Midlend Energy Res Case Study (Wacc)
1) Why are we computing the Cost of Capital? Why is it important?
A “Firm” will want to know the overall or average required rate of return on its aggregate investments. The Cost of capital allows us to set a benchmark that new projects need to meet in order to be viable. In the case of a “Project” it is a way to calculate the minimum required rate of return for an investment depending on its riskiness of its cash flow therefore it is a way to; a) Evaluate the Investment Decision
b) Decide on a debt policy
c) Appraise the performance of top managers
2) Compute the corporate WACC. Be sure to state all your assumptions to get the various inputs to the WACC.
r_e=r_f+ β(EMRP)
WACC= r_e (E/V)+ r_d (D/V)(1-t)
E=Midland’s Equity Market Value
D=Midland’s Net Debt
(E/V)= Weight for the cost of equity
(D/V)= Weight for the cost of
V (E+D)= Midland’s total Market Value r_e =Equity cost of capital r_f =risk-free rate r_d= Cost of Debt. t= tax rate of the company
The inputs for the computation are derived from the case.
r_f = 4.66%
The appropriate risk-free rate is 4.66% which is the rate of 10-year U.S. Treasury bonds in 2007 as specified in Table 2. The US Treasury bill was a good benchmark We needed to use a rate that provided non default risk and no re-investment risk and. Our horizon was long thus and the 10-year Bond rate was determined best to use as the majority of large firms and financial analysts report using long-term yields for bonds to determine the risk-free rate .
EMRP= 5.1%
We considered 3 alternatives in determining this EMRP. First option was the data provided by surveys, but it can be misleading as it portrays what people think based on past information. The results of the survey than then lead to results being ‘reactive’ to what is happening today, disjointed from reality and can represent what people hope the risk premium would be. The second method to determine the EMRP was to look at
A “Firm” will want to know the overall or average required rate of return on its aggregate investments. The Cost of capital allows us to set a benchmark that new projects need to meet in order to be viable. In the case of a “Project” it is a way to calculate the minimum required rate of return for an investment depending on its riskiness of its cash flow therefore it is a way to; a) Evaluate the Investment Decision
b) Decide on a debt policy
c) Appraise the performance of top managers
2) Compute the corporate WACC. Be sure to state all your assumptions to get the various inputs to the WACC.
r_e=r_f+ β(EMRP)
WACC= r_e (E/V)+ r_d (D/V)(1-t)
E=Midland’s Equity Market Value
D=Midland’s Net Debt
(E/V)= Weight for the cost of equity
(D/V)= Weight for the cost of
V (E+D)= Midland’s total Market Value r_e =Equity cost of capital r_f =risk-free rate r_d= Cost of Debt. t= tax rate of the company
The inputs for the computation are derived from the case.
r_f = 4.66%
The appropriate risk-free rate is 4.66% which is the rate of 10-year U.S. Treasury bonds in 2007 as specified in Table 2. The US Treasury bill was a good benchmark We needed to use a rate that provided non default risk and no re-investment risk and. Our horizon was long thus and the 10-year Bond rate was determined best to use as the majority of large firms and financial analysts report using long-term yields for bonds to determine the risk-free rate .
EMRP= 5.1%
We considered 3 alternatives in determining this EMRP. First option was the data provided by surveys, but it can be misleading as it portrays what people think based on past information. The results of the survey than then lead to results being ‘reactive’ to what is happening today, disjointed from reality and can represent what people hope the risk premium would be. The second method to determine the EMRP was to look at