Why Companies Have to Make Rights Issue?

To put it bluntly, a company only needs to make a rights issue when it is short of money. 

A business, any business, requires investment in various forms of assets in order to carry out its operations.  A company is usually required to continually buy new assets in order to carry on its business either because its old assets have to be replaced or its expanding business requires more assets.  To buy new assets, it will need new capital. 

A company can obtain necessary money to purchase its assets from any one of three sources or a combination of all three. 

• It can borrow the money,
• retain part or all of its profit or
• it can sell new shares. 

Under the normal circumstances, a company should be able to finance its additional purchase of assets from either retained earnings or new borrowing or a combination of the two.  There are many examples of very fast growing businesses in Malaysia that have prospered without recourse to issuing rights (for examples:   Nestle and BAT  )

But, companies may have to raise new capital by making rights issues under three types of abnormal circumstances.  These three cases are:

(1)  The company is improperly managed such that it is either not very profitable (or even losing a lot of money) such that the incoming cash is not adequate to support the need to purchase more assets.  Or owing to poor management of its assets, it now requires a lot more assets to support its operations.

(2)  The company is moving into another line of business which is large relative to its current size and it requires a great deal of additional capital to start up the new venture.

(3)  The company is in a very fast growing business.  In fact, it is so fast growing that retained earnings and new borrowing alone are insufficient to sustain the growth.

In order to be a prudent investor, we must analyse the situation of the company which has announced a rights issue carefully to see which category it falls into in the first place. 

Depending on which category of rights it is issuing, we can then carry out a further analysis to decide whether the rights issue is a good or a bad one. 

• Through examining each type of rights issue, an intelligent investor can tell the wolves from the sheep. 
• Pricing the rights also requires proper evaluation.