Rights Issue, Revaluation Reserve & Other Queries

Modified on July 2, 2018

The current article in this series provides responses related to:

  • Rights Issue
  • Revaluation of assets by company and usage of revaluation reserves
  • Clarification about reserves & surplus

Query

Hello Vijay,

  1. What is the meaning of rights issue? – I understand it that the company allots ordinary shares in a fixed ratio to existing shareholders. Correct me if I’m wrong
  2. Why is this done?
  3. Who decides the price? Could this pose a conflict of interest to majority shareholders?
  4. Normally if this is done at a significant discount to market price, then share price falls immediately. How to interpret this
  5. Any red flags to be aware of during rights issue?

Anything else one needs to know about rights issue?

Author’s Response:

Hi,

Thanks for writing to me!

1) What is the meaning of rights issue? – I understand it that the company allots ordinary shares in a fixed ratio to existing shareholders. Correct me if I’m wrong

You are right about the concept of rights issue. However, subscribing to rights issue is option for shareholders and thereby not a mandatory event.

2) Why is this done?

To raise the additional resources for the company. Simply an alternative to follow on public offer (FPO) etc. It many a times forces existing shareholders to subscribe to maintain their same percentage stake in the company because if one does not subscribe, then her percentage shareholding would go down in the company.

3) Who decides the price? Could this pose a conflict of interest to majority shareholders?

I could not find any regulatory reference to any pricing formula for rights issue. The rights issue logically has to be at a discount to market price otherwise, the existing/new shareholders can always buy additional shares at a cheaper price from the open market instead of subscribing to rights issue. Additional inputs from one of the readers of the website, Trivendraa. We thank him for sharing his valuable thoughts!

Hi Dr. Vijay, With reference to above reply, it may be added that rights issue can be priced at =>CMP, it is indicator of indirectly increasing management holding in the company as no existing ordinary/minority shareholder shall ever like to subscribe at =>CPM. Only management subscribes to such issues at slightly higher price and tights grip over the affairs of the company. Easily non-discount priced rights issue is an indirect tool in the hands of management to increase shareholding, acquire the company which pointing towards mismanagement, poor corporate governance. Such company can be easily flaged investor unfriendly. Price of rights issue may be indicator of onwards journey of the company.

4) Normally if this is done at a significant discount to market price, then share price falls immediately. How to interpret this?

Rights issue at a significant discount to market price indicates that the company believes that it would not be able to raise sufficient money at a right issue price near the market price. That indicates lack of confidence of the company about the right value of the share at the current market price. The market would take this as a cue that the current market price is overvalued than the fair value of the stock and thereby the market price takes a correction.

5) Any red flags to be aware of during rights issue? Anything else one needs to know about rights issue?

I as an investor do not prefer companies going for rights issue for two reasons:

  1. it indicates that the cash flow generation by the company is insufficient and it is growing more than what its resources are permitting or it has bungled up things in the past and needs these funds to repay existing lenders.
  2. it arm twists existing shareholders to subscribe to maintain their percentage holding. If one does not subscriber, then the earnings attributable to her share falls.

Read: Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Query

Read: Analysis: Indo Count Industries Limited

If the assets are revalued and depreciation is charged on percentage basis it should be higher and would end up reducing the profit as well as the tax burden. How it was used to increase profits is not very clear?

How building, machinery and generator set can be revalued up is another riddle. Don’t income tax authorities and banks have any say in the matter?

Obviously the management is not overly investor friendly but their performance warrants investment consideration at the current price.

Author’s Response:

Hi,

Thanks for writing to me and providing your inputs.

Company does not seems to have done anything contrary to the existing rules. However, the rules many a times provide companies the opportunities to benefit from accounting practices e.g. in the case of Indo Count, by revaluing the DG sets etc. the company could increase its assets & net worth and thereby could show an improved/lower debt to equity ratio.

Moreover, the company could avoid the logical impact of higher assets on profits (means higher depreciation) by adjusting revaluation reserve against depreciation.

It’s like benefiting at both ends. “Heads I win, tails also I win”.

Read: 7 Steps to find out whether a Company is Cooking its Books

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Query

Read: Why Management Assessment is the Most Critical Factor in Stock Investing?

Hello Sir,

Considering GAGL in management analysis (Part – 1), I am not able to differentiate between reserves & surplus and cash + investments (CI+NCI).

Is reserves & surplus notional value whereas cash + investments (CI+NCI) is actual liquid cash available with the company?

Author’s Response:

Hi,

Thanks for writing to me!

Reserve & surplus is a source of funds whereas cash & investments is a usage of funds.

For example, it might be that a company has ₹100 as reserves (e.g. from equity infusion or from profits) and is holding all this amount as cash, then both reserves and cash would be almost equal at about ₹100 cr.

In another case, if the company invests the entire ₹100 from its reserves (e.g. from equity infusion or from profits) in to plant & machinery, then the reserves and fixed assets would be almost equal at about ₹100 cr and there would be nil cash.

There can be other situations apart from the above two hypothetical situations cited above.

Read: Understanding the Annual Report of a Company

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

P.S.

 

DISCLAIMER

  • The above discussion is only for educational purpose to help the readers improve their stock analysis skills. It is not a buy/sell/hold recommendation for the discussed stocks.
  • I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.
  • Currently, I do not own stocks of the companies mentioned above in my portfolio.

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