How are Mortensen’s estimates of Midland’s costs of capital used? How, if at all, should these anticipated uses affect the calculations?
The cost of capital is the minimum acceptable rate of return for new investments in the corporation. Estimates of Midland’s cost of capital are used in many analysis within Midland, including asset appraisal for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. These estimates are used at the divison or the business unit level and also on the corporate level. When asses the cost of capital on different levels of business, managers must invest in new ventures that have an expected rate of return higher than the cost of capital. Different investments on different levels of business have different levels of risk, therefore, the cost of capital has to be a pertinent return for that particular division.
Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations. Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why?
The appropriate EMRP to use in the 2007 WACC calculation is 6.0% as listed in Table 2. Team 1 compared this rate to real-world data using the average annual total return on common stocks from Yahoo! Finance and the risk free rate from Exhibit 1.
6.0% is reasonable for the Market Risk Premium in the WACC calculation.
Midland’s Equity Market Value from Exhibit 5 =E= $134,114 million
Midland’s Net Debt from Exhibit 5 = D = $79,508 million
Midland’s Total Market Value = V = E + D = $213,622 million
Weight for the cost of debt = D/V = 0.3722= 37.22%
Weight for the cost of equity = E/V = 0.6278= ^2.78%
The 2006 corporate tax rate for Midland is calculated as 38.58% from taking the ratio of Taxes ($30,447 million) to the Income Before Taxes ($11,747...
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