Cost of Capital
Table of Contents
I. Executive Summary
III. Cost of Capital
IV. Risk & Tax Rate
V. Capital Structures
I. Executive Summary
MidlandEnergyResources is a global energy company with operations in oil and gas exploration and production(E&P) providing a broad array of products and services to upstream oil and gas customers worldwide including refining and marketing (R&M), natural gas, and petrochemicals. Janet Mortensen, the senior vice president of project finance for MidlandEnergyResources must determine the weighted average cost of capital (WACC) for the company as a whole and each of its divisions as part of the annual capital budgeting process. Various considerations have to be evaluated as risk factors when calculating the cost-of capital.
MidlandEnergyResources is a leading global energy developer dedicated to providing advanced power systems and energy services around the world. MidlandEnergy...
MidlandEnergyResources 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.
MidlandEnergyResources 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...
...Mortensen estimate Midland's cost of capital? What would be the potential consequences of a too high estimate compared to the firm's “true” cost of capital? What about a too low estimate?
The purpose is that the costcapital will be used for capital budgeting, financial accounting, performance assessment, stock repurchases estimations. Also the cost of capital is a necessary basis for the expected growth and forecasted demand.
The too high estimated cost of capital means that Midland may miss out on investment opportunities and will under value the investment at hand. Furthermore, it is possible for shareholders to see a lower return on their investment. On the other hand, a too low estimated cost of capital means that Midland may engage in an investment that is potentially “bad” and will be overvalued. Shareholders will see over inflated returns.
2. Calculate Midland’s firm-wide WACC. Make sure you explain clearly your method and your choice of inputs. In particular, is Midland’s choice of market risk premium appropriate, and if not, what recommendations would you make and why?
Based on our calculations, the Midland’s firm-wide WACC we have got is 8.48%.First, we choose the rate of 30-year U.S. Treasury bonds in 2007 (4.98%) as the risk free rate we use in the...
...MidlandEnergyResources, Cost of Capital
The case is about how Janet Mortensen, senior vice president of project finance for MidlandEnergyResources, prepare her annual cost of capital estimates for midland and each of its three divisions for her company. Midland was a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing(R&M), and petrochemicals. Estimates of cost of capital prepared by Mortensen were used in many analyses within Midland, including asset appraisals for both capital budgeting and financial accounting, performance assessments. Since her calculations had been widely applied in various areas and became influential, she was considering appending a sort of user’s guide to the 2007 set of calculations for reference to different applications.
Mortensen used WACC formula to estimate cost of capital, compute the cost of debt by adding a premium over US Treasury securities of a similar maturity, and calculate the cost of equity by using the CAPM formula. After reviewing the case and tables given, we calculated the company’s composite WACC and WACCs for each division respectively. The company’s composite WACC...
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...
MidlandEnergyResources, Inc. is a global energy company that operates in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. Midland’s most profitable segment is its E&P division which produces 67% of the company’s net income (Exhibit 3). Its largest division is R&M with the Petrochemical division being the smallest. The primary goals of Midland’s financial strategy are to fund substantial overseas growth, invest in value-creating projects, achieve an optimal capital structure, and repurchase undervalued shares.
To accomplish these goals, Midland must calculate an appropriate cost of capital that will allow reasonable valuations of their strategies. In funding overseas growth, Midland must use its cost of capital to analyze, evaluate, and convert foreign cash flows. In evaluating value-adding projects, the cost of capital must be used to discount project cash flows. To optimize its capital structure, the company must continuously evaluate its ideal borrowing based on its inherent cost. Lastly, when deciding when and how to repurchase shares, Midland’s management has to...
1. For what purposes does Mortensen estimate Midland’s cost of capital? What would be the potential consequences of a too high estimate compared to the firm’s “true” cost of capital? What about a too low estimate?
Estimates of the cost of capital were used in many analyses within Midland, including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. Moreover, depending on correct cost of capital, Midland will be able to make accurate financial forecast on supply, demand, and growth, and will decide their new financial and investment decision on a good direction.
On one hand, when Ms Mortensen get a too high estimate compare to the “true” cost of capital, the estimated NPV of new investment will easily become lower than the “true” NPV. According to the wrong estimate on NPV, Midland might miss out many investment opportunities and underestimate the investments.
On the other hand, when getting too low estimate on cost of capital, midland will estimate the new investment with higher NPV. Midland might waste much money on many bad investments which are...
...MidlandEnergyResourcesMidlandEnergyResources is a fully integrated energy company with operations in E&P, Refining & Marketing (R&M) and Petrochemicals. Capital budgeting at Midland is done using discounted cash flow method and weighted average cost of capital (rwacc).
Corporate Weighted Average Cost of Capital, rwacc
The primary use of the corporate rwacc is valuation (TV=FCF/(rwacc-g)). While the rwacc may be used for evaluating internal projects, the usage will be incorrect owing to the fact that the risk-return profile, debt structure and credit rating of individual projects/departments may be different. Sometimes companies may want to repurchase stock if they think their stock undervalued and to do this valuation cost of capital is required. But this would be a short term valuation and hence the risk free rate of return to be used should be of short term. The corporate rwacc for Midland is 8.55% (refer Ex-1). The following table enumerates the various assumptions:
Assumption Value Remarks
Market risk premium 5.1%
5.1% represents the 200 year average, with the lowest standard error of 1.2%. Moreover this value is between the acceptable range of 4-6%.
Risk free rate of return 4.98%
30 year long term treasury rates have been used for...