Rights Issue - Definition
Rights issue involves the issue of shares to existing members in proportion to their respective shareholding in the company. For example, a ‘one for three rights issue’ would entitle shareholders with one new share for every three shares that are already held in the company. Shares issued in a rights issue normally have an exercise price below the prevailing market price of similar shares.
Rights Issue Adjustment - Rationale
Rights issue necessitates adjustment in Earnings Per Share calculation. This is because rights issues involve an element of bonus shares where the exercise price is set below the market price. As with the EPS calculation involving bonus shares, the effect of bonus shares in the EPS calculation must be cancelled by inflating the number of weighted average shares by the number of bonus shares in the period in which rights issue takes place and as well as for any prior period comparatives presented without any time apportionment.
If no such adjustment is made in the EPS calculation in respect of the bonus element in a rights issue, the performance of an entity may be unnecessarily penalized in the year in which rights issue takes place.
Shares deemed to be issued at the fair market value in a rights issue are accounted for in the EPS calculation in a similar manner to the EPS involving shares issued for full consideration (i.e. included in the weighted average shares from the date of the issue).
Formulae
Following formulae illustrate how rights issue adjustment is incorporated in the Basic EPS calculation:
EPS for the year (X)
|
= |
Earnings attributable to ordinary share holders for the year |
|
|
[Weighted Average Shares + Bonus Element + Fair Value Element x (time apportionment)] |
||
EPS for the year (X-1)
|
= |
Earnings attributable to ordinary share holders for the year |
|
|
[Weighted Average Shares + Bonus Element] |
||
EPS for the year (X+1)
|
= |
Earnings attributable to ordinary share holders for the year |
|
|
[Weighted Average Shares + Bonus Element + Fair Value Element] |
||
| Where: | ||
|---|---|---|
|
Year (X) |
= |
Year in which rights issue is made (current period) |
|
Year (X-1) |
= |
Year preceding the period in which rights issue takes place (prior period comparative) |
|
Year (X+1) |
= |
Year subsequent to the period in which rights issue is made (subsequent period) |
|
Weighted Average Shares |
= |
Number of shares at the start of the year |
|
PLUS Shares issued for consideration x (time apportionment) |
||
|
Less Shares redeemed during the year x (time apportionment) |
||
|
Bonus Element |
= |
Number of shares in the rights issue deemed to be issued without consideration. Bonus shares are added in the calculation of the denominator in full without any adjustment for time apportionment. The number of deemed bonus shares included in the rights issue are added in current period, comparative prior periods and all subsequent periods in the EPS calculation as though the bonus shares had been issued before the earliest period presented. |
|
Fair Value Element |
= |
Number of shares in the rights issue deemed to be issued at the fair value with reference to the theoretical ex-rights price. These shares are included in the EPS calculation from the date of rights issue. |
Example
ABC PLC, which has a year end of 31st December 2012, issued 1 for 3 rights shares on 30th June 2012. The exercise price for shares was $1.5 whereas the market price of ABC PLC shares just prior to the issue of rights shares was $2. All rights were exercised on 30th June 2012.
Following information relates to ABC PLC:
Ordinary Shares as on 1st January 2011: 3,000,000
Earnings attributable to ordinary shareholders:
2011 $6,400,000
2012 $7,200,000
Calculation of Earning Per Share for 2011 and 2012 for presentation in financial statements for the year ended 31st December 2012 would be as follows:
| Step 1: | Calculate the Theoretical Ex-Rights Price | $ |
|---|---|---|
|
|
Value of ABC PLC prior to rights issue |
$6,000,000 |
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Cash raised from rights issue |
$1,500,000 |
|
|
Value of ABC PLC after rights issue |
$7,500,000 |
|
|
Theoretical Ex-Rights Price per share |
$1.875 |
| Step 2: | Calculate the Fair Value Element | $ |
|---|---|---|
|
|
Cash raised from rights issue |
$1,500,000 |
|
|
Theoretical Ex-Rights Price per share |
$1.875 |
|
|
Number of shares deemed to be issued at fair value |
800,000 |
| Step 3: | Calculate the Bonus Element | $ |
|---|---|---|
|
|
Number of shares deemed to be issued at fair value |
800,000 |
|
|
Total number of shares issued (3,000,000 / 3) |
1,000,000 |
|
|
Number of deemed bonus shares (Difference) |
200,000 |
| Step 4: | Calculate Weighted Average Shares | |
|---|---|---|
|
|
2011: Shares at the start of the year |
3,000,000 |
|
|
Add: Bonus shares (Step 3) |
200,000 |
|
|
Weighted Average Shares |
3,200,000 |
|
|
2012: Shares at the start of the year |
3,000,000 |
|
|
Add: Bonus Share (Step 3) |
200,000 |
|
|
Add: Share issued at fair value |
400,000 |
|
|
Weighted Average Shares |
3,600,000 |
As with the EPS calculation involving bonus issue, the number of deemed bonus shares are added in the weighted average shares calculation without time apportionment to facilitate comparison.
| Step 5: | Calculate Earnings Per Share | |
|---|---|---|
|
|
2011 Earnings attributable to ordinary share holders |
$6,400,000 |
|
|
Weighted Average Shares (Step 4) |
3,200,000 |
|
|
Earnings Per Share ($ 6,400,000 / 3,200,000) |
$2 |
|
|
2012 Earnings attributable to ordinary share holders |
$7,200,000 |
|
|
Weighted Average Shares (Step 4) |
3,600,000 |
|
|
Earnings Per Share ($ 5,000,000 / 5,000,000) |
$2 |
ABC PLC’s EPS for the two years show that its profitability has remained constant over the period and the level of earnings have increased in line with the increase in company’s resources from the rights issue.
If the EPS calculation ignored the bonus element, EPS for the two years would be as follows:
2011 EPS ($6,400,000 / 3,000,000) $2.13
2012 EPS ($7,200,000 / 3,500,000) $2.06
Clearly the decline in the EPS as presented above does not reflect the trend in the profitability of ABC PLC as the calculation ignores the fact that 20% of the shares issued in the rights issue were effectively free of cost to the owners (i.e. bonus share). It is for this reason that it is necessary to incorporate the effect of the bonus element involved in rights issue in the EPS calculation.
