A rights issue and bonus issue offer new shares to existing shareholders. Companies aim to handle their cash problems using these two methods.
However, both of these options offer different benefits and limitations to the issuing companies as well as their shareholders.
Let us discuss what is a rights issue, a bonus issue, and their key differences.
What is Rights Issue?
A rights issue means offering new shares to existing shareholders by the company. This offer gives shareholders a right but not an obligation to buy new shares of the company.
As the name suggests, the offer is a rights issue. Shareholders have the option of subscribing to new shares, doing nothing, or selling the rights in the market.
The “rights” enable shareholders to buy new shares of the company. The price of a right attached with a share is higher than the share value. It means shareholders would receive a discount on the share price through the rights issue.
A rights issue results in issuing new shares. Therefore, the company will have an increased number of shares after the rights issue. It will decrease the earnings and dividend per share of the company in the future.
How Does a Rights Issue Work?
A rights issue is one method of raising capital from the market. Companies use this method when they are cash-strapped.
Often, companies issue a rights issue when they cannot raise capital through debt financing. In some cases, a company may be facing covenants from banks or other lenders from raising capital through debt financing.
A rights issue offers existing shareholders to buy new shares at a discounted price. Each shareholder receives the offer in the same proportion.
For example, if a company decides a rights issue of 3 for 10, it means every shareholder with 10 shares has the right to subscribe to 3 new shares of the company.
Companies offer new shares at a discount to attract shareholders. For instance, if the current market price of the share is $10, the company would offer $6 or $7 per share with the rights issue.
Issuing new shares results in a decrease in the share price of the company initially. theoretically, there will be more shares in the market after the issue, therefore the share price will be diluted.
In practice, the market price of shares will depend on how the market perceives the rights issue. If it is a successful event, then share prices would increase. Otherwise, the share prices may fall further.
Options for Shareholders After a Rights Issue
Existing shareholders have three options with a rights issue offer.
Subscribe to the Offer
Suppose a company offers a 3 for 10 rights issue. Every shareholder with 10 shares will have 3 more shares after the rights issue.
Shareholders will receive 3 new shares at a discounted price to the market share price as well.
Then, the shareholders can choose any action with newly bought shares as they would normally.
The rights issue is an offer to the shareholders. It means it is a right and not an obligation. Therefore, shareholders may opt not to buy new shares.
Sell the Rights
In some cases, the issuing company may allow shareholders to sell rights in the market. It means shareholders can sell newly bought shares without spending money and receive the profits immediately.
Pros and Cons of the Rights Issue
A rights issue has several advantages and disadvantages for the company and shareholders.
The motive behind a rights issue is to raise capital. It offers a convenient method of raising capital from existing shareholders.
Companies under covenants or other financial issues can raise capital through this method.
In other cases, a company may use the rights issue to decrease its share prices. A decreased share price will increase liquidity as shares become more affordable to retail investors.
Shareholders receive new shares at cheaper prices. They can detach rights and sell them as an alternative to cash dividends.
Also, when shareholders fully subscribe their shareholding rights do not dilute.
A rights issue will dilute the share prices. An increased number of shares will decrease the earnings per share (EPS) and dividends per share (DPS) for shareholders.
Also, the issuing company would need to use internal cash resources like reserves to fund the rights issue.
Raising capital through a rights issue may send a negative signal to the market. Also, it cannot solve the liquidity issues for the company in the long term.
What is a Bonus Issue?
A bonus or scrip issue is an event when a company issues new shares to its existing shareholders.
It is an offer to existing shareholders for receiving additional shares in proportion to their existing shareholding in the company.
Unlike a rights issue, a bonus issue does not offer a choice to the shareholders. Shareholders cannot decline the offer. However, they can decide to sell newly received shares in the market.
How Does a Bonus Issue Work?
Bonus or scrip issue is used by companies offering regular dividends to their shareholders.
It is used as an alternative to dividends to pay shareholders a proportion of profits. It is used when companies make profits but are short of cash.
With a scrip or bonus issue, the issuing company does not need to make cash outflow. However, there is no cash inflow for the company as well.
Each shareholder receives bonus shares in equal proportion. For instance, if a company issues a 2 for 5 bonus issue, every shareholder with 5 shares would receive 2 new shares.
Therefore, the shareholders’ total wealth would remain the same. Their shareholding does not get affected by a bonus issue.
Issuing new shares results in an increased number of outstanding shares. That in turn would decrease the EPS and DPS of the company.
Options for Shareholders with a Bonus Issue
A bonus issue offers limited options to shareholders as compared to a rights issue.
Subscribe Fully to the Offer
When a company announces a bonus issue, all shareholders receive new shares. It means the company does not make an offer practically.
Shareholders have to fully subscribe to the issue once even if they do not wish to receive new shares.
Sell Bonus Shares
Existing shareholders can sell newly received bonus shares as an alternative to dividends.
However, in the long term, it will dilute their shareholding in the company. Therefore, a bonus issue does not offer a good alternative to dividends for the shareholders.
Pros and Cons of a Bonus Issue?
A bonus issue also offers some pros and cons to the company and its shareholders.
Companies use the bonus issue as an alternative to issuing cash dividends to keep shareholders satisfied.
It helps companies to preserve cash and keep shareholders satisfied.
Shareholders receive the same proportional shares from the company. They can sell bonus shares to make quick profits.
A bonus issue results in decreased share prices due to an increased number of outstanding shares. It will also reduce the EPS and DPS for shareholders.
If shareholders sell newly received shares, their shareholding will reduce. If they do not sell newly received shares, they will not receive cash as they would with dividends.
Also, companies want to preserve cash with a bonus issue. However, they may need to fund the bonus issue using internal reserves which can be an expensive option. Therefore, in practice, the company may end up using the cash reserves.
Rights Issue Vs Bonus Issue- Key Differences and Similarities
Let us now summarize the key differences and similarities between a rights and bonus issue.
A bonus issue and rights issue have the following similarities.
- They increase the share capital and number of outstanding shares.
- Both offers are made to existing shareholders.
- Issuing companies do not need a cash outflow with both options.
- Both options help companies to preserve cash resources.
- These offers decrease share prices that result in increased liquidity for the company.
Here are a few key differences between a rights issue and a bonus issue.
- A rights issue is a choice and offers a right to existing shareholders but not an obligation. Whereas, a bonus issue does not offer a choice to shareholders.
- Rights can be used to buy new shares or traded in the market without buying new shares on offer. Bonus shares should be fully subscribed first before they can be sold in the market.
- A Rights issue results in a cash inflow for the company as it looks to raise capital from the market. A bonus issue does not result in a cash flow.
- Rights issue offers a discount on the share price whereas a bonus issue does not.
- Shares prices fall for a brief period at the ex-rights date. Then, the share prices may increase if the rights issue is successful. Share prices almost fall certainly with a bonus issue.