ABC Plc is planning an expansion of existing business activities. It needs to raise funds for this expansion. One of the managers of Financing division, Bob, stated that WACC should be used in all circumstances.Another manager Ted stated "It is in the management's interest to keep the financial gearing level as low as possible, while it is in the shareholders' interests to keep it at a high level. The team have decided to calculate its weighted average cost of capital in preparation of this. ABC plc has the following capital structure:

mm

Equity

Ordinary shares250

Reserves650

900

Non-current liabilities

Loan notes200

1,100

The ordinary shares of ABC plc have a nominal value of 50 pence per share and are currently trading on the stock market on an ex dividend basis at 5.97. ABC plc has an equity beta of 1.15.

The loan notes have a nominal value of 100 and are currently trading on the stock market on an ex-interest basis at 105.50 per loan note. The interest on the loan notes is 7% per year before tax and they will be redeemed in six years' time at a 7% premium to their nominal value.

The risk-free rate of return is 4% per year and the equity risk premium is 6% per year. ABC plc pays corporation tax at an annual rate of 25% per year.

a)Critically assess Manager Bob's comment.

b)Comment on any difference between the market value weighted average cost of capital and the book value weighted average cost of capital of ABC plc, all calculation to support your comment should be included in the appendix.

c)Critical discussion of the impact of capital structure on cost of capital and firm value considering manager Ted's comment.