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Midland

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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 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

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