By Carla PasternakWhen a stock like Zweig Total Return Fund (NYSE:ZTR) makes a rights offering, many investors are besieged with questions: "What should I do?" one reader asked us. "Is this a good thing, or will it just dilute my current holdings?"
The simple answer is "yes." By adding to the number of shares outstanding, a rights offering will dilute the value of the holdings of existing shareholders. But it's important to take a closer look at the rights offering to see what strategies the company has put in place to offset the potential dilution.
A rights offering doesn't just involve the issuance of new shares. Specifically, it issues new shares for existing shareholders and it issues these shares at a discount to the going market price. That discount is key for offsetting the potential dilution.
Here's why: Zweig Total Return, for instance, said it would offer existing shareholders the right to buy one share for every five shares of ZTR they already own. The company also said it would sell these shares at the fund's net asset value per share or at a 5% discount to the market value -- whichever is lower.
Let's say you hold 1,000 shares of ZTR and the market price is $6.00. You then subscribe to the rights offering and buy another 200 shares at a 5% discount, or $5.70. The total value of your 1,200 shares is $7,140, as shown below. The so-called "ex-rights" price of the shares once the rights offering expires -- the weighted average of the market price and the discount price -- is $5.95.
In other words, the value of your existing shares in ZTR would fall from $6.00 to $5.95 once the offering expires. But this loss is offset by the fact that the 200 new shares cost you $5.70 and now have an ex-rights value of $5.95.
One caveat: The ex-rights share price shows how the discounted price of the shares exactly offsets the dilutive effect of a rights offering. The actual share price after the rights offering may differ depending on market factors.
Suppose you decide not to subscribe to the rights offering. Then, your existing shares could suffer some dilution, depending on how the rights offering is structured.
Some offerings carry "transferable rights" that allow shareholders to sell their rights on the open market or to the underwriter. For example, if you decide not to buy additional shares of ZTR yourself, then you can try to sell them for the ex-rights price of $5.95. If you subtract the $5.70 issue price from that, you would have a capital gain of $0.25 per share.
The Zweig Total Return planned rights offering is "non-transferable." In other words, if you decide not to subscribe to the offering, then you can't sell the rights and the value of your existing shares may decline due to the new shares issued.
ZTR's management attempts to address the dilution that could occur from non-subscribing shareholders by giving shareholders the right to buy additional shares not taken by non-subscribing shareholders. Assuming shareholders do exercise that right and recoup the additional shares, the offering should have little dilutive affect on subscribing shareholders.
You can make some quick profits by finding securities with planned rights offerings and scooping up additional shares at a discount or by trading their rights. But before you jump in, be sure to do your due diligence. Find out why the firms are considering the rights offering, how they plan to use the additional capital raised from the offering, and whether the capital infusion will re-energize the company's growth plans.