# How to Calculate Theoretical Ex-Rights Price (TERP)

## What is the Right Issue of Shares?

A right issue of shares (rights offering) is where a company provides an offer to their existing shareholders to purchase additional shares at a discounted price in a particular ratio proportionate to their existing shareholding. Shareholders have the option to purchase shares at a lower price on or before a specific date in order to keep their existing shareholding percentage (without dilution).

## What is the Theoretical Ex-Rights Price (TERP) of a Share?

Usually, the share price will be changed after conducting the right issue. The new share price after the right issue is known as the theoretical ex-rights price (also known as ex-right price or TERP). It is calculated by sum the market value of existing shares and proceeds of right issues divided by the total number of shares after the right issue.

## Formula to Calculate the Theoretical Ex-Rights Price (TERP)

Theoretical Ex-Rights Price (TERP) = [ Market Value of Shares Already Issued + Proceeds of New Right Issue ] / The Total number of Shares After Right Issue

• Current share price: \$50
• Subscription price: \$40
• Number of existing shares: 1,000,000
• Number of new shares: 200,000 (if the rights issue is 1 new share for every 5 existing shares)
1. Proceeds of new right issue = \$40 x 200,000 = \$8,000,000
2. Total number of shares after right issue = 1,000,000 + 200,000 = 1,200,000
3. Total value after the right issue = (\$50 x 1,000,000) + (\$40 x 200,000) = \$50,000,000 + \$8,000,000 = \$58,000,000
4. TERP = \$58,000,000 / 1,200,000 = \$48.33

## What Happens to the Share Price after the Right Issue?

Usually, the share price will be decreased than the market price which was available before the right issue, but not less than the right issue subscription (discounted) share price.

Value of a Right = Theoretical Ex-Rights Price – Right Issue Subscription (Discounted) Share Price

## Importance of Theoretical Ex-Right Price (TERP)

• Price Adjustment: TERP provides an estimate of what the stock price should be after the rights issue, reflecting the dilution effect. This helps investors understand how the issuance of additional shares at a discounted price will impact the overall value of the shares.

• Fair Valuation: TERP ensures a fair valuation for both existing and new shareholders. It helps in determining a balanced price that takes into account the new shares issued at a discount, ensuring that the market price adjusts appropriately.

• Investment Decisions: For potential investors, TERP serves as a useful benchmark. It helps them decide whether to buy the stock before or after the rights issue, based on the anticipated price adjustment and the value of the rights.

• Avoiding Arbitrage: By calculating TERP, the market can prevent arbitrage opportunities where traders might exploit price discrepancies between the cum-rights and ex-rights periods. This helps maintain market efficiency.

• Strategic Planning for Shareholders: Existing shareholders can use TERP to make informed decisions about whether to subscribe to the rights issue. Knowing the TERP helps them assess if the investment is worthwhile and how it will affect their portfolio value.

• Financial Analysis: Analysts and investors use TERP to perform a more accurate financial analysis and valuation of the company post-rights issue. It helps in adjusting models and forecasts to reflect the new capital structure.

• Market Stability: Understanding and anticipating the impact of rights issues on stock prices through TERP can contribute to market stability. Investors are less likely to react unpredictably when they have a clear expectation of the price adjustment.

• Communication with Stakeholders: Companies can use TERP to communicate the potential impact of a rights issue to their shareholders transparently. This helps in managing shareholder expectations and maintaining trust.

## Factors Affecting TERP

• Current Share Price: The existing market price of the stock before the rights issue is a primary factor. A higher current share price generally results in a higher TERP, all else being equal.
• Subscription Price: The price at which new shares are offered to existing shareholders significantly influences TERP. A lower subscription price compared to the current share price will usually result in a lower TERP due to the dilution effect.
• Number of Existing Shares: The total number of shares already issued by the company before the rights issue affects TERP. The larger the base of existing shares, the smaller the relative impact of the new shares on the overall stock price.
• Number of New Shares: The number of new shares being issued plays a critical role. More new shares relative to existing shares will increase dilution, potentially lowering the TERP.
• Ratio of Rights Issue: The ratio at which new shares are offered (e.g., 1 new share for every 5 existing shares) affects TERP. A higher ratio means more shares are being introduced, which can lower the TERP due to increased dilution.
• Market Conditions: General market conditions and investor sentiment can also influence TERP. Positive market conditions may mitigate the dilution effect, while negative conditions could exacerbate it.
• Company Performance and Outlook: The perceived future performance and financial health of the company can impact how the rights issue is viewed by investors, subsequently affecting TERP. If investors believe the additional capital will lead to significant growth, the dilution impact might be lessened.
• Purpose of the Rights Issue: How the company intends to use the funds raised from the rights issue can influence TERP. If the funds are aimed at strategic investments that are expected to generate high returns, the negative impact on TERP might be reduced.
• Investor Participation: The level of participation by existing shareholders in the rights issue can affect TERP. Higher participation levels indicate confidence in the company, potentially leading to a smaller drop in the share price.
• Dividends and Earnings Prospects: Expectations regarding future dividends and earnings can affect investor sentiment and thus the TERP. If the rights issue is expected to enhance earnings or dividends, the negative impact on TERP might be mitigated.

## Drawbacks / Limitations of Theoretical Ex-Right Price (TERP)

• Simplistic Assumptions: TERP calculations often rely on simplified assumptions about market behavior, such as the efficient market hypothesis, which assumes all information is reflected in stock prices instantly. In reality, market reactions can be more complex and influenced by various factors beyond the scope of TERP.
• Dynamic Market Conditions: Market conditions can change rapidly, especially during the period between the announcement of a rights issue and its execution. TERP calculations may not fully account for changes in investor sentiment, economic conditions, or sector-specific developments that impact stock prices.
• Impact on Shareholder Perception: Theoretical models like TERP may not fully capture the psychological impact on shareholders. Even if the TERP suggests a fair valuation post-rights issue, investor sentiment and confidence in management’s decisions can affect actual market behavior.
• Assumption of Perfect Information: TERP assumes that all investors have perfect information about the rights issue and its implications. In reality, not all investors may fully understand the details or implications of the rights issue, potentially leading to market inefficiencies or mispricing.
• Market Liquidity and Trading Dynamics: Rights issues can introduce liquidity challenges and affect trading dynamics, particularly when rights are tradable separately from the underlying shares. TERP calculations may not fully account for these liquidity impacts, which can influence actual market prices.
• Model Sensitivity: TERP calculations are sensitive to the inputs used, such as the current share price, subscription price, and number of new shares issued. Small changes in these inputs can lead to significant variations in the TERP estimate, making precise predictions challenging.
• Limited Scope of Dilution: TERP primarily focuses on the dilution effect of additional shares issued through the rights offering. It may not capture other potential impacts on shareholder value, such as changes in the company’s capital structure or strategic implications of the rights issue.

## Similar Methods Like Theoretical Ex-Right Price (TERP)

1. Ex-Dividend Pricing: This method calculates the expected decrease in a stock’s price once it goes ex-dividend. It considers the dividend amount that will be paid out to shareholders and adjusts the stock price downward accordingly on the ex-dividend date.
2. Ex-Rights Price (ERP): Similar to TERP, ERP estimates the expected price of a stock immediately after a rights issue. It factors in the theoretical value of the subscription rights issued to existing shareholders and adjusts the stock price accordingly.
3. Ex-Split Pricing: This method estimates the expected price of a stock after a stock split has occurred. It adjusts the price downward based on the increased number of shares outstanding resulting from the split.
4. Ex-Bonus Price: In markets where bonus shares are issued, this concept estimates the expected price of a stock immediately after the bonus issue. It adjusts the stock price downward to account for the additional shares issued to existing shareholders.

## FAQs of Theoretical Ex-Right Price (TERP)

What is TERP (Theoretical Ex-Right Price)?

• TERP is a theoretical calculation used in finance to estimate the expected price of a stock immediately after a rights issue. It takes into account the theoretical value of the subscription rights issued to existing shareholders and adjusts the stock price accordingly.
• TERP helps investors and analysts understand the potential impact of a rights issue on a company’s stock price. It allows them to evaluate whether the rights issue is beneficial or dilutive to existing shareholders.
• TERP indicates the expected immediate impact on the stock price once the rights issue is executed. If TERP is higher than the current market price, it suggests that the rights issue may be favorable for existing shareholders. Conversely, if TERP is lower, it indicates potential dilution.
• No, TERP is a theoretical calculation and actual market conditions may vary. Factors such as market sentiment, investor perception, and broader economic conditions can influence actual stock price movements post-rights issue.
• Investors can use TERP to assess the fairness of a rights issue and its potential impact on their investment. By comparing TERP with the current market price, investors can make informed decisions on whether to exercise their rights, sell them, or adjust their portfolio accordingly.
• Yes, TERP assumes rational market behavior and perfect information. Actual market reactions to rights issues may vary due to factors that are difficult to predict, such as investor sentiment and market volatility.
• You can either sell your rights in the market or allow them to expire worthless if you choose not to participate in a rights issue. Your ownership stake in the company will be diluted as a result of the issuance of new shares to other shareholders who do participate.
• Participating in a rights issue allows shareholders to maintain their proportional ownership in the company, potentially acquire additional shares at a discounted price, and support the company’s growth initiatives.
• Risks associated with rights issues include dilution of ownership for existing shareholders who do not participate, potential undersubscription leading to insufficient capital raised, and negative market reactions that could impact the company’s stock price and investor sentiment.