Advanced Financial Management · Financing acquisitions and mergers

Cash Offers and Funding via Debt or Rights Issue in ACCA AFM

Updated 11 October 2026 · Fact-checked

A cash offer is paid for with new debt, a rights issue or internal cash. Debt raises gearing and financial risk. A rights issue keeps gearing lower but moves the share price to the theoretical ex-rights price. To solve it, find the cash needed, size the funding, then recompute TERP, gearing and WACC.

Understand Cash Offers and Funding via Debt or Rights Issue

A cash offer means the bidder pays target shareholders in cash, not in its own shares. The bidder must find that cash. There are three sources: internal funds (surplus cash or asset sales), new debt (bank loans or bonds) and a rights issue (new shares offered to existing shareholders first).

Cash offers have a clear advantage. Target shareholders get certain value, and the bidder's existing shareholders keep control and take all the synergy gains. The cost is that the funding must be raised, and each source changes the bidder's risk.

Debt is usually cheaper than equity, and interest is tax deductible. But it raises gearing and interest payments. More financial risk pushes up the cost of equity because shareholders face more volatile earnings. Too much debt can also raise the cost of debt, trigger covenant breaches or hit debt capacity.

A rights issue is priced below the current share price, so existing shareholders are offered a discount. The share price falls to the theoretical ex-rights price (TERP), a weighted average of old shares at market price and new shares at the issue price. Shareholders are not worse off if they take up the rights or sell them. The rights issue lowers gearing compared with debt, but it costs issue fees and may signal that management has no cheaper source.

In AFM you compare the options on gearing, interest cover, EPS, cost of capital and WACC. Then you recommend one, using the scenario. WACC is calculated with market value weights, so a change in funding changes the weights, the cost of equity and sometimes the cost of debt.

Key rules to remember

Number of new shares needed: New shares = (Cash required + issue costs) ÷ issue price; Add issue costs to the cash required if the question says the issue costs are paid from proceeds.
Theoretical ex-rights price (TERP): TERP = [(N × cum-rights price) + (n × issue price)] ÷ (N + n); N is existing shares and n is new shares. Assumes no other information reaches the market.
Value of a right: Per new share = TERP − issue price; per existing share = (TERP − issue price) × n ÷ N; Use the per-existing-share figure when comparing against the shareholder's current holding.
After-tax cost of debt (approximate): Kd (1 − t) = pre-tax interest rate × (1 − tax rate); For an irredeemable bond. For redeemable debt use the IRR of the after-tax cash flows.
WACC: WACC = Ke × E ÷ (E + D) + Kd (1 − t) × D ÷ (E + D); Use market values of equity and debt, after the funding is raised.
Modigliani-Miller cost of equity (with tax): Ke(geared) = Ke(ungeared) + [Ke(ungeared) − Kd] × (1 − t) × D ÷ E; Use only when the question gives the ungeared cost of equity and assumes risk-free debt. Kd here is pre-tax.
Gearing measures: Debt ÷ equity, or debt ÷ (debt + equity); Use the measure the question defines, and be consistent. Market or book values should match the data given.
Interest cover: Interest cover = profit before interest and tax ÷ interest; Recalculate with the new interest from acquisition debt and the target's earnings.

How to solve Cash Offers and Funding via Debt or Rights Issue questions

Use this order for any question on funding a cash bid. It keeps your working structured and earns both technical and application marks.

1Work out the total cash required: offer price × target shares, plus fees and any target debt to be repaid. Note any internal cash that is available.
2Find the external funding gap after internal funds. State your assumption on whether the issue costs reduce the proceeds.
3For a rights issue, calculate the new shares (gap ÷ issue price), the ratio of new to old shares, and then the TERP.
4For debt, calculate the new annual interest, the after-tax cost, and the new debt balance.
5Recalculate the capital structure at market values: total debt, total equity and the gearing ratio before and after.
6Update the cost of equity if the data allow, using the given beta, the M&M formula or the figure in the question. Then recalculate WACC with new weights.
7Compare the options on gearing, interest cover, EPS, WACC, control and cost. Include the target's earnings and synergies if they are given.
8Recommend one option and tie it to the scenario: debt capacity, covenants, shareholder appetite, market conditions, and the risk of a failed rights issue.

Quickest way: Fast funding comparison

When to use it: Use this when time is short and the question asks you to compare debt with a rights issue on gearing and WACC.

Write the cash gap first and box it.
Rights issue: new shares = gap ÷ issue price, then TERP in one line.
Debt: new interest = gap × rate. After-tax cost = interest × (1 − t).
Build a small before and after table in your answer: debt, equity, gearing, WACC.
Take Ke from the question. Only change it if told how, such as a new beta or the M&M formula.
Finish with two lines of recommendation that refer to the scenario.

Common mistakes in Cash Offers and Funding via Debt or Rights Issue

Using the issue price instead of the cum-rights price when computing TERP for the existing shares.
Students mix up which price applies to which group of shares.
Fix: Existing shares go in at the current market price. Only the new shares go in at the issue price.
Using book values of equity in WACC.
The balance sheet is the first data source students see.
Fix: Use market values of equity and debt unless the question says otherwise. State your assumption.
Leaving the cost of equity unchanged after raising a large amount of debt.
Students focus on the cheaper cost of debt and forget the extra financial risk.
Fix: Show that Ke rises with gearing, using the data given, then recompute WACC. Comment that cheaper debt is partly offset by costlier equity.
Forgetting tax relief on interest, or applying it to the equity cost.
Tax is added late or in the wrong place.
Fix: Multiply only the debt cost by (1 − t). Dividends and Ke get no tax adjustment.
Ignoring issue costs or treating them as a separate cash need without saying so.
The question mentions fees briefly and students skip them.
Fix: State clearly whether the gap is grossed up for costs, then use that number to size the new shares or debt.
Giving a numbers-only answer with no recommendation.
Students run out of time or think calculation is the whole task.
Fix: Allow time for a short advice paragraph. Professional skills marks reward judgement based on the scenario.

Worked examples

Example 1

Alpha plc has 10 million shares in issue at a market price of $5.00. It needs $12 million to pay cash for a target and will fund it with a rights issue at $4.00 per share. Ignore issue costs. Calculate the rights ratio, the theoretical ex-rights price and the value of a right per existing share.

Show the solution

New shares needed = $12m ÷ $4.00 = 3 million.
Rights ratio = 3 million new to 10 million existing = 3 new shares for every 10 held.
TERP = [(10m × $5.00) + (3m × $4.00)] ÷ 13m = ($50m + $12m) ÷ 13m = $62m ÷ 13m = $4.77 (rounded).
Value of a right per new share = $4.769 − $4.00 = $0.769.
Value of a right per existing share = $0.769 × 3 ÷ 10 = $0.23 (rounded).

Answer: 3 for 10 rights issue; TERP is about $4.77; each right is worth about $0.77 per new share, or about $0.23 per existing share.

Example 2

Beta plc has equity at market value of $400 million and debt of $100 million. Its cost of equity is 12%, pre-tax cost of debt is 6% and the tax rate is 25%. It borrows a further $100 million at 7% pre-tax to pay cash for a target. Assume no change in the equity value and that the cost of equity rises to 13.5% after the deal. Calculate gearing and WACC before and after.

Show the solution

Before: debt ÷ equity = 100 ÷ 400 = 25%. Debt ÷ (debt + equity) = 100 ÷ 500 = 20%.
Before: after-tax Kd = 6% × 0.75 = 4.5%. Weights are E = 80% and D = 20%.
Before: WACC = (0.8 × 12%) + (0.2 × 4.5%) = 9.6% + 0.9% = 10.5%.
After: debt = $200m and equity = $400m. Debt ÷ equity = 200 ÷ 400 = 50%. Debt ÷ (debt + equity) = 200 ÷ 600 = 33.3%.
After: new debt after-tax cost = 7% × 0.75 = 5.25%. Blended after-tax Kd = (100 × 4.5% + 100 × 5.25%) ÷ 200 = 4.875%.
After: weights are E = 400 ÷ 600 = 2/3 and D = 1/3.
After: WACC = (2/3 × 13.5%) + (1/3 × 4.875%) = 9.0% + 1.625% = 10.625%, about 10.63%.
Comment: gearing doubles on a debt ÷ equity basis. With these inputs the rise in Ke outweighs the cheaper debt weight, so WACC rises slightly. Check covenants and interest cover.

Answer: Debt ÷ equity rises from 25% to 50%. WACC moves from 10.5% to about 10.63% on the given cost of equity.

Exam tips

Read for the funding instruction. If the question says to ignore issue costs or to use market values, follow it and say so.
Set out TERP as a single clean line. Markers award method marks even if the arithmetic slips.
When comparing sources, always cover gearing, interest cover, cost and control. Add one point from the scenario, such as covenants or a weak share price.
Do not state that debt always lowers WACC. Say that it does under the stated assumptions, and that financial risk raises Ke.
Leave time for the recommendation. It carries professional skills marks for commercial judgement and clear communication.

Practice questions from Financing acquisitions and mergers

Cash Offers and Funding via Debt or Rights Issue: frequently asked questions

How do I calculate the theoretical ex-rights price for acquisition funding?

Multiply existing shares by the current share price. Add the new shares multiplied by the issue price. Divide the total by the combined number of shares. This gives the expected price after the rights issue, assuming no other news.

Does debt financing always reduce WACC after an acquisition?

No. Debt has a lower after-tax cost, so a modest amount can reduce WACC. But more gearing raises the cost of equity and may raise the cost of debt. The net result depends on the figures given, so calculate it rather than assume it.

Is a rights issue better than debt for a cash bid?

It depends. A rights issue keeps gearing and interest commitments lower, but it costs fees and can fail if the market is weak. Debt is cheaper and keeps control with existing shareholders, but it raises financial risk and may breach covenants.

Are shareholders worse off after a rights issue at a discount?

Not by the discount itself. The price falls to TERP, but each shareholder holds rights with value. If they take up the rights or sell them, their wealth is unchanged, ignoring costs. Shareholders who do nothing lose value.