Rights Issue: TERP, Dilution and Why Not a Placement

Step 1: Number of New Shares Issued

New Shares = Existing Shares x (1 / 4)

New Shares = 200.0m x 0.25 = 50.0m new shares

The ratio is the single most visible feature of a rights issue and it is what fixes the scale of the dilution before any price is even quoted. A 1-for-4 issue enlarges the share count by 25%, meaning existing holders drop from 100% to 80% of the company unless they take up their rights. Post-issue share count is therefore 200.0m + 50.0m = 250.0m shares.

Step 2: Gross and Net Proceeds

Gross Proceeds = New Shares x Subscription Price

Using 50.0m new shares at a subscription price of EUR 20.00:

Gross Proceeds = 50.0m x EUR 20.00 = EUR 1,000.0m

Net Proceeds = Gross Proceeds x (1 - Fee Rate) = EUR 1,000.0m x (1 - 0.02) = EUR 980.0m

Gross proceeds are what the equity story is built on, but net proceeds are what actually reaches the balance sheet and repays debt. Underwriting fees on a rights issue typically run 1.5% to 3.0% of gross proceeds because the banks commit to buying any shares shareholders do not take up, and that underwriting commitment is exactly what makes the proceeds certain enough to promise to lenders.

Step 3: Theoretical Ex-Rights Price (TERP)

TERP = [(Existing Shares x Cum-Rights Price) + (New Shares x Subscription Price)] / (Existing Shares + New Shares)

Where: Cum-Rights Price = the last traded price while the shares still carry the right to subscribe; Subscription Price = the discounted price at which new shares are offered.

Using 200.0m shares at EUR 25.00 and 50.0m new shares at EUR 20.00:

TERP = [(200.0m x EUR 25.00) + (50.0m x EUR 20.00)] / 250.0m

TERP = (EUR 5,000.0m + EUR 1,000.0m) / 250.0m = EUR 6,000.0m / 250.0m = EUR 24.00

TERP is the weighted average price at which the shares should theoretically open once the rights detach. It is not a loss to shareholders: the market capitalisation rises from EUR 5,000.0m to EUR 6,000.0m because EUR 1,000.0m of cash entered the company, and the lower per-share price simply reflects that value now spread over more shares. TERP matters in practice because it becomes the reference price for every subsequent statement about the deal, for index adjustment factors, and for the historical price series, which is retrospectively restated by a TERP adjustment factor of 24.00 / 25.00 = 0.96.

Step 4: Value of One Right

Value of One Right = Cum-Rights Price - TERP

Value of One Right = EUR 25.00 - EUR 24.00 = EUR 1.00 per existing share

Cross-check via the new share: Value per New Share Subscribed = TERP - Subscription Price = EUR 24.00 - EUR 20.00 = EUR 4.00. Because four rights are needed to subscribe for one new share, EUR 4.00 / 4 = EUR 1.00 per right, which confirms the first calculation.

This number is the whole economic point of the pre-emptive structure. A shareholder who does not want to put in more money is not simply diluted and left worse off: the rights are separately tradable during the subscription period, so they can sell them for roughly EUR 1.00 per share and be compensated in cash for the value transferred to subscribers. Interviewers frequently test this by asking whether a rights issue "destroys value" for a non-participating holder, and the correct answer is that in theory it does not, provided the holder sells the rights rather than letting them lapse.

Step 5: Discount to TERP

Discount to TERP = (TERP - Subscription Price) / TERP

Discount to TERP = (EUR 24.00 - EUR 20.00) / EUR 24.00 = EUR 4.00 / EUR 24.00 = 16.7%

Discount to Cum-Rights Price = (EUR 25.00 - EUR 20.00) / EUR 25.00 = EUR 5.00 / EUR 25.00 = 20.0%

The market convention is to quote the discount to TERP, not to the cum-rights price, because TERP is the price the shares are expected to trade at once the offer is live and it therefore measures the genuine incentive to subscribe. Getting this reference point wrong is the single most common error in the question: quoting 20.0% overstates the concession the company made. The size of the discount is a deliberate choice, not a valuation judgment. A deeper discount raises the probability that the shares stay above the subscription price throughout the offer period, which is what makes the issue succeed and limits the underwriters' risk.

Step 6: Post-Issue EPS and Dilution

Pre-Issue EPS = Net Income / Existing Shares = EUR 300.0m / 200.0m = EUR 1.50

Interest Saved After Tax = Net Proceeds x Interest Rate x (1 - Tax Rate)

Using net proceeds of EUR 980.0m, an interest rate of 5.0% (0.05) and a tax rate of 25% (0.25):

Interest Saved After Tax = EUR 980.0m x 0.05 x 0.75 = EUR 49.0m x 0.75 = EUR 36.8m

Post-Issue Net Income = EUR 300.0m + EUR 36.8m = EUR 336.8m

Post-Issue EPS = EUR 336.8m / 250.0m = EUR 1.35

EPS Dilution = (EUR 1.35 - EUR 1.50) / EUR 1.50 = -10.2%

The share count rises 25% while net income rises only 12.3%, so EPS falls. This is the standard tension in any equity raise used to repay debt: the after-tax cost of the debt being retired (5.0% x 0.75 = 3.75%) is far below the earnings yield the new equity has to carry, so the transaction is EPS dilutive even though it makes the balance sheet safer. A well-prepared candidate does not stop at the negative number but points out that dilution measured on EPS alone ignores the lower financial risk, the reduced probability of a covenant breach and the lower cost of equity that should follow deleveraging.

Step 7: Could a Placement Have Done the Job?

Maximum Placement Shares = Existing Shares x Non-Pre-Emptive Authority

Maximum Placement Shares = 200.0m x 0.10 = 20.0m shares

Placement Price = Cum-Rights Price x (1 - Placement Discount) = EUR 25.00 x (1 - 0.05) = EUR 23.75

Maximum Placement Proceeds = 20.0m x EUR 23.75 = EUR 475.0m

Against the EUR 1,000.0m of gross proceeds required, a placement executed under the existing authority falls short by EUR 525.0m, so it is not a viable alternative without convening a shareholder meeting to disapply pre-emption rights, which costs weeks and removes the speed advantage that is the only real reason to choose a placement. There is a second, more fundamental reason: a placement issues shares to new investors at a discount with no compensating instrument for existing holders, so their dilution is economic and permanent, whereas the EUR 1.00 right calculated in Step 4 makes the rights issue value-neutral for a shareholder who sells rather than subscribes. That is why large, dilutive raises in Europe are almost always structured as pre-emptive rights issues, while placements and accelerated bookbuilds are reserved for small, opportunistic top-ups of roughly 5% to 10% of share capital.

Final Results

• New shares issued: 50.0m (post-issue share count 250.0m)
• Gross proceeds: EUR 1,000.0m (net proceeds EUR 980.0m)
• Theoretical ex-rights price (TERP): EUR 24.00
• Value of one right: EUR 1.00 per existing share
• Discount to TERP: 16.7%
• Post-issue EPS: EUR 1.35, i.e. -10.2% dilution
• Maximum placement proceeds under existing authority: EUR 475.0m versus EUR 1,000.0m required

TERP feeds directly into the next stage of the analysis: it is the reference price used to restate historical share prices and valuation multiples, to set the index adjustment factor, and to judge whether the shares are trading above the subscription price during the offer period, which is what ultimately determines whether the underwriters are left holding stock.

Would you like to explore further variations, such as how the answer changes if the issue is only partially underwritten, or how a deeply discounted 2-for-1 rescue rights issue at a 40% discount to TERP would reshape both the right value and the dilution?