QUESTIONS FOR THE OVERALL ASSIGNMENT
1. What is the best way to estimate the company and divisions’ cost of
capital?
Answer:
The best way to estimate the cost of capital is by using the CAPM
(Capital Asset Pricing Model) where the Weighted-Average Cost of
Capital (rwacc) is given by the formula
rwacc 
D
E
(1  T )rd  re
V
V
Where,
D is the market value of the net debt
E is the market value of the total equity
V is the total market value of debt and equity = D + E
T is the corporate tax rate
rd is the appropriately calculated discount rate for debt (cost of debt)
re is the appropriately calculated discount rate for equity (cost of
equity)
The cost of capital (rwacc) for the company can be calculated from the
observable market values of debt (D), equity (E), & corporate tax rate
(T) and calculated discount rate for debt (rd) & discount rate for equity
(re). The market values of debt can be estimated from the company’s
current amount of debt, their maturity levels, and credit rating and by
utilizing the risk-free rate that can be observed in the market. The
market value of equity can be estimated from multiplying the total
number of outstanding shares and the company’s stock-price. The
discount rate for debt can be calculated from on market value of debt
and credit rating for the company’s debt, which includes adjustments
for the company debt’s default risk. The discount rate for equity can
be calculated from estimated values for the equity market risk
premium (EMRP) and risk level (beta) for the company’s stock.
The cost of capital (rwacc) for the division can be calculated similarly
using the debt level used by the division, the overall company’s tax
rate, and an estimated market value of the equity (E) for the division.
The equity market value for the division is not directly observable via
stock prices. However, the equity market value of the division can be
estimated from the present value of its future equity cash flows
discounted at an appropriate rate. This equity discount rate for the
division (re) can be estimated from observing the stock prices and
market values of other companies (‘pure play’ approach) engaged in
similar business as the division with similar risk.
2. Should it be calculated differently for different purposes?
The cost of capital should be calculated differently for different
purposes. It should be based on actual interest rates paid on debt for
tax accounting purposes (tax accounting does not recognize the
concept of cost of equity so there is no rate that can be applied for the
cost of equity). 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 equity. The
cost of capital for all other ‘internal business decision purposes’
Capital budgeting, Performance assessments, Merger & Acquisition
proposals, and Stock-repurchase decisions should be based on the
CAPM model and appropriate market-value based and risk-based
estimated discount rates for debt and equity. The risk levels and
hence the risk premiums required could differ for different decisions
and purposes. For example, the risk premium required for a M&A
proposal (Merger and Acquisition) should be based on the estimated
incremental market value due to the M&A whereas the risk premium
required for capital budgeting should be based on the company’s
established operations in the current and future lines of business and
investments.
Questions to specifically address
1. What is the appropriate risk-free rate to use in the WACC
calculations? How did you arrive at this number?
The appropriate risk-free rate to use in the 2007 WACC calculations
is 4.98%, the rate of 30-year U.S. Treasury bonds in 2007. The rate is
specified in the case, in Table 2. Team 1 compared the rate to U.S.
Treasury data online (See Exhibit 1); while the rate from the case is
slightly different than the average rate found online for the January
2007 average (4.85%), the Team will use the rate specified in the
case. The 30-year rate is used for the risk-free rate because the
majority of large firms and financial analysts report using long-term
yields for bonds to determine the risk-free rate1.
The appropriate risk-free rate to use for the Exploration and
Production division is also the 30-year Treasury rate of 4.98%.
2. What is the Market Risk Premium (EMRP) that is most appropriate
to use in the calculation for the cost of equity? How did you arrive at
that number?
The appropriate EMRP to use in the 2007 WACC calculation is 6.0%
as listed in Table 2. Team 1 compared this rate to real-world data using the
average annual total return on common stocks from Yahoo! Finance and the
risk free rate from Exhibit 1.
EMRP= rm-rf
EMRP=10.3%-4.85%= 5.45%
We determined that 6.0% is reasonable for the Market Risk Premium in the
WACC calculation.
3. What weights for the cost of capital will you use? Answer
specifically what weights you will use for your capital components in
calculating the cost of capital for the company as a whole.
Answer:
The weights for the cost of debt and cost of equity are calculated from
the given data in Exhibit 5 based on the given Equity Market Value
and Net Debt for the Midland Company:
Midland’s Equity Market Value from Exhibit 5 =E= $134,114 million
Midland’s Net Debt from Exhibit 5 = D = $79,508 million
Midland’s Total Market Value = V = E + D = $213,622 million
Weight for the cost of debt = D/V = 0.3722
Weight for the cost of equity = E/V = 0.6278
Berk and DeMarzo. Corporate Finance – Professional Copy. Second Edition. Chapter 12, Pages 381-382.
“The Market Risk Premium”
1
4. What Beta will you use for your calculation of cost of capital for the
company? How did you arrive at that Beta? Are there any
adjustments you made to calculation based upon your knowledge?
5. What, then, is your cost of equity for the company as a whole?
6. What is the appropriate cost of debt for the company? How did you
arrive at this number?
To measure ‘r’ or cost of debt, the yield would ordinarily be
calculated based on outstanding debt, if the company has debt
outstanding that is traded2. If the company’s debt is only thinly traded,
the bond rating would be used to find the average return on the bonds.
If the company is private and non-rated, the company’s balance sheet
and income statement would be used; or by discussions with the
company’s banker.
In the Midland case, we have no detailed information about the
company’s bonds outstanding. The only detail provided is the amount
of long-term debt on the balance sheet. However, detail is provided
about the credit rating and the spread to Treasury. For purposes of
estimating the cost of debt for Midland, the 30-year US Treasury
bond yield of 4.98% can be used. The Spread to Treasury will be
added to the yield; therefore for Midland as a whole, 4.98% + 1.62%;
or 6.60% can be used to estimate the cost of debt.
For Midland’s E&P division, the same logic can be used to estimate
the cost of debt. The 30-year US Treasury yield of 4.98% is added to
the E&P Division’s spread to Treasury of 1.60% for a total cost of
debt of 6.58% cost of debt. Ordinarily, as mentioned in the case, a
premium would be added to this cost of debt to account for
politically volatile countries which support less borrowing. Since
insufficient details are provided in the case regarding this volatility,
the Team is unable to make an approximation of the premium and
will therefore use the 6.56% cost of debt for the E&P division.
2
FINA 6241 Lecture Notes, “Capital Components,” slide 5-12.
7. Finally, show your calculation for the cost of capital for the
company. What rate did you calculate? Does it seem consistent with
the case data?
Answer:
The 2006 corporate tax rate for Midland is calculated as 38.58% from
taking the ratio of Taxes ($30,447 million) to the Income Before
Taxes ($11,747 million) in Exhibit 1.
The (weighted-average) cost of capital (rwacc) is then calculated using
the formula
rwacc 
D
E
(1  T )rd  re
V
V
Therefore, the cost of capital is
rwacc = 0.3722 (1 - 0.3858) rd + 0.6278 re =
8. Secondarily, follow up with questions 3-7 above but in relation to the
Exploration & Production Division of the company. What rate is
appropriate for this division’s cost of capital? What refinements (if
any) did you make to arrive at this rate?
Questions for discussion in class (do not write up)
(2) Was there other data you wish you would have had for your
calculations? Where might you find this data in the real world?
It would be helpful to have had information regarding the company’s bonds,
such as amount of bonds outstanding (we know the total amount of longterm debt but a portion of this could be notes payable instead of bonds), the
average price of a bond, perhaps the average coupon rate and the average
time to maturity. With this information, the cost of debt could be calculated
more easily for Midland. Divisional information would have also been
helpful. Perhaps bonds were issued divisionally and a divisional cost of debt
could have been calculated.
Typically in the “real world” this information would be displayed
somewhere in the 10-K annual report or in a prospectus for a specific bond
issuance.