Question 4

You have recently joined the finance department of Flames plc as a graduate trainee. The Finance Director would like to use the weighted average cost of capital as the discount rate to calculate whether to invest in a new overseas plant. She is comfortable calculating the cost of equity however she is unsure of how to calculate the cost of listed debt finance. You have been provided with the following information and asked to look into this.

The company has issued HK$50,000,000 of bonds (par value HK$1,000) which are redeemable at par in 3 years. These are currently trading at HK$ 1,015. The coupon payable is 8% annually and the tax rate is 25 %

The issued share capital of the company is HK$75,000,000 each with a nominal value of 50 cents. These are currently trading at 98 cents. The Finance Director has calculated the cost of equity to be 9%. 

Required:

a) Calculate Flames’ current after tax cost of debt. 

b) Calculate Flames’ current weighted average cost of capital.

c) Discuss fully how the decision to go ahead with the new project would affect the market value of the company if the capital markets are;

i) Strong form efficient

ii) Semi strong form efficient 

Your answers should consider the assumptions underpinning the efficient market hypothesis.