A scrip issue and a rights issue are both alternative funding methods for listed companies. These methods provide additional equity capital in different ways.
Let us discuss what are scrip and rights issues and their key differences.
What is Scrip Issue?
A scrip or bonus issue refers to additional shares being issued to existing shareholders of a company. It is also termed a capitalization issue.
Existing shareholders receive bonus shares in proportion to their existing shares. Since the company announces a scrip issue, shareholders have no choice but to receive these shares.
A scrip issue does not come with an option for shareholders to lapse or deny. However, shareholders can sell bonus shares in the market like other shares.
A scrip issue does not dilute the shareholders’ ownership stakes as every shareholder receives new shares in proportion. It will dilute the earnings per share (EPS) and often bring the share price down.
Issuing new shares through a scrip issue does not increase the net assets of a company. Although there is no cash flow involved in a bonus issue but it increases the share capital of the company.
Why Do Companies Make Scrip Issues?
A scrip issue is commonly issued by companies with an established history of dividends or companies with a constant dividend policy.
When companies are short of cash reserves and they must fulfill their commitment to dividends, they issue bonus shares instead of cash dividends.
Shareholders can sell these bonus shares if they require cash immediately. However, it reduces the proportional shareholding as they sell newly issued bonus shares.
Companies often have to rely on external debt financing for a scrip issue as it is an expensive task. Often cash reserved from a dividend issue is less than the cost of a scrip issue.
Another common reason for issuing bonus shares is to control the share price. Directors may perceive a share price as too high for trading and decide to issue new shares.
Issuing more shares dilutes the share price which attracts investors and helps improve liquidity through frequent trading.
However, the company must consider the long-term impact of a scrip issue as it will dilute the dividend per share in the future. Also, more shares mean a lower EPS for existing shareholders even when they retain bonus shares.
Advantages of Scrip Issue
A scrip issue is a viable option for companies with a constant dividend policy facing a cash shortage. It can satisfy existing shareholders for the lack of cash otherwise received through dividends.
Bonus shares are not taxable as normal income. However, when shareholders sell these shares, they’ll incur capital gains taxes.
The company can maintain its perception of the constant dividend history by replacing it with a scrip issue. It does not dilute the ownership stakes of the shareholders as well.
More shares bring the current share price down. It increases liquidity for the company as the new share price becomes attractive to investors.
Disadvantage of Scrip Issue
A scrip issue comes with several disadvantages as well.
Foremost, the cost of a scrip issue may easily outweigh the cost of issuing dividends. The company may have to rely on debt financing for a bonus issue as well.
Investors may also perceive the lack of cash reserves negatively. It means the share price may fall further than just the impact of absorbing new shares.
Shareholders receiving bonus shares also face some disadvantages. If they keep their shares, it dilutes their EPS and DPS for the future.
Conversely, if shareholders decide to sell their bonus shares, it will incur capital gains tax. Either way, shareholders will have to sacrifice some income with a scrip issue.
What is Rights Issue?
A rights issue refers to the rights offered to exist shareholders to purchase additional shares from the company.
In simple words, it is an offer to existing shareholders for buying new shares at a predefined ratio decided by the company. It offers a choice to shareholders and not an obligation.
The number of rights depends on the existing ownership stakes for a shareholder. They can keep their proportional ownership stakes by subscribing to the rights offered.
The company announces the date for subscribing to rights offered. A company will offer a significant discount on a rights issue to attract investors otherwise they will see no benefit in subscribing to rights.
Shareholders have three options when a company announces a rights issue.
Shareholders can let the offer lapse and do nothing about it. However, it will dilute their shareholding stakes.
Purchase the Rights
The second option is to subscribe to the rights offered. It keeps the proportional stakes of shareholders and also helps them buy new shares at a discounted price.
Sell the Rights
Another option for shareholders is to first receive new shares at a discounted price and then sell them at the ex-rights price to generate profit.
Why Do Companies Make a Rights Issue?
A rights issue is a form of raising equity capital. Companies raise capital for expansion or regular investment requirements through a rights issue.
The capital raised can be for product expansions or a new project launch in a new market. This method is used when the company does not have access to debt financing or it is too expensive.
Companies also issue new shares through a rights issue when they want to manage their debt-to-equity ratio. It may help the company to report a better financial position in the short term.
Sometimes, lenders may impose debt covenants or require a certain debt-to-equity ratio for approving a new debt financing. A company may issue new shares to achieve that goal as well.
Advantages of Rights Issue
A rights issue is an alternative financing option for companies struggling to secure debt financing. It helps them raise capital through equity.
It is a cheaper option as compared to an IPO or public share offering. Also, it does not require approval from shareholders as long as it is within the limits according to SEC rulings.
A rights issue offers a chance to shareholders to keep their stakes in the company. If they subscribe fully, their existing stakes do not dilute.
Alternatively, shareholders can receive cash by selling newly issued rights. They can hold these rights for a while and sell them at a profit.
Disadvantages of Rights Issue
A company can issue new shares through a rights issue with some limits as per SEC rulings. Typically, they cannot issue new shares of more than 25% of their authorized share capital.
If a company wants to issue more shares, it must seek approval from shareholders and SEC.
Issuing new shares comes with a cost as well. So, it is not entirely effective or cheap as compared to debt financing. It will also affect the debt-to-equity ratio of the company in the long run.
Shareholders can be at a disadvantage if they do not subscribe to the rights. It can dilute their proportional stakes in the company and they may forego profits by missing a cheaper buy option.
Broadly, a company may fail to raise capital through a rights issue if investors perceive it as a risky option. However, it is rarely the case as rights issues are normally successful.
Rights Issue Vs Scrip Issue – Key Differences
Let us now summarize some key differences and similarities between a scrip issue and a rights issue.
A bonus or scrip issue is to compensate shareholders if a company cannot issue dividends. Else, it is to raise equity capital.
A rights issue is always planned to raise alternative funds through equity capital.
Subscription Options for Shareholders
Shareholders have no choice but to accept bonus shares in their proportional ownership weightage.
Shareholders have three options with a rights issue; full subscription, ignoring the offer and selling the rights after receiving them.
Impact on the Company
A bonus issue dilutes the earnings per share (EPS) and dividend per share (DPS) of the company for the future. It also affects the share capital of the company.
A rights issue also results in the dilution of share capital for the company. If fully successful, it also affects the EPS and DPS of the company.
Impact on the Shareholders
Shareholders can maintain their stakes and net gains through scrip issues. However, if they sell bonus shares, it will dilute their EPS and dividend income in the long run.
A rights issue is a more flexible option for shareholders as they can choose to maintain their ownership stakes or take advantage of lower share prices through the offer and make quick profits.
Chances of Success
A scrip issue is theoretically successful as shareholders cannot reject the offer. However, the long-term impact of the move will depend on how well the company utilizes the capital.
A rights issue is almost certainly subscribed by the shareholders. The long-term success largely depends on whether the company can maintain its share price through better performance.