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.
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 .
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 the implied premium. This is a very good way to measure risk but due to lack of information on index return yield and market stock repurchase it will result in an inaccurate number. The final method of using historical premium gives more accurate results in comparison to the other two methods and thus we took the longest period available to reduce the Std Error and the excess amount over 200 years =5.1%.
r_d = 4.66 + 1.62=6.28%
The cost of debt was calculated by adding the risk free rate and the spread over treasury bonds. The reason being the spread shows the riskiness of holding Midland`s debt as derived by the market`s perception of it`s level of risk.
While the dividend discount model to calculate r_e is highly inaccurate for an individual firm and can be more reasonable for the overall market, the CAPM can give the best estimation because Beta better captures the market risk of a security. We took the beta computed by Janet Mortensen. It was sufficient that she got the beta for Midland using beta’s of commercially available companies with similar operations.
The tax rate was calculated using the average of the three years tax rates, by taking the ratio of Taxes to the Income Before Taxes. This rate was thought to be most appropriate because the corporate rate was not provided. This rate is used for the divisional computational purposes also.
This value is provided in Exhibit 5
This value is provided in Exhibit 5
V = $213,622,000
D/V = 0.3722
E/V = 0.6278
WACC= 0.11035(134,114,000/213,622,000)+ 0.0628(79,508,000/213,622,000)(1-0.3946)
3) Compute divisional WACC`s. Make sure you show how you derived the inputs. You will need asset beta`s.
In order to determine the Beta`s that should be used in calculating the Equity cost of Capital for each division, we must find the unlevered Beta from comparable companies with comparable...
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