Midland Energy Resource keeps measuring their cost of capital since it is puting in spread outing its operations outside US, besides funding its important abroad growing and to optimise its capital construction. Therefore, it is of import to cipher an accurate cost of capital.
The cost of capital was calculated by the Leaden Average Cost of Capital ( WACC ) expression as shown below.
Cost of debt was calculated for each division by utilizing a ‘bond output plus hazard premium ‘ attack in which the hazard premium depended on assortment of factors. The cost of equity is calculated utilizing the Capital Asset Pricing Model ( CAPM ) shown below.
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The beta ( for Midland Energy Resource was taken from the published informations in commercially available databases and for the divisions the informations were taken from similar publically traded companies.
Question 1: How are Mortensen ‘s estimations of Midland ‘s cost of capital used? How, if at all, should these awaited utilizations affect the computations?
Answer -1: Harmonizing to the instance, Janet Mortensen ‘s estimations are used for many analyses and determination devising processes at different degree. Following are few of the utilizations as mentioned in the instance:
aˆ? Asset assessments for capital budgeting and fiscal accounting
aˆ? Performance Appraisals
aˆ? M & A ; A proposals
aˆ? Stocks Repurchase Decisions
Question 2: Calculate Midland ‘s corporate WACC. Defend your specific premises about the assorted inputs to the computations. Is Midland ‘s pick of EMRP allow? If non, what recommendations would you do and why?
Answer-2: As mentioned in the Table 1 in the instance the Spread to treasury for each division and the outputs of adulthood for U.S. Treasury bonds in table 2. As Janet Mortensen computed the cost of dept for each division by adding a premium, or spread, over U.S. Treasury securities of a similar adulthood
So utilizing the information and the information we get,
Consolidated Spread to Treasury = 1.62 %
Output to 30-years adulthood of U.S. Treasury bonds = 4.98 %
So Cost of Debt ( rd ) = 4.98 % +1.62 %
= 6.6 %
Tax rate can be calculated based on the ratio of the Income revenue enhancements paid to the income before revenue enhancement. Midland ‘s Income Statement for old ages 2004, 2005 and 2006 are given in Exhibit 1.
So ciphering the ratio of the Income revenue enhancements paid to the Income before revenue enhancement and averaging it for the 3 old ages period we get the revenue enhancement rate = 39 %
Harmonizing to the information given in the last paragraph of the instance in 2006 Midland used EMRP of 5 % . In past they have used higher EMRP which is besides supported by the historical information on the stock returns and bond outputs ( as shown in Exhibit 6 ) . On the other manus the study informations ( besides shown in Exhibit 6 ) suggested lower value of EMRP.
After audience with its professional advisers Midland is following its current estimation of 5 % . This pick is appropriate as it is in audience with the professionals and besides it is mediate the higher and lower scope which both affect the WACC.
Cost of Equity ( rhenium )
Cost of Equity can be calculated utilizing the CAPM theoretical account.
Risk Free Rate of Return ( releasing factor ) = 4.98 % ( as mentioned in Table 2 )
? = 1.25 ( as given in the instance )
EMRP = 5 %
rhenium = releasing factor + ? ( EMRP )
= 4.98 + 1.25*5
= 4.98 + 6.25
= 11.23 %
rhenium = 11.23 %
rd = 6.6 %
Tax Rate ( T ) = 39 %
D/E = 59.3 %
E = 100 units
D = 59.3 units
V = 159.3 units
Using the WACC expression we get
WACC = 6.6*59.3*0.61/ 159.3 + 11.23*100/159.3
= 8.548 %
Question 3: Should Midland utilize a individual corporate hurdle rate for measuring investing chances in all of its divisions? Why or why non?
Answer 3: As mentioned in the instance each division of the Midland Energy Resources has different hazards associated with regard to its operations. As the E & A ; P division has been seeing a displacement in the geographic composing of end product and due to high monetary values heavy investings are put in for acquisitions of assuring belongingss. In R & A ; M division the border is shriveling and its steadily worsening since last 20 old ages. In Petrochemicals division several older installations were sold or retired and capital disbursement is expected to turn.
In Exhibit 5, the Equity Beta represents the hazard factor of those divisions and as the hazard profile are different per division the hurdle rate for each division should besides be different and should be calculated based on the I? of the division.
Midland should non utilize individual corporate hurdle rate as this will misdirect rating of the investings, and will ensue on Midland invest on hazardous undertakings and will go hazardous a corporate by clip
If investings are done at the corporate degree the Midland WACC can be considered but when the investings are at concern unit degrees the hurdle rate of different divisions should be considered.
Question 4: Calculate a separate cost of capital for the E & A ; P and Marketing & A ; Refining divisions. What causes them to differ from one another?
Answer 4 E & A ; P
= 4.98 % + 1.15 ( 5 % )
= 10.73 %
rd = releasing factor + E & A ; P Spread to Treasury ( as mentioned in Table 1 and Table 2 )
rd = 4.98 % + 1.60 %
= 6.58 %
rd =6.58 %
Tax rate ( T ) = 39 %
D/E = 39.8 %
E = 100units
D = 39.8units
V = 139.8units
E/V = 0.715308
D/V = 0.284692
To cipher the cost of capital utilizing WACC expression we get
= & gt ; WACC for E & A ; P division = 8.818 %
R & A ; M
rhenium = 4.98 % + 1.20 ( 5 % ) = 10.98 %
rd = releasing factor + R & A ; M Spread to Treasury ( as given in Table 1 & A ; Table 2 )
rd = 4.98 % + 1.80 % = 6.78 %
rhenium = 10.98 %
rd = 6.78 %
Tax rate ( T ) = 39 %
D/E = 20.3 %
E = 100units
D = 20.3units
V = 120.3units
E/V = 0.831255
D/V = 0.168745
= & gt ; WACC for R & A ; M division =9.825 %
As already discussed the different concern units operate in different environments hence hold a different hazard profiles and betas ( I? ) . Besides as we see in the Table 1 of the instance both the divisions have different recognition evaluations. As a consequence of which, the E & A ; P and R & A ; M have different WACC ‘s ( 8.818 % and 9.825 % severally )
Question 5: How would you calculate a cost of capital for the Petrochemical division?
Answer 5: To cipher cost of capital for Petrochemical, we would seek for twosome of companies which focus merely on Petrochemical industry. And utilize their fact sheet and acquire an norm on their I? and D/E ratio.
aˆ? By utilizing the information available on Exhibit 5, and utilizing arithmetic norms on D/E ratio and I? to cipher cost of capital for Petrochemical division.
Sing that the Corporate I? = Average ( E & A ; P I? , R & A ; M I? , Petrochemical I? )
1.25 = Average ( 1.15, 1.20, Petrochemical I? )
Petrochemical I? = 1.40
rhenium = releasing factor + I? ( EMRP )
rhenium = 4.98 % + 1.40 ( 5 % ) = 11.98 %
rd = rf +Petrochemical Spread to Treasury ( as given in table 1 and table 2 )
rd = 4.98 % + 1.35 % = 6.33 %
Corporate D/E = Average ( E & A ; P D/E, R & A ; M D/E, Petrochemical D/E )
59.3 % = Average ( 39.8 % , 20.3 % , Petrochemical D/E )
Petrochemical D/E = 117.8 %
rhenium = 11.98 %
rd = 6.33 %
Tax rate ( T ) = 39 %
D/E = 117.8 %
E = 100 units
D = 117.8 units
V = 217.8 units
E/V = 0.459137
D/V = 0.540863
= & gt ; WACC for Petrochemical 7.589 %
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