Rights Issues

An invitation to existing shareholders to purchase additional shares in the company in proportion to their existing holdings.

Now imagine that the railway company has been operating for 10 years. It has paid out large dividends over the decade and still has shareholders' funds of £12 million on its balance sheet. Unfortunately, borrowings are also quite large at £15 million, and interest rates in the economy generally are high and on an upward trend. The directors, still led by Mr. Stephenson and Mr. BruneI, would like to spend £10 million building an extension to the current lines. This plan makes good economic sense and should be funded, but the company would be taking on too much risk if it borrowed the additional £10 million - the annual fixed cost of the interest bill could cripple the company. So it decides to sell more shares, which have the advantage over debt capital of not carrying the right to receive an annual payout. Equity capital has the benefit that it acts as a 'shock absorber' to business crises because a company can choose not to pay a dividend when times are bad.

Under UK law it is generally not possible for the company to sell the new shares to raise the £10 million to outside investors without first offering them to existing shareholders (called a pre-emption right). The owners of the company are entitled to subscribe for the new shares in proportion to their existing holding. This will enable them to maintain their existing percentage ownership - so, if a shareholder currently owns 10 per cent of the shares he/she is entitled to purchase 10 per cent of any new shares issued. While those shareholders who take up their rights will have the same proportion of the company cake as they had before, each slice of the cake becomes bigger because the company has more financial resources under its control. Rights issues are a popular method of raising new funds - they are relatively easy and cheap for companies.