What it means
When a company needs to raise money, it sometimes offers existing shareholders the chance to buy additional shares at a discount, which is known as a rights issue. Because the company is creating more shares and selling them below the current market value, the overall value of the business gets spread more thinly.
The theoretical ex-rights price tells us what a single share should be worth on paper once the new shares are added to the total count. Why does this matter for managers and business owners?
It helps everyone understand the dilution that happens during a capital raise. Existing shareholders will see the market value of their current shares drop because the pie is now cut into more pieces, but they also gain the opportunity to buy cheap new shares.
Calculating this price beforehand helps investors decide whether to exercise their rights, sell them to someone else, or ignore them entirely. In practice, the actual market price on the day the rights take effect often differs slightly from the theoretical price.
Market sentiment, overall economic conditions and investor demand can push it up or down, but the theoretical price remains the baseline for brokers, investors and company directors to price the new shares fairly and manage expectations. Imagine you own four slices of a large pizza worth $10 each.
If you buy a fifth slice for $4, the total value becomes $44 across five slices, or $8.80 each, so your average slice value drops, just like a share price after a rights issue.
In practice
Real-world examples
Example 1
TechStart Inc. offers existing investors one new share at $2 for every four held, when the current share price is $10. TERP = (4 x $10 + 1 x $2) / 5 = $42 / 5 = $8.40. The share price is expected to fall from $10 to about $8.40 once the rights are detached.
Example 2
Local Bakery Ltd needs funds for a new oven and offers shareholders one discounted share at $0.50 for every two held, when the current market price is $2. TERP = (2 x $2 + 1 x $0.50) / 3 = $4.50 / 3 = $1.50. The theoretical price helps investors assess the deal before they decide.
Example 3
A mid-sized logistics firm with a share price of $20 issues rights to buy one share at $15 for every five owned. TERP = (5 x $20 + 1 x $15) / 6 = $115 / 6 = $19.17. The small fall from $20 reflects that only one in six shares is being sold at a discount.
Think of it
Imagine you own four slices of a large pizza worth 10 pounds each. If you buy a fifth slice at a heavy discount, the total value of the pizza increases, but you now have five slices. Your average slice value drops, just like a share price after a rights issue.
Formula
Calculation
TERP = (Current Market Value of Existing Shares + Total Money Raised from New Shares) / Total Number of Shares After the Issue
Worked example: a company has 1,000 shares at $10 each, worth $10,000. It issues 500 new shares at $4 each, raising $2,000. The total value is $12,000 for 1,500 shares, so TERP = $12,000 / 1,500 = $8 per share.
The same method works for a ratio offer. If you hold 1,000 shares and are offered one new share at $4 for every two held, you can buy 500 shares for $2,000. Before the issue you held $10,000 of shares; after taking up the rights you hold 1,500 shares x $8 = $12,000, having paid $2,000, so your wealth is unchanged at $10,000.Case study
Seen in the real world
GreenTransit Ltd, a fictional urban delivery fleet, needed $500,000 to upgrade its electric vans. Before the announcement, the company had 1,000,000 shares trading at $2.00 each, giving a market capitalisation of $2,000,000. GreenTransit offered shareholders the chance to buy one new share for every two currently held at a discounted price of $1.00 each. This meant issuing 500,000 new shares to raise the required $500,000.
To find the theoretical ex-rights price, financial managers combined the existing value of $2,000,000 with the new cash injection of $500,000, resulting in a total value of $2,500,000. They then divided this by the new total share count of 1,500,000 shares. The resulting theoretical ex-rights price was $1.67 per share. This illustrative case shows the share price dropping from $2.00 to $1.67, a fall of about 16.7%, while the company secures the funds needed for expansion without taking on bank debt.
Consider an investor holding 1,000 shares worth $2,000. If she takes up her rights, she pays $500 for 500 new shares and owns 1,500 shares worth $2,500 at the theoretical price, so she is no worse off. If she ignores them, her 1,000 shares are worth about $1,667, a loss of about $333, unless she sells her rights in the market.
Watch out
Common mistakes
- Assuming the actual market price will match the theoretical ex-rights price exactly on the day of trading.
- Forgetting to include the money raised from the new shares in the numerator of the calculation.
- Believing that share dilution from a rights issue automatically means the company is losing fundamental value.
Questions
People also ask
Why does the share price drop when a rights issue happens?
The share price drops because the company is issuing more shares and diluting ownership. The total value of the company is spread across a larger number of shares.
Is the theoretical ex-rights price guaranteed in the stock market?
No. It is a mathematical calculation based on existing prices. Actual market trading is influenced by buyer demand, company news, and market sentiment.
What happens if an investor chooses not to take up their rights?
If they ignore their rights, the value of their existing shares usually drops to the theoretical ex-rights price, resulting in a loss of wealth unless they sell their rights in the market.