The Theoretical Ex Rights Price Explained (TERP)
Theoretical Ex Rights Price Definition
A theoretical ex-rights price (TERP) is the market price that a stock will have after a rights issue, assuming that all of the newly issued shares are taken up by the existing shareholders.
So, what is a right issue?
Simply put, a rights issue is where a company will offer existing shareholders the opportunity to purchase new shares (in proportion to the number of shares they currently hold).
For example, a “1-for-4” rights issue would mean that the shareholder would receive the opportunity to purchase 1 new share for every 4 shares they currently hold.
If the shareholder currently holds 400 shares, they will have the opportunity to purchase 100 new shares.
It is only an offer, so there is no obligation for the shareholder to take up the offer and buy the new shares.
Typically, the share price offered from a rights issue (issue price) is discounted to the current market value (cum rights price), in an attempt to encourage the shareholder to take up the offer and raise capital for the company.
Now that we understand what a right issue is, what is the theoretical ex rights price?
Simply put, the theoretical ex-rights price is the estimated share price of a company after the rights issue has taken place.
The theoretical ex-rights price helps investors and market participants understand the potential impact of the rights issue on the stock’s value.
Theoretical Ex-Rights Price Formula
To calculate the Theoretical Ex-Rights Price Formula, the following formula can be used:
Where:
N | Number of shares required to buy 1 share (ie for a 1-for-4 rights issue, N would be 4 |
Cum Rights Price | The market value before the rights issue is made |
Issue Price | The new price offered for the rights issue |
Ynew | Rate of return on new funds |
Yold | Rate of return on existing funds |
Theoretical Ex-Rights Price Example
Example 1
A company announces a 1 for 5 rights issue at £3.60. The current share price is £4.
How to calculate the Theoretical Ex-Rights Price:
Cum rights price = £4.00
N = 5 shares
Issue price = £3.60
= 1/(5+1) x [(5 x £4.00) + £3.60]
= 0.166 x [£20 + £3.60]
= £3.93
Example 2
A company is looking to raise £80m through a 1 for 4 rights issue.
The current share price is £25 (cum rights price), and there are 20m shares in issue.
How to calculate the Theoretical Ex-Rights Price:
Firstly, calculate the number of new shares that will be issued:
- 20m x [1 / 4] = 5m new shares
Then, work out what the issue price will be:
- £80m / 5m new shares = £16
Therefore, the TERP would be:
- 1/(4+1) x [(4 x £25) + £16] = £23.20
What Is The Value of a Right?
As a rights issue gives the shareholder the right, but not the obligation, to purchase discounted shares, the actual right has value in itself, and can be bought and sold.
The value of a right would be:
Theoretical Ex Rights Price – Issue Price
However, it is important to remember that the rights are only available to trade for a limited time, namely the period between the rights issue being announced, and the new issue taking place.
For example, if a company’s current share price is £5.00 and they announce a 1-for-4 rights issue at £3, the TERP and the value of a right can be calculated as follows:
Cum rights price = £5.00
N = 4 shares
Issue price = £3.00
TERP = 1/(4+1) x [(4 x £5.00) + £3.00]
TERP = 0.2 x [£20.00 + £3.00]
TERP = £4.60
As the value of a right is calculated through the formula:
- TERP – Issue Price
£4.60 – £3.00 = £1.60
Therefore, the value of a right per existing share = £1.60 / 4 shares = £0.40 per share
Yield Adjusted TERP
During a typical rights issue calculation, it is assumed that the rate of return before and after the rights issue would remain the same.
However, if the rate of return is likely to change after a rights issue, then a yield adjusted theoretical ex-rights price should be calculated.
Simply put, a yield adjusted TERP can be calculated if the new share purchase is anticipated to have a higher growth rate than the previously held shares.
Multiply the new share value by [NEW RETURN / OLD RETURN]
Yield Adjusted TERP Formula
To calculate a yield adjusted TERP, the following formula can be used:
Where:
N | Number of shares required to buy 1 share (ie for a 1-for-4 rights issue, N would be 4 |
Cum Rights Price | The market value before the rights issue is made |
Issue Price | The new price offered for the rights issue |
Ynew | Rate of return on new funds |
Yold | Rate of return on existing funds |
Yield Adjusted TERP Example
A company has a current WACC of 12%, and has 250m shares in issue.
The current share price is £2.50, and they announce a 1 for 4 rights issue at £2.25.
The funds raised by the company will be used to finance a project with an expected return of 14%.
How to calculate the yield adjusted Theoretical Ex-Rights Price:
Cum rights price = £2.50
N = 4 shares
Issue price = £2.25
Yield on new funds = 14%
Yield on existing funds = 12%
Yield-adjusted theoretical ex-rights price
= 1/(4+1) x [(4 x £2.50) + £2.25 x 0.14/0.12)]
=0.2 x [£10 + £2.625]
= £2.525
= £2.53