Case Study of Midland

3. Sol:

a. According to the passage,

β=1.8, D/E=0.05, r_d=6.0%,t=12%,r_f=2.2%,R_M-R_F=8.4%.

Thus λ=D/(D+E)=0.048

Therefore, r_e=r_f+β(R_M-R_F )=2.2%+1.8×8.4%=17.32%;

WACC=λ(1-t) r_d+(1-λ) r_e

=0.048(1-12%)×6.0%+(1-0.048)×17.32%=16.7%

b. When debt-to-equity ratio increase from 0.05 to 0.20,

λ=D/(D+E)=20/(20+100)=0.167,r_e remains the same.

WACC=λ(1-t) r_d+(1-λ) r_e

=0.167(1-12%)×6.0%+(1-0.167)×17.32%=15.3%

c. In the electric utility company,

β=0.84, D/E=0.46, r_d=4.3%,t=30%,λ=D/(D+E)=46/(46+100)=0.315.

Thus r_e=r_f+β(R_M-R_F )=2.2%+0.84×8.4%=9.3%

WACC=λ(1-t) r_d+(1-λ) r_e

=0.315(1-30%)×4.3%+(1-0.315)×9.26%=7.3%

Electric utility corresponds to balance sheet A. Two distinguishable features lead me to draw this conclusion. First, the obviously high property and equipment percentages in balance sheet A are due to the construction and maintenance of large infrastructure for electricity generation and transportation. Moreover, the 52 day receivable collection period is due to the process of customer billing.

Japanese automobile manufacturer corresponds to balance sheet D. The long collection period (232 days) reflects the non-retailer nature of their business. Moreover, the difficult economic conditions in 2009 should also be taken into consideration. American buyers may need more time to pay off their bills on automobile investment.

Discount

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