Case Report for Midland Energy Resources, Inc: Cost of Capital
1. For what purposes does Mortensen estimate Midland's cost of capital? What would be the potential consequences of a too high estimate compared to the firm's “true” cost of capital? What about a too low estimate?
The purpose is that the cost capital will be used for capital budgeting, financial accounting, performance assessment, stock repurchases estimations. Also the cost of capital is a necessary basis for the expected growth and forecasted demand.
The too high estimated cost of capital means that Midland may miss out on investment opportunities and will under value the investment at hand. Furthermore, it is possible for shareholders to see a lower return on their investment. On the other hand, a too low estimated cost of capital means that Midland may engage in an investment that is potentially “bad” and will be overvalued. Shareholders will see over inflated returns.
2. Calculate Midland’s firm-wide WACC. Make sure you explain clearly your method and your choice of inputs. In particular, is Midland’s choice of market risk premium appropriate, and if not, what recommendations would you make and why?
Based on our calculations, the Midland’s firm-wide WACC we have got is 8.48%.First, we choose the rate of 30-year U.S. Treasury bonds in 2007 (4.98%) as the risk free rate we use in the 2007 WACC calculations. The reason is that majority of large firms and financial analysts report using long-term yields for bonds to determine the risk-free rate. Second, we begin to calculate the cost of debt, which is determined by adding the spread to Treasury of A+ to the rate of 30-year treasury bonds in 2007. That is, 4.98%+1.62%=6.60%, which is the cost of debt . Third, the cost of equity is next. The EMRP (5%) was taken out of the context of the case. The tax rate (39.73%) was from the average of amount of taxes paid between year 2004 to year 2006. We also need to calculate the unlevered beta through the formula, βu=(E/E+D)*βe+(D/E+D)*βd. βd=0 Because we cannot find the
The purpose is that the cost capital will be used for capital budgeting, financial accounting, performance assessment, stock repurchases estimations. Also the cost of capital is a necessary basis for the expected growth and forecasted demand.
The too high estimated cost of capital means that Midland may miss out on investment opportunities and will under value the investment at hand. Furthermore, it is possible for shareholders to see a lower return on their investment. On the other hand, a too low estimated cost of capital means that Midland may engage in an investment that is potentially “bad” and will be overvalued. Shareholders will see over inflated returns.
2. Calculate Midland’s firm-wide WACC. Make sure you explain clearly your method and your choice of inputs. In particular, is Midland’s choice of market risk premium appropriate, and if not, what recommendations would you make and why?
Based on our calculations, the Midland’s firm-wide WACC we have got is 8.48%.First, we choose the rate of 30-year U.S. Treasury bonds in 2007 (4.98%) as the risk free rate we use in the 2007 WACC calculations. The reason is that majority of large firms and financial analysts report using long-term yields for bonds to determine the risk-free rate. Second, we begin to calculate the cost of debt, which is determined by adding the spread to Treasury of A+ to the rate of 30-year treasury bonds in 2007. That is, 4.98%+1.62%=6.60%, which is the cost of debt . Third, the cost of equity is next. The EMRP (5%) was taken out of the context of the case. The tax rate (39.73%) was from the average of amount of taxes paid between year 2004 to year 2006. We also need to calculate the unlevered beta through the formula, βu=(E/E+D)*βe+(D/E+D)*βd. βd=0 Because we cannot find the