Midland Energy Resources, Inc. Case Study

Topics: Weighted average cost of capital, Modigliani-Miller theorem, Cost of capital Pages: 3 (747 words) Published: September 23, 2013
Midland Energy Resources, Inc.

1.The Use of Cost of Capital

First of all, cost of capital is an essential component in WACC. WACC is composed of cost of equity and cost of debt.The Mortensen’s estimates are used in various ways including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals and stock repurchases at division ,business unit level and corporate level. 2. The Calculation for Wacc

Midland’s wacc at the corporate level is calculated based on the formula

WACC=rd*(D/V)*(1­t)+re*(E/V). We calculate the cost of debt by adding a premium over the

30­year US T­bill rate. We choose 30­year US t­bill rate because most of the large firms, such

as Midlands, usually use the long­term yield of the U.S Treasury bond to determine risk­free rate. Similarly, to estimate the cost of equity, we use the CAPM: re=rf+ beta*(EMRP). Beta for Miland is 1.25 base on commercially available database.After reviewing the recent research, Midland adopts an EMRP of 5%. The cost of debt is 6.6% while the cost of equity is 11.23% for Midland. Therefore, the wacc is 8.16% based on the estimate of 42.2% leverage and tax rate of 40%. Actual Leverage Different From Target If the actual leverage ratio is lower than 42.2%,WACC for Midland will increase. On the other hand, if the actual leverage ratio is higher than 42.2%, WACC will decrease. The key reasoning is that the cost of debt is less than the cost of equity. Consequently, the change in re*(E/V) is greater than the change in rd*(D/V). 3. Single Corporate WACC for Evaluation Purpose

We should not use a single corporate WACC for evaluating investment opportunities in all its division. The firm should value its projects using a discount rate determined by the characteristics of the risk of the project rather than a single company­wide discount rate. Different divisions have different weighted average cost of capital. If we use the single discount rate of the...
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