Case Report for Midland Energy Resources, Inc: Cost of Capital Essay
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? The purpose is that the cost capital 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 2007 WACC calculations. The reason is that majority of large firms and financial analysts report using long-term yields for bonds to determine the risk-free rate. Second, we begin to calculate the cost of debt, which is determined by adding the spread to Treasury of A+ to the rate of 30-year treasury bonds in 2007. That is, 4. 98%+1. 62%=6. 60%, which is the cost of debt .
Third, the cost of equity is next. The EMRP (5%) was taken out of the context of the case. The tax rate (39. 73%) was from the average of amount of taxes paid between year 2004 to year 2006. We also need to calculate the unlevered beta through the formula, ? u=(E/E+D)*? e+(D/E+D)*? d. ?d=0 Because we cannot find the debt beta through the case. In this formula, we use recently found D/V ratio (59. 30%) and multiplied it by equity beta (1. 25) to come the unlevered beta (0. 7847). To relever the ? e, we use the formula, ? e = ? u +(D/E)*(? u-? d).
And the “Target D/E” was found by taking “Target D/V” divided by “1-Target D/V”. So we get the new ? e, 1. 3576. Then to get cost of equity, we use the CAPM formula, Re=Rf+? (EMRP), 11. 7679%. Since we have get the cost of equity and cost of debt, we can determined the WACC, which is equal to Equity/Value*Cost of Equity+Debt/Value*Cost of Debt*(1-tax rate). In the end ,we arrived at 8. 48%. Midland’s choice of market risk premium of 5% does appear to be an appropriate selection in this instance. From exhibit 6, we found that this EMRP is lower than the historical data of U.
S. stock returns minus Treasury bond yields and is higher than the market risk premium from the survey results. So we recommend that the risk premium rate can be narrowed between 4. 8% to 5. 6%. 4. 8% is the lowest of higher EMRP while 5. 6% is the highest of the lower EMRP. In a word, our team think that 5% is a reasonable market risk premium. 3. Should Midland use a single corporate hurdle rate (i. e. a firm-wide WACC) for evaluating investment opportunities in all of its divisions? Why or why not? I do not think it is proper.
Since hurdle rate is the key factor to determine whether we should accept a project, it is concerned with a specific investment opportunity belonging to a division. As we can see in Table 1, each of Midland`s divisions had its own target debt ratio. Those targets were set based on consideration involving each division`s annual operating cash flow and the collateral value of its identifiable assets. In the other hand, the risks of investment opportunities vary. So the riskier projects deserve higher hurdle rates while the less riskier ones should lower their hurdle rates.
Using different hurdle rates will enable us to draw more accurate conclusions. Or, if the real hurdle rate of a project is lower than a firm-wide hurdle rate, we might reject it which should have been accepted and brought positive NPV; if the real hurdle rate of a project is higher than a firm-wide hurdle rate, we might accepted it which should have been rejected and cause negative NPV damaging the stock holders` value. 4. Does your conclusion in (3) change if you instead assume that Ocean Carriers operates the capesize for the full life of 25 years before selling it for scrap value (grown by inflation)?
In order to get the estimation of the WACC for E&P and R&M, we need to make sure the percent of D/V and E/V, the cost of debt , the cost of equity and the tax rate. According to the Table 1, we can clearly get the percent of D/V and E/V. DivisionsD/VE/V E&P46%54% R&M31%69% For cost of debt, it equals to the risk-free rate plus spread to Treasury. Because we are actually interested in the future market risk premium and it usually takes many years of data to produce more moderately accurate estimation of market premium, we choose the yield of 30-year US Treasury bond as risk-free rate, which is 4. 8%. So for E&P, =4. 98%+1. 6%=6. 58% while for R&M, =4. 98%+1. 8%=6. 78%. Since we can’t get the beta of E&P and R&M, we should depend on the information of comparable companies on Exhibit 5. We can get the average unlevered beta according to the formula . We assume the ? D equals to zero, the unlevered beta of E&P and R&M are 0. 823 and 0. 998 separately with the date of average value of D/E and average equity beta. Based on , the levered equity beta of E&P and R&M can be calculated with the D/E of E&P and R&M.
Finally cost of equity of E&P is 1. 523, while the R&M’s cost of equity is 1. 446. Under CAPM model, , E&P and R&M have the cost of equity of 12. 597% and 12. 208%. The taxes of 2004 to 2006 are shown on Exhibit1 Midland Income Statement, the tax rates from 2004 to 2006 are 41. 40%, 39. 21% and 38. 58%, so the average tax rate is 39. 73. DivisionsD/V E/V tr E&P46%6. 58%54%12. 597%39. 73%8. 63% R&M31%6. 78%69%12. 208%39. 73%9. 69% Using the formula ,the cost of capital for E&P and R&M is 8. 63% And 9. 69%.