Rights Issue and Revaluation Reserve: Queries Answered

The current article in this series provides responses related to:

• Rights Issue
• Revaluation of assets by company and usage of revaluation reserves

Rights Issue

Hello Vijay,

1. What is the meaning of the rights issue? – I understand 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 the 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 the rights issue?

Author’s Response:

Hi,

Thanks for writing to me!

1) What is the meaning of the rights issue? – I understand 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 the rights issue. However, subscribing to rights issue is an 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 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 the 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 the 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 the 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 the right issue price near the market price. That indicates a 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 the 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

Revaluation of Assets and its impact on Profits

Read: Analysis: Indo Count Industries Limited

If the assets are revalued and depreciation is charged on a 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 seem to have done anything contrary to the existing rules. However, the rules many times provide companies with 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 the 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

Impact of revaluation on depreciation and tax payouts

Read: Analysis: Indo Count Industries Limited

Hi Vijay,

Thank you for sharing your knowledge and made my day in knowledge accumulation. The notes on Revaluation Reserves is very interesting. Please clarify, does the company also considers the same methodology in calculating net depreciation (after revaluation) for computation of corporate tax. If they do, what’s the advantage as there will be more tax outgo in initial years?

Please correct me if I miss anything.

Thank you.

Please also suggest me some company Annual Reports you find it more interesting and knowledgeable.

Author’s Response:

Hi,

Thanks for writing to me! I am happy that you found the article useful.

The company has been showing lesser tax in cash flow statement than the tax expense in profit & loss statement. Even though the company has shown net tax paid (adjusting for refunds, if any), still, the difference of the tax between P&L and CF statement is significant. Looking at the amount of difference in tax between two statements for FY2016 (₹73 cr), it looks highly likely that there would be many other factors other than the treatment of revaluation reserve, which has led to this difference.

Read: Understanding the Annual Report of a Company

One reason might be that the revaluation reserve, which is adjusted from depreciation in P&L might not be adjusted in IT return filing, which can be one of the reasons leading to the higher tax payout in P&L. It needs to be confirmed by any tax consultant or from the company.

The higher tax payout as per P&L might not be a very undesirable thing for promoters as even after payment of 33% tax on it, the balance 67% gets reflected in PAT, which in turn increases the EPS and thereby increases the share price, which in the majority of cases is based on the P/E ratio. Therefore, as the EPS increases, the market sentiment towards the stock changes and this, in turn, expands the P/E ratio as well, which in turn creates wealth.

A similar case was seen in Emami Limited. You may read its annual report as well as the analysis of Emami Limited present on drvijaymalik.com

Read Analysis: Emami Limited (Emami, Himani and Zandu brands)

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.