Midland Energy Resources was fortunate enough to have a skilled financial manager in Mortensen. Her expertise had come to be respected as was evidenced by her promotion and the reliance on her calculations. However, her cost of equity numbers were used as a starting point and manipulated rather than used as presented.
Examining the calculation of the firms weighted average cost of capital and betas as well as comparing with others in the same type of industries indicates that assumptions should be changed for the project being analyzed. Consideration of debt, equity, and costs must be given for the specific project while being mindful of company strategy. Although projects may be evaluated differently, company directives should be followed.
Midland Energy Resources was fortunate enough to have a skilled financial manager in Mortensen. Her expertise had come to be respected as was evidenced by her promotion and the reliance on her calculations. However, her cost of equity numbers were used as a starting point and manipulated rather than used as presented.Midland utilizes a four prong approach to financial and investment policies. Deviation from strategy is not surprising given the volatility in production, pricing, and politics in overseas markets. When analyzing the proceeds from overseas projects,Midland converted proceeds to US dollars and used discount rates in US dollars instead of analyzing in the appropriate currency and converting the discount rate to the appropriate currency. Whether or not the project actually produced the earnings as evaluated is questionable. Under the value-creating investment prong,some projects were considered as future equity cash flows using the cost of equity as the discount rate instead of the hurdle rate based on the project or divisional WACC. The calculation of EVA (economic value added) was manipulated by a “capital charge” and the “capital charge” was used in the calculation of WACC for the business or division. This manipulation would lead to an inaccurate evaluation. Optimal capital structures were challenged by market fluctuations. Midland reevaluated debt levels regularly and adjusted as necessary. Mortensen did set the target debt levels for the divisions. Divisional targets were not adjusted when debt levels were reevaluated. Also, hedging activities by Midland’s in-house traders caused deviations from the targets set for Midland.Repurchasing shares as a strategy was one not utilized in many years. Mortensen used a premium in her WACC calculation to allow for risk. When calculating the cost of equity she used the Capital Asset Pricing Model to estimate divisional betas with betas from pure play companies. This methodology is typically used for evaluating projects outside the normal scope of business and not on projects it normally engages such as ones within a clearly defined strategy. Mortensen should continue the calculations she is currently making. Mortensen should also provide guidance on adjusting calculations for the specific intent of the division rather than the company as a whole as each division has different fixed costs, variable costs, and debt and equity positions. When specifically considering the handling of Midland’s calculation of WACC the company’s assumptions were challenged. Midland’s WACC is 9.3176%. The 10 year Treasury bond plus the spread to treasury is used for the rate of debt is used because the 10 year rate fit the current debt practice of Midland, having both long term and short term debt. The equity and debt used in the calculation came from exhibit 5 in the case. These numbers were used, because the equity is close to the price per share time’s shares outstanding. The difference in these two is most likely due to rounding errors. The tax rate is calculated from the 2006 taxes paid. The beta that is used is also from exhibit 5. The risk free rate of return that is...