Essay on Case 13 - Best Practices in Estimating the Cost of Capital

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

Mortensen’s cost of capital estimates are used for a variety of purposes at both the divisional and corporate levels. Examples include internal analyses such as financial accounting, performance assessment and capital budgeting, while others are used for strategic planning purposes such as merger and acquisition, as well as stock repurchase decisions (Luehrman and Heilprin, 2009, pg.1). When used at the divisional rather than corporate level, special consideration should be given to the fact that Midland’s divisions are not publicly traded entities, and therefore do not have individual Beta

Barb Williams and Rick Thomas, while attending an executive education course at a well-known business school, came across a case which involved calculating the cost of capital for Telus Corporation (Telus). Basic data such as the Balance Sheet, Income Statement, Data on Telus’ Common Stock, Market Index, and the Average Annual Returns in North American Capital Markets were provided. In order to calculate Telus’ cost of capital we need to calculate the company’s Cost of Equity, Cost of Debt, and Tax Rate along with their weighted cost and then apply these to the Weighted

We use Capital Asset Pricing Model (CAPM) approach to calculate the cost of equity. The formula of CAPM is re = rf + β × (E[RMkt] – rf).

Here we choose VW NYSE, AMEX, and NASDAQ data as market returns, because it’s value weighted and more reliable. The results show CSC’s equity beta = 2.27, QRG’s equity beta = 1.79.

* Stock Beta: Exhibit 5 shows a detailed measurement of the company’s stock returns in relation to the rest of the market through 5-year historical price and index data. The analysis includes monthly returns of both the NYSE and the S&P 500 index in order to capture a comprehensive view of the market return. In each comparison, the monthly returns of the Target stock and market are plotted on Y-axis and X-axis respectively to get the regression line’s slope or beta. The analysis arrives at an average beta of 0.988 which indicates a similar movement of Target stock’s returns in comparison to the whole market over time.

Two managers attending an executive education course attempt to develop a cost of capital estimate for a leading telecommunications company, Telus The two managers are somewhat confused about the costs of various sources of capital, the calculation of the overall cost of capital and the appropriate use of the hurdle rate

The mixture of debt-equity mix is important so as to maximize the stock price of the Costco. However, it will be significant to consider the Weighted Average Cost of Capital (WACC) as well so that it can evaluate the company targeted capital structure. Cost of capital (OC) may be used by the companies as for long term decision making, so industries that faced to take the important of Cost of capital seriously may not make the right choice by choosing the right project(Gitman’s, ).

At first, WACC and CAPM was attempted to be used as a source of cost of capital. However, for WACC, there is no available proportion of debt and cost of debt for MW. For CAPM, no available data seems to support the acceptable

* We assume the cost of capital to be a stated annual rate to facilitate calculations;

1-a How can the CAPM be used to estimate the cost of capital for a real business investment decision?

Since there are significant changes in the company for the last 3 years such as descending trend in car and truck market in 1991, sale of one of their core electronics business, terminated Volvo agreement etc.; the company thinks that their financial value (equity and debt ratios and weights) and accordingly cost of capital is changed. Also company has free cash (derived from the sales of electronics

For estimation of betas, the above equation was run for the period from Jan, 2003 to Dec, 2006. Based on the estimated betas we have divided the sample of 63 stocks into 10 portfolios each comprising of 6 stocks except portfolio no.1, 5 and 10 having seven stocks each. The first portfolio 1 has the 7 lowest beta stocks and the last portfolio 10 has the 7 highest beta stocks. The rationale for forming portfolios is to reduce measurement error in the betas.

1. Please define Weighted Average Cost of Capital (WACC). Write down the WACC formula, and discuss its components.

We use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. As