QUESTIONS FOR THE OVERALL ASSIGNMENT

1. What is the best way to estimate the om!a"y a"# #i$isio"s% ost o&
a!ita'(
Answer:
The best way to estimate the cost of capital is by using the CAPM
(Capital Asset Pricing Model) where the Weighted-Aerage Cost of
Capital (r
wacc
) is gien by the formula
e d wacc
r
V
E
r T
V
D
r + = ) ! (
Where"
# is the mar$et alue of the net debt
% is the mar$et alue of the total e&uity
' is the total mar$et alue of debt and e&uity ( # ) %
T is the corporate ta* rate
r
d
is the appropriately calculated discount rate for debt (cost of debt)
r
e
is the appropriately calculated discount rate for e&uity (cost of
e&uity)
The cost of capital (r
wacc
) for the company can be calculated from the
obserable mar$et alues of debt (#)" e&uity (%)" + corporate ta* rate
(T) and calculated discount rate for debt (r
d
) + discount rate for e&uity
(r
e
), The mar$et alues of debt can be estimated from the company-s
current amount of debt" their maturity leels" and credit rating and by
utili.ing the ris$-free rate that can be obsered in the mar$et, The
mar$et alue of e&uity can be estimated from multiplying the total
number of outstanding shares and the company-s stoc$-price, The
discount rate for debt can be calculated from on mar$et alue of debt
and credit rating for the company-s debt" which includes ad/ustments
for the company debt-s default ris$, The discount rate for e&uity can
be calculated from estimated alues for the e&uity mar$et ris$
premium (%M0P) and ris$ leel (beta) for the company-s stoc$,
The cost of capital (r
wacc
) for the diision can be calculated similarly
using the debt leel used by the diision" the oerall company-s ta*
rate" and an estimated mar$et alue of the e&uity (%) for the diision,
The e&uity mar$et alue for the diision is not directly obserable ia
stoc$ prices, 1oweer" the e&uity mar$et alue of the diision can be
estimated from the present alue of its future e&uity cash flows
discounted at an appropriate rate, This e&uity discount rate for the
diision (r
e
) can be estimated from obsering the stoc$ prices and
mar$et alues of other companies (2pure play- approach) engaged in
similar business as the diision with similar ris$,
). Sho*'# it be a'*'ate# #i&&e+e"t'y &o+ #i&&e+e"t !*+!oses(
The cost of capital should be calculated differently for different
purposes, 3t should be based on actual interest rates paid on debt for
ta* accounting purposes (ta* accounting does not recogni.e the
concept of cost of e&uity so there is no rate that can be applied for the
cost of e&uity), The cost of capital for financial accounting purposes
will need to be calculated based on financial accounting rules using
actual interest rates for debt and the accounting return on e&uity, The
cost of capital for all other 2internal business decision purposes-
Capital budgeting" Performance assessments" Merger + Ac&uisition
proposals" and 4toc$-repurchase decisions should be based on the
CAPM model and appropriate mar$et-alue based and ris$-based
estimated discount rates for debt and e&uity, The ris$ leels and hence
the ris$ premiums re&uired could differ for different decisions and
purposes, 5or e*ample" the ris$ premium re&uired for a M+A
proposal (Merger and Ac&uisition) should be based on the estimated
incremental mar$et alue due to the M+A whereas the ris$ premium
re&uired for capital budgeting should be based on the company-s
established operations in the current and future lines of business and
inestments,
Q*estio"s to s!ei&ia''y a##+ess
1. What is the a!!+o!+iate +is,-&+ee +ate to *se i" the WA..
a'*'atio"s( How #i# yo* a++i$e at this "*mbe+(
The appropriate ris$-free rate to use in the 6778 WACC calculations
is 9,:;<" the rate of =7-year >,4, Treasury bonds in 6778, The rate is
specified in the case" in Table 6, Team ! compared the rate to >,4,
Treasury data online (4ee %*hibit !)? while the rate from the case is
slightly different than the aerage rate found online for the @anuary
6778 aerage (9,;A<)" the Team will use the rate specified in the
case, The =7-year rate is used for the ris$-free rate because the
ma/ority of large firms and financial analysts report using long-term
yields for bonds to determine the ris$-free rate
!
,
The appropriate risk-free rate to use for the Exploration and
Production division is also the 30-year Treasury rate of 4.98%.
). What is the Ma+,et Ris, /+emi*m 0EMR/1 that is most a!!+o!+iate
to *se i" the a'*'atio" &o+ the ost o& e2*ity( How #i# yo* a++i$e at
that "*mbe+(
The appropriate %M0P to use in the 6778 WACC calculation is B,7<
as listed in Table 6, Team ! compared this rate to real-world data using the
aerage annual total return on common stoc$s from CahooD 5inance and the
ris$ free rate from %*hibit !,
%M0P( r
m
-r
f
%M0P(!7,=<-9,;A<( A,9A<
We determined that B,7< is reasonable for the Mar$et 0is$ Premium in the
WACC calculation,
=, What wei3hts &o+ the ost o& a!ita' wi'' yo* *se( A"swe+ s!ei&ia''y
what wei3hts yo* wi'' *se &o+ yo*+ a!ita' om!o"e"ts i" a'*'ati"3
the ost o& a!ita' &o+ the om!a"y as a who'e.
Answer:
The weights for the cost of debt and cost of e&uity are calculated from
the gien data in %*hibit A based on the gien %&uity Mar$et 'alue
and Eet #ebt for the Midland Company:
Midland-s %&uity Mar$et 'alue from %*hibit A (%( F!=9"!!9 million
Midland-s Eet #ebt from %*hibit A ( # ( F8:"A7; million
Midland-s Total Mar$et 'alue ( ' ( % ) # ( F6!="B66 million
Weight for the cost of debt ( #G' ( 7,=866
Weight for the cost of e&uity ( %G' ( 7,B68;
!
Her$ and #eMar.o, Corporate 5inance I Professional Copy, 4econd %dition, Chapter !6" Pages =;!-=;6,
JThe Mar$et 0is$ PremiumK
4. What 5eta wi'' yo* *se &o+ yo*+ a'*'atio" o& ost o& a!ita' &o+ the
om!a"y( How #i# yo* a++i$e at that 5eta( A+e the+e a"y
a#6*stme"ts yo* ma#e to a'*'atio" base# *!o" yo*+ ,"ow'e#3e(
7. What8 the"8 is yo*+ ost o& e2*ity &o+ the om!a"y as a who'e(
9. What is the a!!+o!+iate ost o& #ebt &o+ the om!a"y( How #i# yo*
a++i$e at this "*mbe+(
To measure 2r- or cost of debt" the yield would ordinarily be
calculated based on outstanding debt" if the company has debt
outstanding that is traded
6
, 3f the company-s debt is only thinly traded"
the bond rating would be used to find the aerage return on the bonds,
3f the company is priate and non-rated" the company-s balance sheet
and income statement would be used? or by discussions with the
company-s ban$er,
3n the Midland case" we hae no detailed information about the
company-s bonds outstanding, The only detail proided is the amount
of long-term debt on the balance sheet, 1oweer" detail is proided
about the credit rating and the spread to Treasury, 5or purposes of
estimating the cost of debt for Midland" the =7-year >4 Treasury
bond yield of 9,:;< can be used, The 4pread to Treasury will be
added to the yield? therefore for Midland as a whole" 9,:;< ) !,B6<?
or B,B7< can be used to estimate the cost of debt,
or !idland"s E#P division$ the sa%e lo&ic can 'e used to esti%ate
the cost of de't. The 30-year () Treasury yield of 4.98% is added to
the E#P *ivision"s spread to Treasury of +.,0% for a total cost of
de't of ,.-8% cost of de't. .rdinarily$ as %entioned in the case$ a
pre%iu% /ould 'e added to this cost of de't to account for
politically volatile countries /hich support less 'orro/in&. )ince
insufficient details are provided in the case re&ardin& this volatility$
the Tea% is una'le to %ake an approxi%ation of the pre%iu% and
/ill therefore use the ,.-,% cost of de't for the E#P division.
6
53EA B69! Lecture Eotes" JCapital Components"K slide A-!6,
:. Fi"a''y8 show yo*+ a'*'atio" &o+ the ost o& a!ita' &o+ the om!a"y.
What +ate #i# yo* a'*'ate( ;oes it seem o"siste"t with the ase
#ata(
Answer:
The 677B corporate ta* rate for Midland is calculated as =;,A;< from
ta$ing the ratio of Ta*es (F=7"998 million) to the 3ncome Hefore Ta*es
(F!!"898 million) in %*hibit !,
The (weighted-aerage) cost of capital (r
wacc
) is then calculated using
the formula
e d wacc
r
V
E
r T
V
D
r + = ) ! (
Therefore" the cost of capital is
r
wacc
( 7,=866 (! - 7,=;A;) r
d
) 7,B68; r
e
(
<. Seo"#a+i'y8 &o''ow *! with 2*estio"s =-: abo$e b*t i" +e'atio" to the
E>!'o+atio" ? /+o#*tio" ;i$isio" o& the om!a"y. What +ate is
a!!+o!+iate &o+ this #i$isio"%s ost o& a!ita'( What +e&i"eme"ts 0i&
a"y1 #i# yo* ma,e to a++i$e at this +ate(
Q*estio"s &o+ #is*ssio" i" 'ass 0#o "ot w+ite *!1
(6) Was the+e othe+ #ata yo* wish yo* wo*'# ha$e ha# &o+ yo*+
a'*'atio"s( Whe+e mi3ht yo* &i"# this #ata i" the +ea' wo+'#(
3t would be helpful to hae had information regarding the company-s bonds"
such as amount of bonds outstanding (we $now the total amount of long-
term debt but a portion of this could be notes payable instead of bonds)" the
aerage price of a bond" perhaps the aerage coupon rate and the aerage
time to maturity, With this information" the cost of debt could be calculated
more easily for Midland, #iisional information would hae also been
helpful, Perhaps bonds were issued diisionally and a diisional cost of debt
could hae been calculated,
Typically in the Jreal worldK this information would be displayed
somewhere in the !7-M annual report or in a prospectus for a specific bond
issuance,