New capital requirement of a growing company

A hypothetical example to understand the above more clearly.  The following reasonable assumptions can be made based on this example:

Sales to Assets Ratio = 2x
Profit after Tax to Sales = 6%
Debt to Equity Ratio = 1.2
Dividend Payout Ratio = 0.5
Sales in Year 0 = $10 million
Growth Rate = 10% pa

Simplified Balance Sheet ($M)

At End of Year 0
Assets 5.00
Financed by:
Shareholders' Equity 3.33
Borrowing 1.67

Simplified P&L Statement ($M)

For Year 1
Sales 11.00
Profit after Tax 0.66
Dividend 0.33
Retained Profit 0.33

Simplified Balance Sheet ($M)

At End of Year 1
#   Assets 5.50
Financed by:
@  Shareholders' Equity 3.66
**  Borrowing 1.84

Notes on Balance Sheet at Year 1
#     Increase at the same rate as sales
@    = 3.33 (at Year 0) + 0.33 (Retained Profit of Year 1)
**   By difference = 5.50 - 3.66

• From the above example, by maintaining the D/E ratio at around 1:2 (3.66 = 2 x 1.83), the company has no difficulty in financing a 10 percent increase in sales in one year. 
  
• By having a zero dividend payout, it can in fact grow at 18 percent per year without increasing its D/E ratio.

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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.

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.

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.

Not all right issues are the same; ought to treat them with a bit more suspicion

Many companies are making rights issues in this recent bull market..

Whenever a company announces that it is making a rights issue, the market in Malaysia/Singapore, on the whole, does not react adversely especially when the right issues are accompanied by a bonus issue. 

• The price of the company's shares usually moves up and seldom does one come across cases where rights are badly undersubscribed. 

In Britain and more in particular, the US, the market seldom reacts so kindly to rights issues. 

• Most rights issues are treated with great suspicion. 
• The market usually takes a "wait and see" attitude and will only react favourably if it is convinced that the new capital obtained from the rights issue is put to good use and that the profit of the company can increase as a result of the rights issue.
• In fact, the market in the US is so suspicious of rights issues that it is most unusual for a large US corporation to make a right issue.

Though not all rights are automatically bad, local investors could do with a good dose of cynicism and ought to treat rights issues with a bit more suspicion. 

• Local investors ought to be aware of the fact that not all rights issues are the same. 
• Each rights issue should be treated on its own merit and if it is truly good, then there is a case for bidding up the price of the shares and taking up the rights issues.

If we blindly follow the market without knowledge what we are doing, we can so easily be taken advantage of. 

• Opportunists, insiders and rumour-mongers are abound in the local market. 
• Here, as with everywhere else, Caveat Emptor (Latin for "let the buyer beware") is the key.

In order to understand why the Western investors are so suspicious of rights, we must go back to the first principle and try to understand:

• what is so bad about a right issue and
• the reason a company has for making a rights issue.

SPG guide on capitalisation changes

Internal capitalisation changes are those capitalisation changes which affect the number of shares held by the pre-existing shareholders (i.e. bonus, rights, splits, etc.).

Shares issued to outsiders in the case of share swaps, special issues, etc., do not affect the number of shares held by the pre-existing shareholders.

SPG does not believe that bonuses increase the value of shares, and advise investors not to pay much attention to the past number of bonus issues.

We look at rights in another light, however, as we are not in favour of rights issues unless the company has been an exceptionally fast growing ones (i.e. growth in excess of 20% per year). In other cases, a company which has issued more than one rights in the past decade ought to be viewed with caution.

It is perhaps worth pointing out that a company which has many capitalisation changes all bunched together during a short space of time without a concomitant increase in earnings could be trying to impress its sharehodlers and the stockmarket. Historically, such companies usually performed poorly after such capitalisation changes were over.

Any existing issues which will lead to future dilution should be noted. Dilution means the creation of extra number of shares which will cause the per share earnings and dividend to decline. Normally, dilutive issues include warrants (TSR) and convertibles. By comparing the number of new shares which will be issued with the existing number of shares, the user would have an idea of the potential dilution.

For example, if a total of 100 million new shares will be issued and the exisitng number of shares is 300 million; the potential earnings dilution would be 25% without taking into consideration the notional interest saving. That is the EPS will decline, say, from 10 sen per share to 7.5 sen.

Fixed income securities (i.e. bonds etc) issued by the company should be considered too.


Ref:
How to use the Stock Performance Guide (SPG)
Stock Performance Guide by Dynaquest Sdn. Bhd.