1. Cost of capital is the term used in the field of financial investment to refer to the cost of a company’s funds (both debt and equity), or, from an investor’s point of view “the shareholder’s required return on a portfolio of all the company’s existing securities”. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

In the case, Janet Mortensen prepared the annual cost of capital estimates for Midland Energy Resources Inc. and each of its three divisions. Estimates of the cost of capital were used in many analyses within Midland, including asset appraisal for both capital budgeting and financial accounting, performance assessments, M&A proposal, and stock repurchase decisions.

No, they were using the formula for WACC to estimate the cost of capital.

2. Assume the business is on-going for a long period of time. We use 4.98%, which is the 30-year yield to maturity for U.S. Treasury bonds in January 2007 in Table 2, as the risk-free rate. Assume the Spread to Treasury of the company is 1.62%, which is equal to the Spread to Treasury of the consolidated part.

According to the case, “Mortensen compute the cost of debt for each division by adding a premium, or spread, over U.S. Treasury securities of a similar maturity,” we can get:
Rd=Rf+Spread to Treasury

The rate of debt for the company:
Rd=4.98%+1.62%=6.6%

From Exhibit 5, we can get
D/E=59.3%, E=D/59.3% D/V=D/(D+E)=D/(D/59.3%+D)=0.3722 E/V=1-0.3722=0.6278

For EMRP, Midland’s beta was 1.25, and they used an equity market risk premium of 5%.
Determining the
Re=Rf+beta*(EMRP)=4.98%+1.25*5%=11.23%
Re=Rua+D/E(1-Tc)(Rua-Rd)
0.1123=Rua+59.3%*(1-40%)*(Rua-6.6%)
Rua=0.1001495
From table 1, we can get
D/V=0.422 E/V=1-0.422=0.578