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This article appeared in the May 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Learn about the benefits and risks of different types of capital raising.

By Morningstar

If a company requires a cash injection to expand existing operations, protect market share, develop new businesses or buy another company, it may require more funds than its retained earnings. The company's directors have two options: borrow the money or raise more equity.

Taking on debt requires the company's managers to have a reasonable expectation of steady cash flow to make regular interest repayments, and there is a risk that investors may feel the company is too highly geared (has too much debt in relation to shareholders' funds), which may weigh heavily on the share price.

Taken to the extreme, high debt magnifies the risk of bankruptcy, which is precisely what happened in the late 1980s when rising interest rates crippled some of Australia's highest-profile companies. Banks stopped lending to some companies during the 2008-09 financial crisis, which forced many listed companies to raise equity funds at vastly discounted prices in order to remain afloat.

Interest is a tax-deductible expense, however, and less equity raised means less of the company is being shared around. So debt certainly has its attractions.

Corporate finance strategists charge big fees to decide on the best way for companies to raise funds and, despite years of effort, research remains inconclusive on the ideal capital structure to maximise a corporation's value to shareholders.

It is a complex matter that spans issues as diverse as taxation, interest expense, public relations, and overall financial management, and that's probably all we need say about it for now.

If a company chooses to issue fresh equity, it is again faced with two main options: give all existing shareholders the right to buy more shares, or offer shares in a "placement" to a group of people, or an institution.

It also has a third, less common, option of creating a specialised spin-off company, which gives investors the opportunity to direct funds toward a specific aspect of the business, usually with high-growth prospects.

Assessing a rights issue

One of the most common ways companies raise new equity is through a rights issue. This means offering existing shareholders the right to buy further shares, in proportion to their existing holdings, at a specified price. Naturally, the issue price for the rights has to be a little less than the current share price, to make the deal worthwhile.

If you hold shares for any length of time you will soon come across this method of raising funds. At first, it might sound like something for nothing. After all, you pay nothing for the rights, which usually have a market value and can even be sold, and you get to buy shares at less than the current market price. However, rights issues are not always as generous as they might sound.

Before worrying about the numbers, your first consideration is why the company is undertaking a rights issue: what does it plan to do with the money? If it is raising extra capital to buy an expanding business that will greatly improve the company's competitive positioning and earning power, then the rights issue may be good news.

However, if the company has to pay out virtually all of its profits just to maintain its dividend to shareholders and keep the share price up, a rights issue may be lurking around the corner for less glamorous reasons.

It could be that earnings are weakening so much that the company needs that extra cash just to maintain its core business. It could be a good reason to look for better value elsewhere. Again, consider where the money is going - to growth or stagnation?

The next thing to check is the mathematics of the deal. It is usually quite straightforward, so here is a quick example.

Say you have 1000 shares in Quicksand Constructions Limited, currently trading at $2 a share, and the company has one million shares on issue. You therefore own $2000 worth of Quicksand or 0.1 per cent of the company. The directors identify a growth opportunity and make a 1-for-4 rights issue at the discounted price of $1.60.

You get the right to buy one new share at $1.60 for every four shares you own. That is a substantial discount to the current share price, so the issue sounds attractive. But is it, and how much are your rights really worth? If you take up the offer, your shareholding will include:

1000 shares at the current market price ($2.00)          $2000
250 new shares at the rights price ($1.60)                   $400
Cost of all your shares                                                $2400

So what is the average cost of all your shares after the rights issue? Because the shares bought via rights are cheaper than the current market price (and because free lunches are hard to come by), these lower-priced shares theoretically drag down the market price post-rights to $1.92.

This means you lose 8 cents a share (a total of $80) on the original shares you held, because the price is 8 cents lower. But you get the same amount back by exercising your right to buy 250 shares at $1.60 instead of the expected market price of $1.92. Exercising your rights also means your shareholding as a percentage of issued capital remains the same.

While this is essential in understanding that rights are often not what they are cracked up to be, in reality the share price may not behave this way at all.

There could be a free lunch after all

As mentioned, investors will judge the rights issue according to what use the company is putting the money and whether it is expected to increase earnings over time.

If, in the Quicksand example, the share price did not fall to $1.92 but managed to hold firm at $2 because the project it would finance was so compelling, investors would indeed enjoy a free lunch. They would effectively be getting their hands on new shares for $1.60 compared with a market price of $2, while losing nothing on their existing holdings.

The other option you may have (but not always) is not to exercise the rights at all but to sell them. The value of your rights, in theory at least, is the difference between the expected market price of the stock after the rights issue and the exercise price of the rights.

The trade-off, of course, is that your percentage equity holding (or theoretical claim over the earnings) in the company will be diluted to the extent that other investors convert their rights to shares.

Placements

Rights issues can get a bit messy for everyone involved and they take a bit of organising. So some companies raise new equity, usually in relatively small amounts, by making a placement to an institution or small group of people.

Placements can sometimes disadvantage excluded shareholders by diluting their interests in the company's earnings. For example, say you own 1000 out of a total of 10,000 issued shares in Marigold Hotels Limited. In other words, you own 10 per cent of the company and are theoretically entitled to 10 per cent of its earnings. If the company makes $1 million, you make $100,000 - although obviously it may not all be paid out to you as a dividend.

What if Marigold now decides to raise equity through a placement of 1000 shares at the current market price to a major fund manager? Suddenly, 11,000 shares are on issue and you still own 1000. Your holding has been diluted to 9.1 per cent of the company.

If the company makes the same $1 million profit, through no fault of your own your share of the profits has fallen from $100,000 to $90,909. The company's actions have "robbed" you of almost $10,000!

The key question is whether earnings will remain at $1 million after the cash injection. If Marigold is raising capital to expand its proven, successful hotel chain into new markets, the equity placement may be just what it needs to take it to the next growth phase.

It could be that instead of a $1 million profit next year, the company's expansion is wildly successful and it makes $1.5 million, of which you have a claim on 9.1 per cent, or $136,350. You're in the money again!

As with rights issues, all you can do is assess to what use the company is putting the new money. Then make a decision on whether you are better off in or out.

Share splits - half the price, double the fun?

You may wonder why so many companies still trade at less than $10. Surely there should be plenty of big companies that have grown consistently for so long that their share price should be $50, $60, even $120.

In the US, you are more likely to come across shares trading at $50 or more. And if you could get your hands on an A-class share in Warren Buffet's Berkshire Hathaway Group, you would be handing over US$125,000 or thereabouts. So why the discrepancies?

The answer lies in a marketing device known as the share split. The theory, in extremis, goes that investors would rather buy 1000 shares at $2 each than two shares at $1000 each. That being the case, every so often companies that have watched their share price rise over the months or years, may reset the price to half or even one-third of its former level (two-for-one, three-for-one splits, and so on).

Bonus issues - a split with a difference

While some investors think of bonus issues as freebies from a company - and the word bonus does imply something for nothing - the reality is they have much the same effect as share splits.

Under a 1-for-4 bonus issue, shareholders receive one free share for every four shares they own. If you own 1000 shares in a stock currently trading at $2, you will receive 250 "free" shares.

Unfortunately, just as in a rights issue, the freebies increase the supply of shares and tend to drag the market price down. Consider this example:

1000 shares at the current market price ($2.00)       $2000
250 "free" shares                                                      $0
Cost of all your shares                                              $2000

The average value of your shares after the bonus issue will be the total cost of the shares ($2000) divided by the number of shares you now own (1250), which comes to $1.60. Your $2000 investment is still worth $2000, only in theory you now have 1250 shares trading at $1.60 instead of 1000 shares trading at $2. Some freebie!

In reality, of course, bonus issues can work in your favour if they are made by quality companies and share prices do not retreat as far as theory would suggest.

But don't assume that you are guaranteed something for nothing. Just as the Reserve Bank can't print money without devaluing paper already in circulation, companies can't create value out of thin air.

Share buybacks - finally, a reward for shareholders

While some rights issues, bonus issues and share splits may be of more benefit to the company than they are to you, there is a relatively simple way a company can reward loyal shareholders: buy back its own shares.

This is the best way a company can create value for shareholders if it has ready funds and no immediate growth opportunities to pour them in to.

In much the same way as a bonus issue increases the number of shares in circulation and depresses their price, a buyback decreases the number of shares in circulation. This raises the earnings per share (same earnings, fewer shares, more to go around), which generally puts an upward influence on the share price.

If a company can halve its earnings per share by doubling its shares on issue, that same company can double its earnings per share simply by halving its number of shares.

Apart from its effect on earnings per share, a buyback is a sign that management is confident enough in the company's future to invest in itself. It also means that management does not necessarily feel obliged to expand for the sake of expansion, unless the right opportunities present themselves.

About the author

Visit Morningstar for information on latest market and company trends, and sharemarket education. The Learn section on the Morningstar website has a wealth of free information to help investors.

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