Mainland Energy Resources Case Analysis
1. The estimation of the cost of capital can be used in many analyses within Midland, including asset appraisals for capital budgeting and financial accounting, performance assessments, M&A proposals and stock repurchase decisions. Results of these analyses are used in division or business unit level, while others were executed at the corporate level. When the cost of capital is highly estimated, the NPV of projects will be smaller, which means that the company may reject projects with positive NPV or even extremely profitable project. And only a few projects would generate an IRR greater than the cost of capital, which also means the company might miss profitable projects. Conversely, when the cost of capital is underestimated, more projects will have positive or large NPV and generate an IRR greater than the cost of capital, the company might accept projects leading to losses.
2. WACC = rd(D/V)(1-t)+re(E/V) According to Table 1: D/V=42.2%; Spread to treasury(Premium)=1.62% • According to Table 2: Because the majority of large firms and financial analysts report using long-term yields to determine the risk-free rate, so we choose the rate of treasury bonds with maturity of 30-Year (4.98%) as the risk-free rate, rf=4.98%. According to the material: Midland’s β=1.25, EMRP=5.0% Cost of Debt rd can be calculated by adding spread over US Treasury securities of a similar maturity. So rd=4.98%+1.62%=6.6% Cost of Equity re = rf + β*EMRP=4.98%+1.25*5.0%=11.23% E/V=1-D/V=57.8% Tax rate is not mentioned in material. But according to Mid land Balance Sheet:
| |2004 |2005 |2006 |Ave. |
|Income Before Tax |17,910 |32,723 |30,447 | |
|Tax |7,414 |12,830 |11,747 | |
|Tax rate |41.40% |39.21% |38.58% |39.73% |
2. WACC = rd(D/V)(1-t)+re(E/V) According to Table 1: D/V=42.2%; Spread to treasury(Premium)=1.62% • According to Table 2: Because the majority of large firms and financial analysts report using long-term yields to determine the risk-free rate, so we choose the rate of treasury bonds with maturity of 30-Year (4.98%) as the risk-free rate, rf=4.98%. According to the material: Midland’s β=1.25, EMRP=5.0% Cost of Debt rd can be calculated by adding spread over US Treasury securities of a similar maturity. So rd=4.98%+1.62%=6.6% Cost of Equity re = rf + β*EMRP=4.98%+1.25*5.0%=11.23% E/V=1-D/V=57.8% Tax rate is not mentioned in material. But according to Mid land Balance Sheet:
| |2004 |2005 |2006 |Ave. |
|Income Before Tax |17,910 |32,723 |30,447 | |
|Tax |7,414 |12,830 |11,747 | |
|Tax rate |41.40% |39.21% |38.58% |39.73% |