Rights Issue: Subscribe, Sell or Lapse
You are an investment adviser reviewing a client's rights entitlement. The client owns 12,000 shares of a Hong Kong-listed manufacturer. The company announces a 2-for-5 rights issue at HKD 3.60 per new share. The last cum-rights price was HKD 5.20. The rights are renounceable and will trade as nil-paid rights for five business days. The client has HKD 25,000 cash and a margin facility. Her broker says the rights are 'free money' and urges her to subscribe for the full 4,800 new shares using margin because the theoretical ex-rights price is above the subscription price. The client is unsure whether to subscribe, sell the rights, or do nothing; she also asks whether the controlling shareholder's 60% underwriting changes the analysis. The company has no dividend restrictions and the issue is not conditional on a minimum subscription. You must explain the economics and advise on suitability.
1. Calculate the theoretical ex-rights price, the theoretical value of the rights attached to the client's 12,000 shares, and the cash needed to subscribe. Show your workings.
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TERP = (5 × 5.20 + 2 × 3.60) / 7 = (26.00 + 7.20) / 7 = 33.20 / 7 = HKD 4.7429, or about HKD 4.74. The client holds 12,000 shares, so the 2-for-5 ratio gives 12,000 × 2/5 = 4,800 new shares. Subscription cash = 4,800 × 3.60 = HKD 17,280. Theoretical value of one right to buy one new share = TERP − subscription price = 4.7429 − 3.60 = HKD 1.1429. Value per existing share = 0.4 × 1.1429 = HKD 0.4571, equivalently 5.20 − 4.7429. Total theoretical value of the client's rights = 12,000 × 0.4571 = HKD 5,485.7, or 4,800 × 1.1429 = HKD 5,485.7. These are theoretical and ignore taxes, fees and market movement.
2. Compare subscribing, selling the nil-paid rights, and doing nothing. Is the broker's 'free money' claim correct?
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Subscribing keeps the client's proportionate exposure and avoids losing the rights value, but requires HKD 17,280 and adds equity concentration. Selling the nil-paid rights converts the theoretical value into cash, subject to market price and fees, and reduces exposure; it is usually the default if the client does not want more shares. Doing nothing, if the rights are not sold or exercised before expiry, lets them lapse and destroys the theoretical HKD 5,486 value. The broker's 'free money' claim is wrong: the rights have value because the cum-rights price already embeds the entitlement, but subscribing requires new cash and risk. The client is not receiving a windfall; she is choosing whether to invest more. The 60% controlling-shareholder underwriting may support the issue but does not change the TERP; it may reduce liquidity in the nil-paid rights and signals alignment, not a guarantee. Using margin is unnecessary because the client has HKD 25,000 cash, and it would add leverage to an already concentrated holding.
3. What suitability and disclosure points should the adviser cover?
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The adviser should confirm the client's holding size relative to her total portfolio, liquidity needs and risk tolerance. The subscription would raise her investment in one small-cap manufacturer to about HKD 79,680 at TERP, so concentration and volatility may be unsuitable. The adviser should explain that rights prices can fall, the theoretical value is not guaranteed, and nil-paid rights may be illiquid. She should document the client's choice, the deadline and the cash flow. If recommending subscription, the adviser should justify why adding exposure is suitable; if not, recommend selling or lapsing with reasons. The broker's 'free money' language should be corrected and not used in marketing. Any margin discussion must include the risk of forced sale. The final advice should be in the client's best interest, not driven by the broker's incentive to generate subscription volume.