Calculating the Theoretical Value of Subscription Rights: A Comprehensive Guide
The theoretical value of a subscription right is the specific value assigned during the period when a rights offering is announced, and it remains effective until three days before the subscription rights expire. To calculate this value, investors need to know the subscription price and the number of rights required to purchase one share of stock.
The formula used to calculate the theoretical value is simple:
1(Stock Price - Rights subscription price per share) / (Number of rights required to buy one share + 1)
Key Insights on Theoretical Value
- The theoretical value of a right can be calculated during the cum rights period.
- Investors with subscription rights are offered shares usually at a discount to the current market price.
- Both the subscription price and the number of rights required to purchase a share are disclosed to investors.
- With this information, the theoretical price can be calculated.
Understanding Theoretical and Market Value of Rights
The theoretical value of a subscription right often matches closely with its market value, commonly known as the intrinsic value. Since stock prices with attached rights may differ from standard shares, investors need to understand this theoretical value.
Real-World Calculation Example
Consider a stock priced at $40, with a subscription price of $35 and four rights required to purchase a share. The theoretical value of the right is calculated as follows:
1($40 - $35) / (4 + 1) = $1
During the exercise of rights period—around three days before expiration—the calculation differs slightly. Suppose the stock price is $38 during this period; the theoretical value would be:
1($38 - $35) / 4 = $0.75
Shorter Lifespan of Rights Compared to Options
A right’s value is determined using principles similar to those used for pricing options, considering factors like the rights subscription price, prevailing interest rates, time to expiration, and the underlying stock’s price and volatility. The key difference, however, is that rights typically have a much shorter lifespan, resulting in significantly less time value compared to options.
Theoretical Nil Paid Price
When an investor sells the right outright in the market or lets it lapse, they receive what is known as the theoretical nil paid price. This value is derived by finding the difference between the subscription price paid by the investor and the theoretical ex-right price.
For the previously mentioned example, the theoretical nil paid price is calculated as follows:
1$40 - $38 = $2
Hence, the investor stands to receive an amount twice the value of the right during the cum rights period and considerably higher than the value during the ex-rights period.
Related Terms: cum rights, intrinsic value, market value, exercise price, volatility, time value, nil paid price.
