Theoretical Ex-Rights Price or TERP is the price of the shares immediately after the rights issue. A rights issue is the offering of shares to existing shareholders. As companies issue new shares, it dilutes the company’s shareholding. Thus, its share prices get affected due to rights issues.
Since rights attached to existing shares have value, investors look for profit opportunities with a rights issue. The share prices settle immediately after the rights issue date. Hence, it is important for investors to calculate the TERP to know their profits before making a decision.
What is Rights Issues?
Before jumping into the theoretical ex-rights price, let’s understand about rights issue.
A rights issue is the offering of new shares to existing shareholders of a company. Each shareholder can buy new shares in proportion to the existing shareholding.
Subscription to rights (buying new shares) comes as an option and not an obligation. Shareholders can sell the rights in the market to receive cash immediately. However, it will dilute their shareholding as there will be new shares in the market.
What is Theoretical Ex-Rights Price – TERP?
Companies raise capital through equity and debt mainly. Offering new shares to existing shareholders is termed a rights issue. Companies offer these rights (new shares) at a discounted price to the existing shareholders.
The rights attached to existing shares have value. Thus, share prices change immediately after the rights issue. It is called theoretical ex-rights price.
Commonly the TERP is lower than the market share price before the rights issue. However, investors must calculate TERP to evaluate their profits if they wish to sell the rights. They can also calculate TERP to evaluate their new shareholding in the company by subscribing to the new shares offered.
Each shareholder can buy new shares through a rights issue. These rights are offered in proportion to the existing shareholding percentage of each shareholder. For instance, a company may offer a 1 for 3 rights issue. It means every shareholder with 3 shares can buy 1 additional share at a discounted price.
Formula
The theoretical ex-rights price is simply the sum of the market value of the shares plus the additional capital raised divided by the total new number of shares.
TERP can be calculated with the simple formula as below.
TERP = (Market Value of Current shares + New capital proceeds) / Total No. Of New Shares
The total number of new shares is the number of shares after the rights issue (ex-rights). It is important to note that not all shareholders would subscribe to the rights offer.
Working Example
Suppose ABC company has 1.2 million shares in issue. Its current share price is trading at $ 4. It offers a rights issue to existing shareholders with a 1 for 4 rights offer at a discounted price of $ 3.
For simplicity, we assume that all shareholders fully subscribed to the rights offer.
We can calculate the TERP with the formula mentioned above.
TERP = (Market Value of Current shares + New capital proceeds) / Total No. Of New Shares
Market value of current shares = 1.2 × $ 4 = $ 4.8 million
New capital proceeds = 300,000 × $ 3 = $ 900,000
New shares issued = 1.2 million ÷ 4 = 300,000.
Total new shares after Rights Issue = 1,200,000 + 300,000 = 1,500,000
TERP = (4,800,000 + 9,00,000) ÷ 1,500,000
TERP = $ 3.80
Explanation
As we can see the theoretical ex-rights price is lower than the market share price before the rights. One simple reason for that is the dilution of shares due to new shares issued.
In practice, the share price will first increase with an announcement of rights issues. As the company offers new shares at discounts and they come with rights attached. The overall demand for shares means the share prices go up.
Once the rights are exercised, there are no warrants attached to shares. The demand for these shares normalizes. Hence, the share prices fall and due to an increased number of shares, the ex-rights price falls below the market share price before the rights issue.
Importance of Theoretical ex-rights Price
Existing shareholders and new investors can use TERP to analyze the share price movement of a company. TERP will always be lower than the market share price before the rights issue. Since new shares come with rights, existing shareholders can subscribe to new shares, sell them in the market, or do nothing to save investment.
In practice, the demand and supply rule would dominate the share prices of a company. If shareholders are bullish on a company’s performance after a rights issue, the share prices will increase above the TERP level soon after the rights issue is completed.