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7 Rights issues 12/07, 6/08, 12/08, 6/09, 12/09, 12/10, 6/14, 12/14, 6/15

7 Rights issues 12/07, 6/08, 12/08, 6/09, 12/09, 12/10, 6/14, 12/14, 6/15

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4.8 Deciding the issue price for a rights issue
The offer price in a rights issue will be lower than the current market price of existing shares. The size of
the discount will vary, and will be larger for difficult issues. In the UK, however, the offer price must be at
or above the nominal value of the shares, so as not to contravene company law.
A company making a rights issue must set a price which is low enough to secure the acceptance of
shareholders, who are being asked to provide extra funds, but not too low, so as to avoid excessive
dilution of the earnings per share.

Exam focus

A question could ask for discussion of the effect of a rights issue, as well as calculations, eg of the effect
on EPS.

4.9 Example: Rights issue (1)
Seagull can achieve a profit after tax of 20% on the capital employed. At present its capital structure is as
200,000 ordinary shares of $1 each
Retained earnings
The directors propose to raise an additional $126,000 from a rights issue. The current market price is


Calculate the number of shares that must be issued if the rights price is:
$1.60; $1.50; $1.40; $1.20.
Calculate the dilution in earnings per share in each case.

The earnings at present are 20% of $300,000 = $60,000. This gives earnings per share of 30c. The
earnings after the rights issue will be 20% of $426,000 = $85,200.

Rights price

No of new share
($126,000  rights


EPS ($85,200  total
no of shares)

+ 0.6

– 0.6
– 2.1

Note that at a high rights price the earnings per share are increased, not diluted. The breakeven point (zero
dilution) occurs when the rights price is equal to the capital employed per share: $300,000  200,000 =

4.9.1 The market price of shares after a rights issue: the theoretical ex-rights price
When a rights issue is announced, all existing shareholders have the right to subscribe for new shares,
and so there are rights attached to the existing shares. The shares are therefore described as being 'cum
rights' (with rights attached) and are traded cum rights. On the first day of dealings in the newly issued
shares, the rights no longer exist and the old shares are now 'ex-rights' (without rights attached).
After the announcement of a rights issue, share prices normally fall. The extent and duration of the fall
may depend on the number of shareholders and the size of their holdings. This temporary fall is due to
uncertainty in the market about the consequences of the issue, with respect to future profits, earnings and

Part E Business finance  12: Sources of finance


After the issue has actually been made, the market price per share will normally fall, because there are
more shares in issue and the new shares were issued at a discount price.
In theory, the new market price will be the consequence of an adjustment to allow for the discount price of
the new issue, and a theoretical ex-rights price can be calculated.

4.9.2 Example: Rights issue (2)
Fundraiser has 1,000,000 ordinary shares of $1 in issue, which have a market price on 1 September of
$2.10 per share. The company decides to make a rights issue, and offers its shareholders the right to
subscribe for one new share at $1.50 each for every four shares already held. After the announcement of
the issue, the share price fell to $1.95, but by the time just prior to the issue being made, it had recovered
to $2 per share. This market value just before the issue is known as the cum rights price. What is the
theoretical ex-rights price?

Value of the portfolio for a shareholder with 4 shares before the rights issue:
4 shares @ $2.00
1 share @ $1.50


So the value per share after the rights issue (or TERP) is 9.50/5 = $1.90.

4.9.3 The value of rights
The value of rights is the theoretical gain a shareholder would make by exercising their rights.

Using the above example, if the price offered in the rights issue is $1.50 per share, and the market
price after the issue is expected to be $1.90, the value attaching to a right is $1.90 – $1.50 = $0.40.
A shareholder would therefore be expected to gain 40 cents for each new share they buy.
If they do not have enough money to buy the share themselves, they could sell the right to
subscribe for a new share to another investor, and receive 40 cents from the sale. This other
investor would then buy the new share for $1.50, so that their total outlay to acquire the share
would be $0.40 + $1.50 = $1.90, the theoretical ex-rights price.


The value of rights attaching to existing shares is calculated in the same way. If the value of rights
on a new share is 40 cents, and there is a one for four rights issue, the value of the rights attaching
to each existing share is 40  4 = 10 cents.

4.9.4 The theoretical gain or loss to shareholders
The possible courses of action open to shareholders are:





To 'take up' or 'exercise' the rights; that is, to buy the new shares at the rights price. Shareholders
who do this will maintain their percentage holdings in the company by subscribing for the new
To 'renounce' the rights and sell them on the market. Shareholders who do this will have lower
percentage holdings of the company's equity after the issue than before the issue, and the total
value of their shares will be less.
To renounce part of the rights and take up the remainder. For example, a shareholder may sell
enough of their rights to enable them to buy the remaining rights shares they are entitled to with
the sale proceeds, and so keep the total market value of their shareholding in the company
To do nothing. Shareholders may be protected from the consequences of their inaction because
rights not taken up are sold on a shareholder's behalf by the company. If new securities are not
taken up, they may be sold by the company to new subscribers for the benefit of the shareholders
who were entitled to the rights.

12: Sources of finance  Part E Business finance


Rights issue

Gopher has issued 3,000,000 ordinary shares of $1 each, which are at present selling for $4 per share.
The company plans to issue rights to purchase 1 new equity share at a price of $3.20 per share for every 3
shares held. A shareholder who owns 900 shares thinks that they will suffer a loss in their personal wealth
because the new shares are being offered at a price lower than market value. On the assumption that the
actual market value of shares will be equal to the theoretical ex-rights price, what would the effect on the
shareholder's wealth be if:

They sell all the rights
They exercise half the rights and sell the other half
They do nothing at all

Value of the portfolio for a shareholder with 3 shares before the rights issue

3 shares @ $4.00
1 share @ $3.20
So the value per share after the rights issue (or TERP) is 15.20/4 = 3.80.


Theoretical ex-rights price
Price per new share
Value of rights per new share
The value of the rights attached to each existing share is

= $0.20.

We will assume that a shareholder is able to sell their rights for $0.20 per existing share held.

If the shareholder sells all their rights:
Sale value of rights (900  $0.20)
Market value of their 900 shares ex rights (900  $3.80)
Total wealth
Total value of 900 shares cum rights (  $4)


The shareholder would neither gain nor lose wealth. They would not be required to provide any
additional funds to the company, but their shareholding as a proportion of the total equity of the
company will be lower.

If the shareholder exercises half the rights (buys 450/3 = 150 shares at $3.20) and sells the other
Sale value of rights (450  $0.20)
Market value of their 1,050 shares, ex rights (  $3.80)
Total value of 900 shares cum rights (  $4)
Additional investment (150  $3.20)


The shareholder would neither gain nor lose wealth, although they will have increased their
investment in the company by $480.

Part E Business finance  12: Sources of finance



If the shareholder does nothing, but all other shareholders either exercise their rights or sell them,
they would lose wealth as follows.

Market value of 900 shares cum rights (  $4)
Market value of 900 shares ex rights (  $3.80)
Loss in wealth

It follows that the shareholder, to protect their existing investment, should either exercise their rights or
sell them to another investor. If they do not exercise their rights, the new securities they were entitled to
subscribe for may be sold for their benefit by the company, and this would protect them from losing

4.10 The actual market price after a rights issue


The actual market price of a share after a rights issue may differ from the theoretical ex-rights price. This
will occur when:

4.10.1 Expected yield from new funds raised  Earnings yield from existing funds
The market will take a view of how profitably the new funds will be invested, and will value the shares
accordingly. An example will illustrate this point.

4.10.2 Example: Rights issue (3)
Musk currently has 4,000,000 ordinary shares in issue, valued at $2 each, and the company has annual
earnings equal to 20% of the market value of the shares. A one for four rights issue is proposed, at an
issue price of $1.50. If the market continues to value the shares on a price/earnings ratio of 5, what would
the value per share be if the new funds are expected to earn, as a percentage of the money raised:


How do these values in (a), (b) and (c) compare with the theoretical ex-rights price? Ignore issue costs.

The theoretical ex-rights price will be calculated first.

Four shares have a current value ( $2) of
One new share will be issued for
Five shares would have a theoretical value of
Theoretical ex-rights price


((4  2) + 1.50)

= $1.90
The new funds will raise 1,000,000  $1.50 = $1,500,000.
Earnings as a % of
money raised



12: Sources of finance  Part E Business finance

Additional earnings

Current earnings

Total earnings
after the issue

If the market values shares on a P/E ratio of 5, the total market value of equity and the market price per
share would be as follows.


Price per share


If the additional funds raised are expected to generate earnings at the same rate as existing funds,
the actual market value will probably be the same as the theoretical ex-rights price.


If the new funds are expected to generate earnings at a lower rate, the market value will fall below
the theoretical ex-rights price. If this happens, shareholders will lose.


If the new funds are expected to earn at a higher rate than current funds, the market value should
rise above the theoretical ex-rights price. If this happens, shareholders will profit by taking up their

The decision by individual shareholders as to whether they take up the offer will therefore depend on:

The expected rate of return on the investment (and the risk associated with it)
The return obtainable from other investments (allowing for the associated risk)

4.11 New issues of shares for listed companies
A listed company can also raise new equity finance through a public offer or a placing. Usually these
methods will be used as a method of refinancing or to finance growth. These methods of issuing shares
will dilute the ownership of the existing shareholders. They are also more expensive as a method of
raising equity finance than a rights issue, as the new issues can incur costs such as those covered in
Section 4.5.

4.12 Stock split
A stock split occurs where, for example, each ordinary share of $1 each is split into two shares of 50c
each, thus creating cheaper shares with greater marketability. There is possibly an added psychological
advantage in that investors may expect a company which splits its shares in this way to be planning for
substantial earnings growth and dividend growth in the future.
As a consequence, the market price of shares may benefit. For example, if one existing share of $1 has a
market value of $6, and is then split into two shares of 50c each, the market value of the new shares might
settle at, say, $3.10 instead of the expected $3, in anticipation of strong future growth in earnings and
A stock split changes the share capital but does not raise any new equity finance for the company. It also
leaves the company's reserves (as shown in its statement of financial position) unaffected.

4.13 Scrip issue
A scrip issue occurs when a company issues new shares to existing shareholders in proportion to their
existing holdings at no charge. The issue is made out of distributable reserves (retained profits).
A scrip issue, like a stock split, raises no extra finance for the company.
The difference between a stock split and a scrip issue is that a scrip issue converts equity reserves into
share capital, whereas a stock split leaves reserves unaffected.

A company may make a scrip issue when it wants to pay a dividend to shareholders, but would prefer not
to pay the dividend in cash. Scrip dividends are explained in the next chapter.

Part E Business finance  12: Sources of finance


Exam focus

Students may find it useful to read the articles called 'Business finance' and 'Analysing the suitability of
financing alternatives' on the ACCA website.

4.14 Preference shares
Preference shares are shares which give the right to receive dividends (typically a fixed percentage of the
nominal value of the shares) before any dividends can be paid to ordinary shareholders.
As a source of finance, preference shares have several advantages over debt capital.

Dividends do not have to be paid if company performance is poor, whereas interest must be paid
on debt capital regardless of profit.


Preference shares are not secured on company assets.


Preference shareholders usually have no voting rights so there is no dilution of control.

There is, however, a fairly significant disadvantage.

Preference share capital is not as tax efficient as debt capital, as dividends paid are not tax
deductible, whereas interest on debt is.

5 Islamic finance
Islamic finance is finance that is compliant with Sharia'a law. Islamic finance has gone through an
exceptional growth period in recent years. The number of fully Sharia'a compliant banks continues to
increase worldwide and Sharia'a compliant financial products are not only offered by Islamic banks but
also by conventional banks using specific distribution channels. The term 'conventional' is used to identify
the financial institutions that have formed part of the financial infrastructure for a long time and are not
specifically based on Islamic principles.

5.1 Wealth creation through trade and investment

Islamic finance transactions are based on the concept of sharing risk and reward between the investor
and the user of funds.

The object of an Islamic finance undertaking is not simply the pursuit of profit, but that the economic
benefits of the enterprise should extend to goals such as social welfare and full employment. Making
profits by lending alone and the charging of interest is forbidden under Sharia'a law. The business of
trading goods and investment in Sharia'a acceptable enterprises form the core of Islamic finance.
Following the ethics of Sharia'a is important for businesses. The ethical framework recognises that capital
has a cost associated with it and is in favour of wealth generation. However, making money with money
is deemed immoral, and wealth should be generated via trade or trade-based investments.
Financial transactions are strongly based on the sharing of risk and reward between the provider of funds
(the investor) and the user of funds (the entrepreneur).
Conventional banks aim to profit by accepting money deposits in return for the payment of interest and
then lending money out in return for the payment of a higher level of interest. Islamic finance does not
permit the use of interest and invests under arrangements which share the profits and losses of the
enterprises. The Islamic bank arranges their business in such a way that the bank's profitability is closely
tied to that of the client. The bank stands to take profit or make loss in line with the projects they are
financing and as such must be more involved in the investment decision-making.

5.2 Riba


Riba (interest) is forbidden in Islamic finance.
Riba is generally interpreted as the predetermined interest collected by a lender, which the lender receives
over and above the principal amount it has lent out. The Quranic ban on riba is absolute. Riba can be
viewed as unacceptable from three different perspectives, as outlined below.


12: Sources of finance  Part E Business finance

For the borrower

Riba creates unfairness for the borrower when the enterprise makes a profit which is less than the
interest payment, turning their profit into a loss.

For the lender

Riba creates unfairness for the lender in high inflation environments when the returns are likely to
be below the rate of inflation.

For the economy

Riba can result in inefficient allocation of available resources in the economy and may contribute to
instability of the system. In an interest-based economy, capital is directed to the borrower with the
highest creditworthiness rather than the borrower who would make the most efficient use of the

5.3 Islamic finance contracts
This section develops the discussion of Islamic finance to include the most commonly used financial
arrangements which offer suitable Sharia'a compliant financial services. Forms of contract include:

Mudaraba – a partnership contract
Musharaka – a form of equity where a partnership exists and profits and losses are shared
Murabaha – a form of credit sale
Ijara – a form of lease
Sukuk – similar to a bond

Unlike conventional banking where a division may exist between the lender of funds and the risks and
actions of the party using the funds, Islamic finance will require that an active role is played in the use of
the asset by the fund provider and that risks and rewards be shared. Instruments such as those listed
above have varied forms and may be applied carefully to offer services comparable to those offered by
conventional banks.

5.4 Mudaraba contract


A mudaraba transaction is a partnership transaction in which only one of the partners (the rab al mal)
contributes capital, and the other (the mudarib) contributes skill and expertise. The contributor of capital
has no right to interfere in the day to day operations of the business. Due to the fact that one of the
partners is running the business and the other is solely providing capital, the investor has to rely heavily
on the mudarib, their ability to manage the business and their honesty when it comes to profit share
Mudaraba transactions are particularly suited to private equity investments or for clients depositing money
with a bank.
Investing Partner
(Rab al Mal)

1. Profit
and Loss

Business Partner

1. Capital

1. Expertise

1. Profit
and Loss

Project or

Part E Business finance  12: Sources of finance


5.4.1 The roles of and the returns received by the rab al mal and mudarib under a
mudaraba contract

Capital injection

The investor provides capital for the project or company. Generally, an investor will not provide any
capital unless a clearly defined business plan is presented to them. In this structure, the investor
provides 100% of the capital.

Skill and expertise

The business manager's contribution to the partnership is their skill and expertise in the chosen
industry or area.

Profit and loss

Any profits will be shared between the partners according to the ratios agreed in the original
contract. Any losses are solely attributable to the investor due to the fact that they are the sole
provider of all capital to the project. In the event of a loss, the business manager does not receive
any compensation (mudarib share) for their efforts. The only exception to this is when the business
manager has been negligent, in which case they become liable for the total loss.
The investor in a mudaraba transaction is only liable to the extent of the capital they have provided. As a
result, the business manager cannot commit the business for any sum which is over and above the capital
The mudaraba contract can usually be terminated at any time by either of the parties giving a reasonable
notice. Typically, conditions governing termination are included in the contract so that any damage to the
business or project is eliminated in the event that the investor would like to take their equity out of the
The rab al mal has no right to interfere with the operations of the business, meaning this situation is
similar to an equity investment on a stock exchange.

5.5 Musharaka partnership contract
Musharaka transactions are typically suitable for investments in business ventures or specific business
projects, and need to consist of at least two parties, each of which is known as musharik. It is widely used
in equity financing.
General Partner

2. Profit
and Loss

General Partner

1. Capital and

1. Capital and

2. Profit
and Loss

Project or

Once the contract has been agreed between the partners, the process can be broken down into the
following two main components.



All partners bring a share of the capital as well as expertise to the business or project. The partners
do not have to provide equal amounts of capital or equal amounts of expertise.


Any profits will be shared between the partners according to the ratios agreed in the original
contract. To the contrary, any losses that the project might incur are distributed to the partners
strictly in proportion to capital contributions. Although profits can be distributed in any proportion
by mutual consent, it is not permissible to fix a lump sum profit for any single partner.

12: Sources of finance  Part E Business finance

This transaction is similar to venture capital, for example a management buyout, where both parties
contribute both capital and expertise. The venture capitalist will want board representation and therefore
provides expertise and they will also want management to provide capital to demonstrate their

5.6 Murabaha contract
Instruments with predictable returns are typically favoured by banks and their regulators since the reliance
on third-party profit calculations is eliminated.
A murabaha transaction is a deferred payment sale or an instalment credit sale and is mostly used for
the purchase of goods for immediate delivery on deferred payment terms. In its most basic form, this
transaction involves the seller and buyer of a good, as can be seen below.
Simple murabaha structure

As part of the contract between the buyer and the seller, the price of the goods, the mark-up, the delivery
date and payment date are agreed. The sale of the goods is immediate, against future payment. The buyer
has full knowledge of the price and quality of goods they buy. In addition, the buyer is also aware of the
exact amount of mark-up they pay for the convenience of paying later. In the context of trading, the
advantage to the buyer is that they can use the goods to generate a profit in their business and
subsequently use the profit to repay the original seller.
The underlying asset can vary, and can include raw materials and goods for resale.
Sharia'a prescribes that certain conditions are required for a sales contract (which include murabaha
contracts) to exist.

The object in the contract must actually exist and be owned by the seller.

The object is offered for a price and both object and price are accepted (the price should be within
fair market range).

The object must have a value.

The object in question and its exchange may not be prohibited by Sharia'a.

The buyer in the contract has the right to demand that the object is of suitable quality and is not

A bank can provide finance to a business in a murabaha transaction as follows.

The manager of the business identifies an asset that the business wants to buy.

The bank agrees to buy the asset, and to resell it to the business at an agreed (fixed) price, higher
than the original purchase price of the asset.

The bank will pay for the asset immediately but agrees to payment from the business under a
deferred payment arrangement (murabaha).

The business therefore obtains the asset 'now' and pays for it later. This is similar in effect to
arranging a bank loan to purchase the asset, but it is compliant with Sharia'a law.

5.6.1 The differences between a murabaha sale and a loan of money
Murabaha is in many ways similar in its nature to a loan; however, there are key characteristics which
must be present in a murabaha contract which distinguish it.

The goods for which the financing is being arranged must effectively be owned by the financing

Part E Business finance  12: Sources of finance


Penalties should not be charged for late payment which would profit the lender. (Extensions are
permissible but not for additional fees or charges.)

5.7 Ijara contract
An ijara transaction is the Islamic equivalent of a lease where one party (lessor) allows another party
(lessee) to use their asset against the payment of a rental fee. Two types of leasing transactions exist:
operating and finance leases. The only distinction between the two is the presence or absence of a
purchase undertaking from the lessee to buy the asset at the end of the lease term. In a finance lease, this
purchase undertaking is provided at the start of the contract. The lessor cannot stipulate that they will only
lease the asset if the lessee signs a purchase undertaking.
Not every asset is suitable for leasing. The asset needs to be tangible, non-perishable, valuable, identifiable
and quantifiable.
In an operating lease, depicted in Figure 1, the lessor leases the asset to the lessee for a pre-agreed period
and the lessee pays pre-agreed periodic rentals. The rental or lease payments can either be fixed for the
period or floating with periodical refixing.
Figure 1: Operating lease

At the end of the period, the lessee can either request to extend the lease or hand the asset back to the
lessor. When the asset is returned to the lessor at the end of the period, they can either lease it to another
counterparty or sell the asset in the open market. If the lessor decides to sell the asset, they may offer it to
the lessee.
In a finance lease, as depicted in Figure 2, the process is the same as for an operating lease, with the
exception that the lessor amortises the asset over the term of the lease and at the end of the period the
asset will be sold to the lessee.
Figure 2: Finance lease

As with an operating lease, rentals can be fixed for the period or floating. As part of the lease agreement,
the amount at which the lessee will purchase the asset upon expiry of the lease is specified.
In both forms of ijara the lessor is the owner of the asset and incurs all risk associated with ownership.
While the lessee bears the responsibility for wear and tear, day to day maintenance and damage, the lessor
is responsible for major maintenance and insurance. Due to the fact that the lessee is using the asset on a
daily basis, they are often in a better position to determine maintenance requirements, and are generally
appointed by the lessor as an agent to ensure all maintenance is carried out. In addition, the lessee is, in
some cases, similarly appointed as agent for the lessor to insure the asset.
In the event of a total loss of the asset, the lessee is no longer obliged to pay the future periodic rentals.
However, the lessor has full recourse to any insurance payments.

5.8 Islamic bond market – sukuk
From the viewpoint of Islam, conventional bonds have two major drawbacks and as a result are prohibited.
Firstly, they pay interest, and secondly there is generally no underlying asset.
Unlike conventional bonds, sukuk are normally linked to an underlying tangible asset. The ownership of
the underlying asset is transferred to the holder of the sukuk certificates together with all ownership


12: Sources of finance  Part E Business finance

benefits and risks. This gives sukuk characteristics of both equity and bonds. Sukuk currently issued have
a shorter term than conventional bonds and are typically three to five years.
The sukuk holder owns a proportional share of the underlying asset and the income that it generates, and
has a financial right to the revenues generated by the asset. However, as mentioned before, the holder is
also subject to ownership risk, which means that they are exposed to any risk and potential losses
associated with the share of the underlying asset. Conventional bonds, on the other hand, remain part of
the issuer's financial liability.
The position of a manager in a sukuk is fundamentally different to that of a manager in a company issuing
bonds. When a sukuk manager sells the assets to investors to raise capital, the management of the assets
remains the manager's responsibility. The sukuk manager is responsible for managing the assets on
behalf of the sukuk holders. The result of this relationship is that holders will have the right to dismiss the
manager if they feel that this is appropriate.
This is different to the relationship between the holders of conventional bonds and bond issuers. In this
situation the issuing company is responsible for fulfilling the terms of the bond, such as paying coupons
and principle, but holders of the bonds have little power to influence the actions of the issuing companies.

5.9 Summary of Islamic finance transactions
The table that follows summarises the Islamic finance transactions already covered and how they differ
from other forms of business financing.
Islamic finance

Similar to



Trade credit /

There is a pre-agreed mark-up to be paid in recognition of the
convenience of paying later for an asset that is transferred
immediately. There is no interest charged.


Venture capital

Profits are shared according to a pre-agreed contract. There are no
dividends paid. Losses are shared according to capital contribution.



Profits are shared according to a pre-agreed contract. There are no
dividends paid. Losses are solely attributable to the provider of



Whether an operating or finance transaction, in ijara the lessor is
still the owner of the asset and incurs the risk of ownership. This
means that the lessor will be responsible for major maintenance and
insurance which is different from a conventional finance lease.



There is an underlying tangible asset that the sukuk holder shares in
the risk and rewards of ownership. This gives the sukuk properties
of equity finance as well as debt finance.

You may find it useful to read the article called ‘Introduction to Islamic finance’ on the ACCA website.

Case Study
Islamic finance 8 September 2014
Neither a borrower nor a lender be. Polonius would have approved of sukuk, instruments which provide a
return but do not technically pay interest. As Goldman Sachs prepares to borrow via sukuk for the first
time, Islamic financing could soon hit the mainstream. Britain has already issued sukuk and other nonMuslim countries look set to follow. One problem: the Islamic academics who interpret Sharia'a law have
their focus far above the bottom line.
Goldman understands how this can happen. In 2011 it had to scrap a $2bn sukuk issue after some Islamic
scholars said that its sukuk was not compliant with Sharia'a, which forbids charging interest because it is
considered to be usury. Furthermore, the workarounds to meet the rules can be complicated. To comply
with Sharia'a a sukuk issuer would instead pay a fixed rent on its own real estate assets to the sukuk
Part E Business finance  12: Sources of finance