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...

...Midland Energy Resources, Inc.: Cost of Capital
Situation Analysis
Company is trying to estimate cost of capital for each of the three divisions, Exploration and Production (E&P), Refining and Marketing (R&M) and Petrochemicals. Cost of capital analysis is used in taking following decisions in the organization:
Project appraisal
Financial accounting
Stock repurchases decisions
Merger & Acquisitions
Performance assessment
The estimates produced by treasury were criticized because of specific assumptions and inputs were challenged.
Options
There are two options before us just go with the cost of capital provided by treasury or revisit the assumptions and inputs and recalculate the cost of capital for specific divisions.
decision
While calculating D/E ratio we have added long term debt and current portion of long term debt and subtracted by cash and cash equivalent
We have calculated BV(Debt) and taken proxy for MV(Debt), for equity we have considered market value
Keeping going concern of company in mind we have taken 30-year treasury yield value in calculation
Taking cost of capital of company as hurdle rate will not be optimal because riskiness of projects from different divisions are different hence we need to calculate cost of capital separately for every division
Then based on Target D/E we have unlevered and levered...

...Cost of equity refers to a shareholder's required rate of return on an equity investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk.
How It Works/Example:
The cost of equity is the rate of return required to persuade an investor to make a given equity investment.
In general, there are two ways to determinecost of equity.
First is the dividend growth model:
Cost of Equity = (Next Year's Annual Dividend / Current Stock Price) + Dividend Growth Rate
Second is the Capital Asset Pricing Model (CAPM):
ra = rf + Ba (rm-rf)
where:
rf = the rate of return on risk-free securities (typically Treasuries)
Ba = the beta of the investment in question
rm = the market's overall expected rate of return
Let's assume the following for Company XYZ:
Next year's dividend: $1
Current stock price: $10
Dividend growth rate: 3%
rf: 3%
Ba: 1.0
rm: 12%
Using the dividend growth model, we can calculate that Company XYZ's cost of capital is ($1 / $10 ) + 3% = 13%
Using CAPM, we can calculate that Company XYZ's cost of capital is 3% + 1.0*(12% - 3%) = 12%
Why It Matters:
Cost of equity is a key component of stock valuation. Because an investor expects his or her...

...
EquityRisk Premiums (ERP): Determinants, Estimation and
Implications – The 2013 Edition
Updated: March 2013
Aswath Damodaran
Stern School of Business
adamodar@stern.nyu.edu
Electronic copy available at: http://ssrn.com/abstract=2238064
2
EquityRisk Premiums (ERP): Determinants, Estimation and
Implications
Equityrisk premiums are a central component of every risk and return model in finance and are a key input in estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equityrisk premiums remains in practice. We begin this paper by looking at the economic determinants of equityrisk premiums, including investor risk aversion, information uncertainty and perceptions of macroeconomic risk. In the standard approach to estimating equityrisk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a...

...Midland Energy Resources, Cost of Capital
The case is about how Janet Mortensen, senior vice president of project finance for Midland Energy Resources, prepare her annual cost of capital estimates for midland and each of its three divisions for her company. Midland was a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing(R&M), and petrochemicals. Estimates of cost of capital prepared by Mortensen were used in many analyses within Midland, including asset appraisals for both capital budgeting and financial accounting, performance assessments. Since her calculations had been widely applied in various areas and became influential, she was considering appending a sort of user’s guide to the 2007 set of calculations for reference to different applications.
Mortensen used WACC formula to estimate cost of capital, compute the cost of debt by adding a premium over US Treasury securities of a similar maturity, and calculate the cost of equity by using the CAPM formula. After reviewing the case and tables given, we calculated the company’s composite WACC and WACCs for each division respectively. The company’s composite WACC is 8.19%. The inputs we used are spread to treasury of 1.62%, debt ratio of 42.2%, Treasury bond yields of 4.98% at a 30-year...

...Cost of Capital at Ameritrade Day 1
1. What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why?
- They should see how revenues have changed after adopting the new ad program and technology upgrades
- They need to see ROI for their investments over time
2. How can the Capital Asset Pricing Model be used to estimate the cost of capital (required return) for calculating the net present value of a project's cash flows?
- it will help us determine the Cost of capital or discount rate which we can use to calculate NPV, in other terms the numerator will never change (FCF), only the denominator will based on the cost of capital
3. What is the estimate of the risk-free rate that should be employed in calculating the cost of capiual for Ameritrade's proposed investment?
- the risk free rate should be the T-bills rate or the average annualized total annual returns on US government securities = 3.8%.
In my opinion, we should use the risk-free rate equal to yield of 20-year US government securities, because it is long-term capital investment. We may use 30-year rate, but we are investing in technology, and concerning the speed of technological enhancements, 20-year rate is optimal. So it is 6,69%
4. What is the estimate of the marketrisk premium that should be...

...
Equity
In accounting and finance, equity is the residual value or interest of the most junior class of investors in assets, after all liabilities are paid; if liability exceeds assets, negative equity exists. In an accounting context, shareholders' equity (or stockholders' equity, shareholders' funds, shareholders' capital or similar terms) represents the remaining interest in the assets of a company, spread among individual shareholders of common or preferred stock; a negative shareholders' equity is often referred to as a positive shareholders' deficit. At the very start of a business, owners put some funding into the business to finance operations. This creates a liability on the business in the shape of capital as the business is a separate entity from its owners. Businesses can be considered, for accounting purposes, sums of liabilities and assets; this is the accounting equation. After liabilities have been accounted for, the positive remainder is deemed the owners' interest in the business. This definition is helpful in understanding the liquidation process in case of bankruptcy. At first, all the secured creditors are paid against proceeds from assets. Afterwards, a series of creditors, ranked in priority sequence, have the next claim/right on the residual proceeds. Ownership equity is the last or residual claim against assets, paid only after all other creditors...

...Cost of Capital questions
and practice problems
Questions
1. What does the WACC measure?
2. Which is easier to calculate directly, the expected rate of return on the assets of a firm or the expected rate of return on the firm’s debt and equity? Assume you are an outsider to the firm.
3. Why are market-based weights important?
4. Why is the coupon rate of existing debt irrelevant for finding the cost of debt capital?
5. Under what assumptions can the WACC be used to value a project?
6. How should you value a project in a line of business with risk that is different than the average risk of your firm’s projects?
7. Maltese Falcone, has not checked its weighted average cost of capital for four years. Firm management claims that since Maltese has not had to raise capital for new projects since that time, they should not have to worry about their current weighted average cost of capital since they have essentially locked in their cost of capital. Critique this statement.
8. Your manager just finished computing your firm’s weighted average cost of capital. He is relieved because he says that he cannot use that cost of capital to evaluate all projects that the firm is considering for the next four years. Evaluate this statement.
9. How should you adjust for the...

...2. Suppose the market portfolio has an expected return of 10% and a volatility of 20%, while Microsoft’s stock has a volatility of 30%.
A. Given its higher volatility, should we expect Microsoft to have an equitycost of capital that is higher than 10%?
No, Microsoft is diversifiable and it will not be affected by the changes in the market. We do not expect Microsoft’s equitycost of capital to be higher than 10%. Each stock carries its own weight.
B. What would have to be true for Microsoft’s equitycost of capital to be equal to 10%?
In order for Microsoft’s equitycost of capital to be 10% its beta will have to be 1.
4. Suppose all possible investment opportunities in the world are limited to the five stocks listed in the table below. What does the market portfolio consist of (what are the portfolio weights)?
Stock Price/Share ($) Number of Shares Outstanding (millions)
A 10 10
B 20 12
C 8 3
D 50 1
E 45 20
Total value of the market = 10x10+20x12+8x3+50x1+45x20= $1.314 billion
Stock Portfolio Weight
A...

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