Introduction
A rights issue is a method of capitalisation where a company offers new shares for sales to the existing shareholders according to their current shareholding proportion. In a rights issue, the existing shareholders have three options:
- Exercise their rights by purchasing all their rights and maintaining their percentage of ownership.
- Sell their rights and receive the proceeds in the form of cash. The shareholders will in this case reduce their percentage of holding.
- Sell a proportion of their rights and use the proceeds to purchase the remaining rights termed as tail swallowing. This option is normally pursued where the shareholders lack enough cash to exercise their rights.
Shareholders, therefore, have to make the appropriate choice that would give them the best returns (Graham, B., Dodd, D. L. 1934). Normally, the shares that are given in this issue are sold below the market price of the existing shares i.e., at a discount. The effect of a right issue is the fall in the price of the shares exhibited by a lower theoretical ex- price value. The shares offered in a rights issue will trade at the bourse as other shares after the issue.
Lloyd bank group conducted two rights issues in the same year with this being the last of their bid to get £25billion, a situation that reflects the risk attitude of the management. The last issue was a success since more than 90% of the rights were exercised. This issue enabled the company to get more capital of £13.5b billion. In this issue, the investors were given a right of 1.34 new shares for every share held. The new shares were also offered at a discount of 59.5% discount. This bank group gave the shareholders the three possible options. If a shareholder exercises the rights, he/ she will be able to retain his percentage of ownership and at the same time benefit from the discount offered in the sales.
The average shareholders who failed to exercise their rights received £315.34 from the bank. This is a move that is justified given the fact that the market price of the shares will be diluted after the placements. At the same time, these investors proportion will decline to make them lose a proportion of their investments and authority in decision making. The two impacts must therefore be mitigated by compensating the investors so that they don’t lose trust in the company. If this is not done, the crowding-out effect may result making the company experience instability
Advantages of a rights issue
Several advantages are associated with a rights issue. First, the rights issue offers equal opportunities to existing shareholders to purchase the shares. This, therefore, helps avoid the bias of some shareholders discriminating against others. Secondly, the commission charged on rights issues is lower compared to placing new shares. Further, the rights issue targets existing shareholders, therefore, making the cost for a roadshow lower compared to that of placing new shares. Moreover, companies with a huge amount of debt have preferences for rights issues because their ability to borrow is low. Since the rights are tradable just like shares, the existing shareholders will have the right to sell their rights if they are incapable of buying new shares. In addition, the rights issue offers an opportunity to the shareholders to buy shares at a discounted price thereby increasing their stock.
A rights issue may only help in correcting the anomalies on the balance sheet for a short period hence may not be instrumental in addressing the underlying financial problems.
Disadvantages of a rights issue
After the rights issue, the companies share prices get diluted due to the increase in the number of shares. If not properly managed, it may lead to capital loss to the shareholders.
Apart from the rights issue, there are several other sources of long-term capital. Long term capital can be defined as the funds that are invested in long term projects. The funds are usually required to finance long term assets e.g., land and buildings, to help in growth orientation and for the permanent financing of the working capital. These projects do not contribute to the current cash flows. The other sources of long-term capital include shareholders funds, debentures, loan capital, finance leases, profit retention. Each of these long-term sources of capital has advantages and disadvantages. The management of any company, therefore, must make an informed decision on the best source of capital that the business should adopt. The advantages and disadvantages of these sources of capital are discussed below.
Shareholder’s fund
This is the source of capital that is contributed by the owners of the business to earn dividends for their funds (Goldthwaite, R. A., 1995). There are various forms of share capital i.e., ordinary share capital held by ordinary shareholders and preference share capital. The ordinary shareholders are expected to have control of the business by attending the general meetings where the directors and other decisions are made. They do this by participating in the voting.
Advantages of share financing
The company can raise a large amount of capital without incurring a charge on the company’s property. When raising funds by issuing shares, the management will not be expected to give a charge for the amount raised. Another advantage of share capital is that it is only refundable when the company gets dissolved. The management is not expected to refund the shareholders their funds hence appropriate for long term expenditures.
In addition, the management is not obliged to pay dividends to the shareholders as opposed to the debt holders. Dividends are only payable out of profits hence the management will only pay dividends when the returns are high. Finally, shareholders funds are used as collateral to the debtors. The ability to raise more share capital increases the qualification of a company to raise debt capital.
Disadvantages of share capital
A share capital doesn’t qualify for tax deductions therefore it does not reduce the tax expense for the company. Another disadvantage of shareholders fund is that it gives the holders the voting rights to participate in the management. At times they may interfere with the management control.
Debenture capital
These are publicly sold securities with a fixed rate of return to the holders. The debentures earn fixed returns for their funds (Hoggson, N. F., 1926). There are various types of debenture capital e.g. redeemable and non-redeemable debentures, convertible and non-convertible debentures. Redeemable debentures are those that are repaid at a given period while non-redeemable shares are not redeemed. On the other hand, convertible shares are those that have an option of being converted into the owner’s capital. Non-convertible debentures cannot be turned into ordinary shares.
Advantages
The debentures holders have no voting rights, therefore, can’t interfere with management decisions. Frank J. F., Steve V. M. And Moorad C. (2002) claim that the interest paid to the debenture holders is tax-deductible thereby reducing the tax liability for the company. Debentures are reliable sources of funds since the management is certain on the interest rates and the repayment period, the management will be able to plan effectively.
Disadvantages
Since debentures attract interest charges whether profits are made or not, the company will be obliged to pay interest even when it incurs losses. Debentures require a charge on the assets of the company (San J., Donatila A., 2007). This will therefore reduce the limit the amount a company can borrow from the debentures. If the proportion of debenture capital is high, the shareholders’ income will decline and this may reduce the attractiveness of the investment. It may in this way increase the liquidity problem of the business.
Retained earnings
When a business makes losses, the company may decide to retain a portion of the profits to undertake profitable ventures. This source of funds will enable the company to avoid the costs incurred in raising capital in the money markets.
Advantages
Retained earnings are a cheap source of finance as there is no obligation to pay interest or dividends out of it (Stein, B., DeMuth, P., 2003 and Chandra G., 2007). This method of financing as well enables the company to avoid the floatation cost and brokerage costs that are incurred in the raising of new capital in the capital market.
Retained earnings increase the value of the firms. This is because it increases the level of reserves making the business gain financial stability.
Disadvantages
The after-tax profit can be appropriated as either retained earnings or dividends. In circumstances where most of the resources are retained, the shareholders will forgo dividends, and this may lead to dissatisfaction.
Moreover, retained earnings can only be made when a company realises a lot of earnings which may not be the case. Again, the availability of excess reserves will lead to the misappropriation of funds by the managers. This will therefore not add value to the company’s operations.
Borrowing from financial institutions
This is when a business obtains a long term debt from a financial institution for investment purposes. The lender will charge interest on the borrowings depending on the interest rates on the market and the financial ability of the company.
Advantages
The interests charged are tax deductibles hence reducing the tax liability. A financial institution may also extend advisory services to the business on how to make investment decisions. This improves the quality and value of the firm. In addition, the loans from these financial institutions are easy to obtain so long as the business has collateral and is financially viable. Other advantages include non-interference by the banks in operations and the cheap cost of getting loans.
Disadvantages
Keynes, J. M. (1936) suggests that the interest charges may sometimes be high hence increasing the expenses on the business thereby reducing the profits. The borrowing also requires collateral making it impossible or inaccessible for small businesses. This further limits the amount of capital that can be obtained through this source.
Public deposits
This is one of the oldest methods of financing where the public placed deposits with the businesses. The businesses would therefore be in a position to use such funds for investment purposes.
Advantages
Is it an easy way of obtaining funds as the public would make direct deposits so long as the rules are adhered to? This method of financing does not require the use of collateral i.e., no charge on the assets of the business. Finally, public deposits are also cheap to acquire as there are no floatation charges
The major drawback of this method is that it requires a very high reputation of the organisation if the funds have to be gotten.
Finance leasing
This method is where a company leases assets for a long duration and pays lease rentals. In this method, the leasing company incurs the maintenance of the property. Advantages of a finance lease are tax allowance from the lease payments and acquiring property without incurring heavy purchase price (Hurst, J. M., 1970). The disadvantage of this method is that it may be expensive in the long run and that the leasing company faces the risk of maintenance of the leased asset. The management of any organisation, therefore, needs to determine the appropriate blend of capital that will be cheaper for the business.
References
Chandra G. (2007). Company Law in Singapore 3rd Edition. New York; McGraw-Hill.
Frank J. F., Steve V. M., and Moorad C. (2002). The Global Money Markets, Finance, Wiley & Sons.
Graham, B. and Dodd, D. L. (1934). Security Analysis: Principles and Technique. New York: McGraw-Hill Book Co.
Goldthwaite, R. A. (1995). Banks, Places and Entrepreneurs in Renaissance Hampshire; Florence Aldershot.
Hoggson, N. F. (1926) Banking Through the Ages, New York; Dodd, Mead & Company.
Hurst, J. M. (1970). The Profit Magic of Stock Transaction Timing. Englewood Cliffs, N. J: Prentice-Hall
Keynes, J. M. (1936). The General Theory of Employment, Interest and Money. London: MacMillan.
Mishler, L. Cole, R. E. (1995). Consumer and business credit management. Homewood: Irwin.
San J., Donatila A. (2007). Fundamentals of Accounting: Basic Accounting Principles Simplified for Accounting Students. AuthorHouse.
Stein, B. and DeMuth, P. (2003). Yes, You Can Time the Market. New Jersey; Wiley.