Case Report for Midland Energy Resources, Inc: Cost of Capital

1189 Words Oct 21st, 2012 5 Pages
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?
The purpose is that the cost capital will be used for capital budgeting, financial accounting, performance assessment, stock repurchases estimations. Also the cost of capital is a necessary basis for the expected growth and forecasted demand.
The too high estimated cost of capital means that Midland may miss out on investment opportunities and will under value the investment at hand. Furthermore, it is possible for shareholders to see a lower return on their investment. On the other hand, a too low estimated cost of capital
…show more content…
In the other hand, the risks of investment opportunities vary. So the riskier projects deserve higher hurdle rates while the less riskier ones should lower their hurdle rates. Using different hurdle rates will enable us to draw more accurate conclusions. Or, if the real hurdle rate of a project is lower than a firm-wide hurdle rate, we might reject it which should have been accepted and brought positive NPV; if the real hurdle rate of a project is higher than a firm-wide hurdle rate, we might accepted it which should have been rejected and cause negative NPV damaging the stock holders` value.

4.Does your conclusion in (3) change if you instead assume that Ocean Carriers operates the capesize for the full life of 25 years before selling it for scrap value (grown by inflation)?
In order to get the estimation of the WACC for E&P and R&M, we need to make sure the percent of D/V and E/V, the cost of debt , the cost of equity and the tax rate. According to the Table 1, we can clearly get the percent of D/V and E/V.
Divisions D/V E/V
E&P 46% 54%
R&M 31% 69%

For cost of debt, it equals to the risk-free rate plus spread to Treasury. Because we are actually interested in the future market risk premium and it usually takes many years of data to produce more moderately accurate estimation of market premium, we choose the yield of 30-year US Treasury bond as risk-free rate, which is 4.98%. So for E&P, =4.98%+1.6%=6.58% while

Related Documents