CIMA F3 Syllabus B. Sources of long term funds - Yield-adjusted TERP - Notes ^{3 / 3}

Yield adjusted ex-rights price

So normally we presume that when we do a rights issue, the money from it generates the same rate of return as existing funds.

But, if the new money raised is likely to earn a different return from to the current return, the yield-adjusted theoretical ex-rights price should be calculated.

The yield-adjusted price demonstrates how the market will view the rights issue.

This formulae is given in the exam:

Legend

• N = number of shares required to buy 1 share

  Cum rights price = the market value before the rights issue is made

Illustration 1 - TERP (simple)

Cow Co. makes a 1 for 5 rights issue, at $2.50 (MV before issue made $3)

This market value just before the issue is known as the cum rights price.

What is the theoretical ex-rights price?

Use the formulae:

Solution:

• So the value per share after the rights issue (TERP) is:

  TERP 
  = 1 / (5 + 1) x [(5 x 3.00) + 2.50]
  = $ 2.92

Illustration 2 - Yield-adjusted TERP

Cow Co. makes a 1 for 5 rights issue, at $2.50 (Cum-rights price $3)

Rate of return on new funds = 15%, and on existing funds = 10%, 

Required
Calculate the yield-adjusted theoretical ex-rights price.

Solution

Cum rights price = 3
N = 5 shares
Issue price = 2.50
Yield on new funds = 15%
Yield on existing funds = 10%

• Yield-adjusted theoretical ex-rights price 
  = 1/(5+1) x [(5 x 3) + 2.50 x 0.15/0.1)]
  = 18.75 / 6
  = $3.13

Illustration 3 - Yield-adjusted TERP

A Cow Co. currently has:

WACC of 10%
Current share price of $2.50

The company announces a 1 for 4 rights issue at a discount of 25% to the current share price to finance a project that has a yield of 14%.

The yield adjusted TERP is:

Solution

Yield-adjusted theoretical ex-rights price 
= 1/(4+1) x [(4 x 2.50) + 1.88 x 0.14/0.1)]
= 12.632 / 5
= $2.53