Question

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:

Calculate Flames’ current after-tax cost of debt, current weighted average cost of capital.      

Answer 1

Solution: For computation of cost of redeemable debt, we use Internal rate of return (IRR) method as follows:

Cash flows PV factor at 5% Pv factor at 10% Time PV PV Interest ($1000*8%*75%) (60.00) 2.723 (163.38) (149.22) 1 to 3 2.487 Market value 1,015.00 1,015.00 1,015.00 3 Redemption value (1,000.00) (864.00) (751.00) 0.864 0.751 $ (12.38) $ 114.78 NPV

After tax cost of debt = L + [ NPV L / (NPV L - NPV H) ] * ( H - L)

= 5 % + [-12.38/ (-$12.38 - 114.78) ] * (10-5)

= 5% + 0.4868

= 5.49 % (rounded off)

Computation of weighted avg. cost of capital :

Book value weight ratio(W) After tax cost(k) Weighted average cost(W*K) $50,000,000 Debt 5.49% 2.20% 0.4 $75,000,000 $125,000,000 Equity 9% 0.6 5.40% Total 7.60%

so, weighted average cost of capital = 7.60%