Midland Energy Resources, Inc. is a global multi-division energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. On a consolidated level, the company had 2006 operating revenue and operating income of $248.5 billion and $42.2 billion, respectively. Its largest division is R&M with the Petrochemical division being the smallest. Midland’s most profitable segment is its P&E division which generates 67% of the company’s net income (Exhibit 3). With regard to division of assets, E&P is 53%, R&M is 36%, and petrochemical is 11%. Midland’s financial strategies are to fund overseas growth, invest in value-creating initiatives, obtain optimal capital structure, and repurchase undervalue shares. In order to accomplish these objectives, Midland must calculate and use an accurate cost of capital that will provide reasonable valuation of their strategies. For example, funding overseas growth, Midland must use its cost of capital to analyze and evaluate the foreign cash flow; valuing projects, the cost of capital is used to discount future cash flow; optimizing capital structure, Midland continuously evaluate the cost of borrowing; and lastly determining the intrinsic value of its shares for repurchasing by valuing the company using the discount cash flow methodology. Question 1: How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations? Estimates of Midland’s cost of capital are used in analysis within the company and its three divisions. Mortensen’s estimates are used for asset appraisals for capital budgeting and financial accounting; performance assessments; M&A proposals; and stock repurchase decisions. The uses of cost of capital will remain constant in the appraisal calculations when the projects risk remains unchanged. If the projects have greater or less risk, the calculations of WACC may be affected. The cost of capital is an essential component in WACC calculations. High estimated cost of capital may cause Midland to miss out investment opportunities by undervaluing the investment and shareholders may see lower return. In contrast, low estimated cost of capital may cause the company to engage in non-profitable opportunities by overvaluing the investment and shareholders may see inflated returns. The practical applications of WACC are intended to stand for the long-term opportunity cost of funds for Midland, one of its divisions, or an acquisition target. It is the discount rate and a benchmark for the discount rate in a discounted cash flow (DCF) analysis. For example, in risky merger and acquisition proposal, the company may adjust the cost of capital by including a higher risk premium. Contrarily, evaluating long-term assets, cash inflows and outflows may have lower risk compare to the company average cost of capital. In addition, Mortensen’s numbers likely will be used in performance assessments at the corporate and division levels and may well affect the incentive compensation awards. Whether the same WACC should be used for both asset and performance assessment is certainly questionable. 2. Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations. Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why? The formula for weighted average cost of capital will be used to find Midland’s corporate cost of capital. WACC = rd(D/V) (1-t) + re(E/V) = 8.12%
rd = Cost of debt = 6.28%
Mortensen computed the cost of debt for each division by adding a premium, or spread, over U.S. Treasury securities of similar maturity. The cost of debt of 6.28% is calculated by the 10-year rate on U.S. Treasury bonds (Table 2) plus the spread to Treasury calculated by Mortensen for the consolidated company (Table 1). The 10-year risk free rate seems...
Please join StudyMode to read the full document