Companies may undertake various corporate actions that affect their share capital and the value of their shares. These actions include rights issues, bonus issues, and stock splits. Understanding these actions is essential for investors, as they can affect the number of shares held, the share price, and the value of the investment.

Rights Issues

A rights issue is a method by which a company raises additional capital by offering new shares to existing shareholders in proportion to their existing holdings. Shareholders are given the right to purchase the new shares at a discount to the current market price, typically for a limited period.

Purpose of Rights Issues:

Companies issue rights to raise additional capital for various purposes. They may need funds for expansion, acquisition, debt reduction, or working capital. Rights issues are a common method of raising equity capital without incurring the costs and complexity of a public offering.

Mechanics of a Rights Issue:

The company announces a rights issue, specifying the number of new shares to be issued, the offer price, and the ratio of new shares to existing shares. Existing shareholders are offered the right to subscribe to the new shares in proportion to their holdings. The rights are typically tradable, allowing shareholders to sell their rights if they do not wish to exercise them. If shareholders do not exercise their rights, they may be diluted. The underwriter ensures that any unsubscribed shares are sold.

Calculation of the Theoretical Ex-Rights Price (TERP):

The TERP is the theoretical price at which the shares should trade after the rights issue. It is calculated as the weighted average of the current market price and the rights issue price.

Example:

  • Current Shares Outstanding: 1,000,000 shares

  • Current Market Price: $10 per share

  • Rights Issue: 1 new share for every 4 existing shares

  • Rights Issue Price: $8 per share

Calculation:

  • Total Existing Value = 1,000,000 × $10 = $10,000,000

  • New Shares Issued = 1,000,000 / 4 = 250,000 shares

  • Proceeds from Rights Issue = 250,000 × $8 = $2,000,000

  • Total Value After Rights Issue = $10,000,000 + $2,000,000 = $12,000,000

  • Total Shares After Rights Issue = 1,000,000 + 250,000 = 1,250,000 shares

  • TERP = $12,000,000 / 1,250,000 = $9.60 per share

Impact on Shareholders:

Shareholders who exercise their rights maintain their proportionate ownership. Shareholders who do not exercise their rights experience dilution. The theoretical value of the rights is the difference between the TERP and the offer price, adjusted for the ratio.

Advantages of Rights Issues:

  • Lower Cost: Rights issues are typically less expensive than public offerings.

  • Protection of Existing Shareholders: Existing shareholders have the first opportunity to maintain their proportionate ownership.

  • Flexibility: Shareholders can choose to exercise or sell their rights.

Disadvantages of Rights Issues:

  • Dilution: Shareholders who do not exercise their rights may be diluted.

  • Market Perception: Rights issues can signal financial distress or a lack of funding options.

  • Complexity: Rights issues are more complex than other forms of capital raising.

Bonus Issues

A bonus issue, also known as a scrip issue or capitalization issue, is the issue of new shares to existing shareholders at no cost. The new shares are issued in proportion to existing holdings. A bonus issue does not raise new capital for the company; it merely converts reserves into share capital.

Purpose of Bonus Issues:

Companies issue bonus shares to increase the number of shares outstanding. This may be done to improve liquidity, reduce the share price to make it more affordable, or reward existing shareholders. Bonus issues do not change the total value of the company or the proportionate ownership of shareholders.

Mechanics of a Bonus Issue:

The company announces a bonus issue, specifying the ratio of new shares to existing shares. New shares are issued to existing shareholders at no cost. The reserves of the company are capitalized, meaning they are transferred from reserves to share capital.

Example:

  • Existing Shares Outstanding: 1,000,000 shares

  • Bonus Issue: 1 new share for every 2 existing shares

  • New Shares Issued: 500,000 shares

  • Total Shares After Bonus Issue: 1,500,000 shares

Impact on Share Price:

The share price adjusts to reflect the increase in the number of shares outstanding. The theoretical price after the bonus issue is the pre-bonus price divided by the bonus factor.

Impact on Shareholders:

The number of shares held by each shareholder increases proportionately. The total value of the holding remains unchanged. The proportionate ownership remains unchanged.

Advantages of Bonus Issues:

  • Improved Liquidity: Bonus issues increase the number of shares outstanding, improving liquidity.

  • Reduced Share Price: Bonus issues reduce the share price, making the shares more affordable for small investors.

  • Positive Signal: Bonus issues can signal confidence in the company’s future prospects.

Disadvantages of Bonus Issues:

  • No New Capital: Bonus issues do not raise new capital for the company.

  • Dilution of Earnings Per Share: Earnings per share are diluted by the increase in the number of shares.

Stock Splits

A stock split is the division of a company’s existing shares into multiple shares. A stock split increases the number of shares outstanding and reduces the price per share. Like a bonus issue, a stock split does not change the total value of the company or the proportionate ownership of shareholders.

Purpose of Stock Splits:

Companies split their stock to reduce the share price and make it more affordable for small investors. Stock splits can also improve liquidity and increase the number of shareholders. A stock split is typically done when a company’s share price has risen significantly.

Mechanics of a Stock Split:

The company announces a stock split, specifying the split ratio (e.g., 2-for-1, 3-for-1). Each existing share is divided into multiple shares. The total value of the shares held by each shareholder remains unchanged.

Example:

  • Existing Shares Outstanding: 1,000,000 shares

  • Share Price: $100 per share

  • 2-for-1 Stock Split

  • New Shares Outstanding: 2,000,000 shares

  • New Share Price: $50 per share

Impact on Shareholders:

The number of shares held by each shareholder increases proportionately. The total value of the holding remains unchanged. The proportionate ownership remains unchanged.

Reverse Stock Split:

A reverse stock split is the consolidation of a company’s shares into fewer shares. A reverse stock split increases the price per share. Reverse stock splits are often undertaken to meet minimum price requirements for listing on a stock exchange.

Advantages of Stock Splits:

  • Increased Affordability: Stock splits make shares more affordable for small investors.

  • Improved Liquidity: Stock splits increase the number of shares outstanding, improving liquidity.

  • Positive Signal: Stock splits can signal confidence in the company’s future prospects.

Disadvantages of Stock Splits:

  • No Change in Value: Stock splits do not change the total value of the company.

  • Increased Administrative Costs: Stock splits involve administrative costs for the company.

  • Potential for Volatility: Stock splits can lead to increased volatility as more shares are traded.

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