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Theoretical Ex-Rights Price (TERP)

Definition

Theoretical Ex-Rights Price (TERP) refers to the estimated future price of a stock when a company offers a rights issue, which allows existing shareholders to buy additional shares at discounted prices. It’s a formula used to calculate the probable new share price post the rights issue. The calculation considers the current stock price, the price of the new rights, and the ratio of existing stock to new rights.

Phonetic

The phonetics of the keyword “Theoretical Ex-Rights Price (TERP)” would be:Theoretical: [thee-uh-reh-ti-kal]Ex-Rights: [eks-rahyts]Price: [prahys]TERP: [t-er-p]

Key Takeaways

  1. Calculation of Ownership Value: TERP or Theoretical Ex-Rights Price is a formula used in financial valuation to calculate the theoretical price at which a shareholder can purchase a company’s shares immediately following a rights issue. This calculation maintains a shareholders’ percentage ownership value constant following the rights offering.
  2. Price Dilution: TERP is used to forecast price dilution associated with a new equity issuance, such as a rights offering, helping shareholders determine whether or not to subscribe to the rights offer. If the subscription price is below the TERP, existing shareholders might be incentivized to subscribe to the new offering to prevent dilution of their holdings.
  3. Investment Decision Tool: Apart from indicating possible dilution, TERP can also act as an investment decision tool. It can help investors compare the subscription price with the TERP, thereby assisting them in deciding whether to sell their rights on the open market, exercise their rights to buy additional shares, or let their current rights expire.

Importance

The Theoretical Ex-Rights Price (TERP) is a crucial concept in business and finance as it offers a theoretical fair value of a company’s stocks after a rights issue, which can help investors make more informed decisions. It’s calculated by taking into account the market price of the stock, the price of the rights issue, as well as the ratio of the rights issue. Significantly, understanding TERP allows investors to evaluate the true value of their stocks post rights issue and the impact of a rights issue on the company’s share price. Hence, it plays an essential role in investment decision-making and in preventing potential financial loss.

Explanation

Theoretical Ex-Rights Price (TERP) is a pricing concept extensively used in the area of corporate finance, particularly relating to equity market transactions. Essentially, TERP is a tool that investors and analysts utilize to estimate the price behavior of a stock after a rights issuance. The primary purpose of calculating the TERP is to give investors an idea of what the new share price might be once the rights offering is complete, thereby aiding them in making more informed investment decisions.In terms of its application, TERP is quite significant during rights offerings, which is when companies offer additional shares of stock to existing shareholders, usually at a discounted price, in an effort to raise additional capital. By calculating the TERP, investors can ascertain the theoretical value of their shares post-rights offering, even before they decide to exercise their rights or not. The TERP calculation takes into account the number of outstanding shares, number of rights required to purchase a new share, subscription price (price at which the new shares are being offered), and the market price of the stock prior to the rights offer. As such, understanding TERP can help investors measure the potential dilution impact and make a more informed decision on their participation in the rights offering.

Examples

1. **Case of Google**: In 2015, Google announced a stock split making each share of class A and class B stock become 3 shares. Under the Theoretical Ex-Rights Price (TERP), investors would’ve estimated the cost of the new shares by using the total market capitalization of Google divided by the new total amount of outstanding shares.2. **Example from a small European firm**: Let’s consider a small European firm that decided to issue rights to its existing shareholders at a discount of 40%. After the rights issue, considering the ratio of the rights to old shares, and adjusting for the market price or rights issue price, investors used the TERP formula to determine what the share price would theoretically be after the rights issue.3. **British telecom firm BT’s Rights Issue**: In 2001, BT, the giant telecom company in the UK, issued rights to its existing shareholders as a part of their fundraising strategy to cover debt. The company issued 3 new shares for every 10 existing shares at a discount of roughly 47% of the original share price. Investors, using TERP, would have calculated the speculated share price considering the subscription price and the existing shares’ market price.

Frequently Asked Questions(FAQ)

What is Theoretical Ex-Rights Price (TERP)?

The Theoretical Ex-Rights Price (TERP) is a financial term that refers to a calculation of the theoretical price of a share of stock after a company has issued new shares. This helps to estimate the effect of a new issuance on a company’s stock price.

How is TERP calculated?

The Theoretical Ex-Rights Price is calculated by adding the market value of all shares existing before the additional issue and the total funder (subscription price multiplied by the number of new shares) and then dividing by the total number of shares after the issuance (existing shares plus new shares).

Why is TERP important?

TERP is important because it provides shareholders and potential investors an idea of what the stock price might look like after an additional share issuance. It helps to evaluate the cost of buying shares directly or via rights issued.

How does a new share issuance affect the stock price?

A new share issuance generally dilutes the value of existing shares, which can lead to a temporary decrease in the stock price. TERP helps gauge this potential price change.

How reliable is TERP as a forecasting tool?

The Theoretical Ex-Rights Price is purely a theoretical calculation. While it can help anticipate how the stock price might be impacted by new share issuance, it doesn’t account for outside market factors or investor sentiment. Thus, it’s a useful tool but may not always accurately predict actual market outcomes.

Does TERP affect the decision of shareholders to participate in the new issuance?

Yes, if the TERP is lower than the existing stock price, it might be advantageous for shareholders to purchase new shares through the rights issue instead of purchasing shares in the open market.

What does ‘ex-rights’ mean in the Terp?

‘Ex-rights’ refers to a stock that is currently trading, but without the additional benefit of a forthcoming rights offering. Essentially, anyone who buys an ‘ex-rights’ share does not have any rights to the new share issuance.

Related Finance Terms

  • Rights Issue: This refers to the issue of additional shares by a company to its existing shareholders, often at a discounted price to encourage participation.
  • Share Dilution: This is a reduction in the ownership percentage of a company or shares due to the issuance of new shares such as in a rights issue.
  • Market Price: The current price at which a stock or other asset is bought or sold in the marketplace.
  • Subscription Rights: These are the rights of existing shareholders to purchase additional shares in a company before they are offered to the public, often at a discount, during a rights issue.
  • Weighted Average: An average where each observation or data point carries a different level of importance. It is commonly used in the calculation of the Theoretical Ex-Rights Price (TERP).

Sources for More Information

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