1. For what purposes does Mortensen estimate Midland’s cost of capital? What would be the potential consequences of a too high estimate compared to the firm’s “true” cost of capital? What about a too low estimate?

Estimates of the cost of capital were used in many analyses within Midland, including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. Moreover, depending on correct cost of capital, Midland will be able to make accurate financial forecast on supply, demand, and growth, and will decide their new financial and investment decision on a good direction. On one hand, when Ms Mortensen get a too high estimate compare to the “true” cost of capital, the estimated NPV of new investment will easily become lower than the “true” NPV. According to the wrong estimate on NPV, Midland might miss out many investment opportunities and underestimate the investments. On the other hand, when getting too low estimate on cost of capital, midland will estimate the new investment with higher NPV. Midland might waste much money on many bad investments which are overestimated.

2. Calculate Midland’s firm-wide WACC. Make sure you explain clearly your method and your choice of inputs. In particular, is Midland’s choice of market risk premium appropriate, and if not, what recommendations would you make and why?

Material:

a. Debt is long-term in nature, the 1-year t-bond yield is not appropriate. 30 years T bond rate seems to be the most stable rate. Therefore, 30-year seems to be a more appropriate time horizon for selecting t-bond yield. rf = 4.98%. b. According to table 1, D/V = 42.2% c. Midland’s beta =1.25 d. EMRP=5% e. In table 1, we find the spread to treasury of consolidated firm is 1.62%. f. Tax rate = 40%, since according to exhibit 1, from 2004 to 2006 the tax rate is around 40%.