Midland: Cost and Equity Market Risk
1. How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations?
Mortensen’s cost of capital estimates are used for a variety of purposes at both the divisional and corporate levels. Examples include internal analyses such as financial accounting, performance assessment and capital budgeting, while others are used for strategic planning purposes such as merger and acquisition, as well as stock repurchase decisions (Luehrman and Heilprin, 2009, pg.1). When used at the divisional rather than corporate level, special consideration should be given to the fact that Midland’s divisions are not publicly traded entities, and therefore do not have individual Beta figures. In order to properly assess the cost of capital for Midland’s divisions, Mortensen collected beta estimates from several businesses with operations similar to those of Midland’s divisions and used the average of these estimates to derive a beta estimate for divisional beta estimates (pg.6).
2. Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations (risk-free rate, equity market risk premium (EMRP), beta). Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why?
Midland’s corporate WACC is 9.17%. Please see exhibit 1 for supporting calculations. The risk-free rate for 2006 came from the Department of Treasury’s website, which we added to Midland’s 2006 Equity Market Risk Premium of 5% (pg.6). We used the 10-year rate to approximate the duration of a corporate investment. Equity and debt are derived from figures in Luerhman and Heilprin’s exhibit 5, and reflect closing prices on December 31st, 2006 rather than an annual average (pg.11). Midland’s choice of EMRP is not appropriate because market risk premium should be estimated individually for each division. Different divisions will have different and
Mortensen’s cost of capital estimates are used for a variety of purposes at both the divisional and corporate levels. Examples include internal analyses such as financial accounting, performance assessment and capital budgeting, while others are used for strategic planning purposes such as merger and acquisition, as well as stock repurchase decisions (Luehrman and Heilprin, 2009, pg.1). When used at the divisional rather than corporate level, special consideration should be given to the fact that Midland’s divisions are not publicly traded entities, and therefore do not have individual Beta figures. In order to properly assess the cost of capital for Midland’s divisions, Mortensen collected beta estimates from several businesses with operations similar to those of Midland’s divisions and used the average of these estimates to derive a beta estimate for divisional beta estimates (pg.6).
2. Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations (risk-free rate, equity market risk premium (EMRP), beta). Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why?
Midland’s corporate WACC is 9.17%. Please see exhibit 1 for supporting calculations. The risk-free rate for 2006 came from the Department of Treasury’s website, which we added to Midland’s 2006 Equity Market Risk Premium of 5% (pg.6). We used the 10-year rate to approximate the duration of a corporate investment. Equity and debt are derived from figures in Luerhman and Heilprin’s exhibit 5, and reflect closing prices on December 31st, 2006 rather than an annual average (pg.11). Midland’s choice of EMRP is not appropriate because market risk premium should be estimated individually for each division. Different divisions will have different and