Question

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a) Briefly explain what is meant by “Right Issue” and explain its role in the Protection of Shareholders’ interests.​​​​​​​​​​​​

b) Briefly explain in Principle a Right Issue has NO impact on the Wealth of Shareholder, whether the Shareholder decides to invest in the issue or sell the Rights to acquire additional shares.

c) Carpets Direct plc wishes to increase the number of its Retail Outlets in the North America. The BOD has decided to finance the expansion programe by raising the funds from existing Shareholders through a 1 for 4 rights issue. The most recent Income Statement of the business as follows:

$m

​​Sales ​​​ 164.5

​​Operating Profit 12.6

​​Interest​​​ (6.2)

​​Profit before Taxation​ 6.4

​​Taxation​​ (1.9)

​​Profit for the Year 4.5

​A $2m ordinary dividend has been paid in respect of the year.

The Share Capital consists of 120m ordinary shares with the Par Value of $0.50 per share. These are currently being traded on the Stock Exchange at a P:E Ratio of 22 times and the BOD has decided to issue the new shares at a discount of 20% on the current Market Value.

Required​​​​​​​​​

i) Calculate the Theoretical Ex Right Price – TERP of an Ordinary Share in Carpets plc.

ii) Calculate the Price at which the Rights in Carpet Direct plc are likely to be traded.

iii) Identify and evaluate, at the time of the Rights issue, each of the Options arising from the Rights Issue to an Investor who holds 4,000 shares before the Rights announcement.

iiii) Briefly Comment on the P: E Ratio of Carpets Direct plc.

Answer 1

a.

RIGHT ISSUE:

A rights issue is a way by which a listed company can raise additional capital. However, instead of going to the public, the company gives its existing shareholders the right to subscribe to newly issued shares in proportion to their existing holdings.

The basic idea is to raise fresh capital. A rights issue is not a common practice that a corporate organisation resorts to. Ideally, such an issue occurs when a company needs funds for corporate expansion or a large takeover. At the same time, however, companies also use rights issue to prevent themselves from being conked out.

An investor should be able to look beyond the discount offered. Rights issue are different from bonus issue as one is paying money to get additional shares and hence one should subscribe to it only if he/she is completely sure of the company's performance.

b.

i.Shareholder decides to invest in the issue:

1. Take up the rights to purchase in full

To take advantage of the rights issue in full, you would need to spend for every share that you are entitled to purchase under the issue. As you hold 1,000 shares, you can buy up to 250new shares (one share for every 4 you already own) at the discounted price.

However, while the discount on the newly issued shares is 20%, it will not stay there. The market price of the shares will not be able to stay after the rights issue is complete. The value of each share will be diluted as a result of the increased number of shares issued. To see if the rights issue does, in fact, give a material discount, you need to estimate how much share price will be diluted.

In estimating this dilution, remember that you can never know for certain the future value of your expanded holding of the shares since it can be affected by any number of business and market factors. But the theoretical share price that will result after the rights issue is complete – which is the ex-rights share price – is possible to calculate.

ii. Sell your rights to acquire additional shares:

In some cases, rights are not transferable. These are known as "non-renounceable rights." But in most cases, your rights allow you to decide whether you want to take up the option to buy the shares or sell your rights to other investors or the underwriter. Rights that can be traded are called "renounceable rights," and after they have been traded, the rights are known as "nil-paid rights."

To determine how much you may gain by selling the rights, you need to estimate a value on the nil-paid rights ahead of time. Again, a precise number is difficult, but you can get a rough value by taking the value of the ex-rights price and subtracting the rights issue price. Selling these rights can create capital gains for you.

c.

i.Theoretical Ex right price:

P/E ratio=MPS / EPS

22=MPS/0.0375

MPS= $ 0.825

Right price is 80% of market price i.e.$ 0.66

Market value of shares + Cash raised from right issue

Number of shares after right issue

0.825*120 mn shares + 120*0.25*0.66

120 + 120*0.25

99 + 19.8

150

= $ 0.792

ii.

Price at which the Rights in Carpet Direct plc are likely to be traded:

Ex right price + Subscription price

Right issue

= 0.792-0.66

4

= 0.033