares in the company for less than the current market price. The company is wanting to raise more capital from existing shareholders. However, it does not mean that the offer is a bargain.

Called a "rights issue" in City parlance, it is an exclusive share offer to existing shareholders with new shares being offered in a fixed proportion to current holdings - eg one new share for each 10 currently held. However, why offer the shares at a discount to the current market price?

Suppose a company with shares currently trading at pounds 5 wanted to raise pounds 10m. It could issue 2 million shares at pounds 5; 4 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 market or against its own shares weakening after the announcement.

Traditionally, rights issues have been underwritten by a merchant bank. This means that by paying a fee, typically 2 per cent of the amount to be raised, the bankers undertake to purchase those shares not taken up by shareholders.

In the past, really big discounts were uncommon. However, last month Bodycote, the metal treatment specialist, announced a one-for-four rights issue at a deeply discounted price of 500p, against a market price of 937p. The issue was not being underwritten. Possibly we shall see more deep discounting in the future.

However, 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 will make it clear.

Suppose an investor has 1,000 shares that before a rights issue trade at pounds 5 each. If the company has a one-for-five rights issue at pounds 4, 200 new shares may be purchased for pounds 800. After taking up the rights the shareholder will have 1,200 shares. Theoretically, these 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, providing nothing else has altered, each share will now be worth pounds 4.83.

If a shareholder is in theory no better off after a rights issue, it is tempting to ask why anyone bothers taking up rights. Of course, if a company puts 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 Gill Nott, chief executive of ProShare, the organisation which promotes share ownership. "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 on 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 cashflow. Comment will appear in the financial press and you can also consult your stockbroker. 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 economical.

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.

However, when a company you invest in has a rights issue the most important thing to remember is that "discount" is not synonymous with "bargain".