Equity financing - New issues, rights issues, and placements

Learning Outcomes

After completing this article, you will be able to explain how companies raise finance through new equity issues, rights issues, and placements. You will learn the procedures, advantages, and disadvantages of each method, and calculate the theoretical ex-rights price and value of a right. You will also assess shareholder impacts and apply these concepts in exam-style scenarios.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand the features and implications of raising equity finance. In particular, focus your revision on:

• The distinction between equity finance and other capital sources
• Methods of raising equity finance: new issues, rights issues, and placements
• The process and rationale for rights issues, and the calculation of the theoretical ex-rights price (TERP)
• The practical advantages and disadvantages of different equity issue methods
• The impact of share issues on shareholder wealth and control

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes a rights issue?
   1. An offer of new shares to the public
   2. An offer of new shares to existing shareholders at a discount
   3. The sale of existing shares to financial institutions
   4. The conversion of debt into equity shares
2. What does the term "theoretical ex-rights price (TERP)" refer to?
   1. The price paid for new rights
   2. The market value of a share after a rights issue, assuming rational pricing
   3. The amount paid to underwriters for a rights issue
   4. The dividend per share after a rights issue

3. True or false? A share placement involves selling shares directly to selected institutional investors rather than the public.

4. Briefly outline two potential advantages to a company of choosing a placement rather than a public offer to raise equity finance.

Introduction

Equity finance is a fundamental way for companies to obtain long-term capital for operations, growth, or acquisitions. Unlike debt, equity raises funds in exchange for ownership—often in the form of ordinary shares. Companies frequently require additional equity for expansion, to strengthen their balance sheet, or to reduce reliance on borrowing. As a Financial Management student, you must be comfortable with how new equity is raised, the strategic considerations for each method, the effects on shareholders, and exam-standard calculations like TERP.

Key Term: equity finance
The capital raised by issuing ordinary shares to investors, representing an ownership interest in the company.

METHODS OF RAISING EQUITY FINANCE

Companies have several ways to issue new shares. The most common are:

New Issues (Public Offerings)

A public issue is when a company offers new shares to the general public or selected institutions, sometimes linked to a stock exchange listing.

• Suitable for both listed and unlisted companies seeking substantial capital.
• Can be carried out as a fixed price offer or by tender (investors bid for shares).
• Often more costly and administratively demanding than other methods.

Key Term: public offer
The process of inviting the public to purchase new shares in a company, typically via a prospectus and often as part of a stock exchange listing.

Rights Issues

A rights issue is an offer to existing shareholders to purchase new shares, usually at a price below current market value, in proportion to their existing holdings. This preserves voting rights and control for current shareholders.

• Quicker and less expensive than a public offer.
• Existing shareholders can take up their rights, sell them, or ignore the offer.
• Common reason: to raise capital for expansion, acquisitions, or to improve financial structure.

Key Term: rights issue
An offer giving existing shareholders the right to buy additional shares in proportion to their existing holdings at a specified, typically discounted, price.

Placements

A placement (or placing) involves selling shares directly to a small number of selected investors, usually institutional. It is a faster and cheaper method for companies needing to raise a moderate amount of capital without full public scrutiny.

• Placements can be of new shares or existing shares.
• They reduce issue costs and time, but may dilute control if shares are placed with new investors rather than existing ones.

Key Term: placement
The sale of shares directly to selected investors, often institutions, rather than through a public offer to all potential investors.

THE RIGHTS ISSUE PROCESS AND PRACTICAL IMPLICATIONS

Rights issues are particularly important for exam purposes because they involve specific calculations and can impact shareholder wealth.

• The company announces the terms (e.g., "one new share for every two held at £2 per share").
• Rights are usually issued at a discount, providing an incentive for shareholders.
• Existing shareholders can:
  • Take up the rights (buy the new shares)
  • Sell the rights (realize immediate value)
  • Do nothing (risk dilution of ownership and wealth)

Calculating the Theoretical Ex-Rights Price (TERP)

The TERP is the weighted average price per share after a rights issue, assuming rational markets.

• Formula:

  $\text{TERP} = \frac{(\text{Existing shares} \times \text{market price}) + (\text{New shares} \times \text{issue price})}{\text{Total shares after issue}}$

• This represents the new share price assuming all shareholders take up their rights.

Determining the Value of a Right

• The value of a right is the difference between the TERP and the issue price, divided by the number of old shares required to obtain one new share.

• Rights are tradable in the period between announcement and completion of the issue.

ADVANTAGES AND DISADVANTAGES OF EACH METHOD

Public Offers:

• + Potential to raise large amounts
• + Increases public profile
• − Expensive (prospectus, underwriting, regulatory requirements)
• − May require significant time and disclosures

Rights Issues:

• + Lower cost and simpler process than a public offer
• + Maintains control with existing shareholders
• + Usually quick to arrange
• − Amount raised limited by existing shareholder base

Placements:

• + Fast and low cost
• + Access to institutional investor funds
• − Not available to very small companies
• − May dilute ownership if not offered to all existing shareholders

IMPACT ON SHAREHOLDERS

• Rights issues allow existing shareholders to maintain their percentage ownership and benefit from discounted pricing.
• Not participating means dilution and potential wealth loss.
• New share issues and placements can alter control and future income rights.

Worked Example 1.1

A company has 2 million shares trading at $5 each and announces a 1-for-4 rights issue at $3 per share. Calculate the TERP and the value of one right.

Answer:
Number of new shares: 2,000,000 × 1/4 = 500,000
Total shares after issue: 2,500,000
Total funds raised = 500,000 × $3 = $1,500,000

TERP = [(2,000,000 × $5) + (500,000 × $3)] / 2,500,000
= ($10,000,000 + $1,500,000) / 2,500,000
= $11,500,000 / 2,500,000
= $4.60

Value of a right per old share = (TERP – issue price) / number of old shares per new share
Old shares per new share = 4
Value = ($4.60 – $3.00) / 4 = $0.40

Worked Example 1.2

Shareholder B holds 800 shares before a 1-for-4 rights issue at $3 per share (as above). What are B's options and related outcomes?

Answer:

• Take up all rights: Buy 200 new shares at $3 ($600).
  • After issue: 1,000 shares at TERP ($4.60) = $4,600.
  • Total investment: ($5 × 800) + $600 = $4,600. No gain or loss.
• Sell rights: 200 rights × $0.40 = $80. Value of remaining 800 shares now: 800 × $4.60 = $3,680; plus $80 = $3,760.
• Do nothing: Shares diluted.
  • New value: 800 × $4.60 = $3,680 vs original $4,000; however, loss of opportunity to gain from rights discount.

Exam Warning

Not all rights issues are fully taken up. When calculating TERP and value of right, always base on the assumption that all rights are exercised, unless told otherwise. For exam purposes, TERP assumes immediate market adjustment.

Revision Tip

Always practice TERP and rights calculations using a proforma: state the number of shares, market price, issue price, and totals clearly before applying formulas.

Summary

Equity finance can be raised through public offers, rights issues, and placements. Rights issues are the most tested method in the exam, requiring understanding of TERP and the value of a right. The choice of method depends on factors like cost, speed, impact on control, and company circumstances. Calculations and practical implications for shareholders are essential exam focus areas.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain how companies raise equity through public offers, rights issues, and placements
• Define and apply the rights issue process, including calculation of TERP and value of a right
• Identify the advantages and disadvantages of different equity issue methods
• Understand the implications for shareholder wealth and control
• Demonstrate these concepts with original calculated examples

Key Terms and Concepts

• equity finance
• public offer
• rights issue
• placement