Midland Energy Essay
Please prepare a 2-3 pages of case memo addressing the following issues. Please include the Excel sheets to support your answers. 1. How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations? Janet Mortensen, Senior Vice President of project finance for Midland Energy Resources has calculated yearly annual cost of capital investments for Midland and each of its three divisions.
The three divisions consist of oil and gas Exploration and Production (E&P), Refining and Marketing (R&M) and Petrochemicals.
E&P is Midland’s most profitable business unit producing 2. 10 million barrels of oil and 7. 28 billion cubic feet of natural gas per day, bringing total earnings after taxes of 12. 6 billion. R&M brought Midland’s its highest operating revenue of $202. 1 billion but an earnings after tax of $4. 0 billion. R&M has ownership interest of forty refineries around the world that produces gasoline for fuel to automobiles.
Lastly, Petrochemical’s was Midland’s smallest division with 25 equity interests in manufacturing facilities and five research centers in eight countries around the world, bringing a earnings after taxes of $2. 1 billion. These estimates have helped Midland in various analyses such as asset appraisal for capital budgeting and financial accounting, performance assessments, Merger and Acquisitions proposals and stock repurchase decisions. The analysis is used to make decisions at the division and corporate level and have an impact in calculating the Weighted Average Cost of Capital (WACC). 2.
Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations (risk-free rate, equity market risk premium (EMRP), beta). Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why? Calculating Midland’s Corporate WACC rd = Cost of debt re = Cost of equity D = Market value of Debt E = Market value of Equity V = D + E = Firm’s or Division’s Enterprise Value t = tax rate Mortensen computes the cost of debt by adding a premium or spread over US treasury securities (Provided in Table 1 and Table 2).
The premium spread is influenced by various factors such as cash flow from operations, the collateral value of assets and external political risks. Calculating the Cost of Equity rf = risk free rate ? = systematic risk EMRP = Equity Market Risk Premium The cost of equity is calculated by using the Capital Asset Pricing Model (CAPM) with various assumptions. Mortensen used published and commercial betas that were comparable to Midland Corporation. Mortensen and her team did not use their own regression model to calculate their beta.
The values used are from Table 2 of a risk free rate of 4. 98% assuming a maturity rate of 30 years and a systematic risk factor (? ) of 1. 25 from Exhibit 5. To calculate Equity Market Risk Premium (EMRP) Mortensen used historical data on stock returns and bond that resulted in an EMRP value of 5%. The value was reviewed and consulted by professional advisors (bankers and auditors) as well as the Wall Street analysts. Using the value of 5% for the EMRP is a valid estimate to use since it has been reviewed by experts from outside companies and compared to other similar industries.
By using the values from Exhibit 5, of an Equity value = $134,114 million and Debt value of $79,508 and the stated assumptions, we were able to calculate the WACC for Midland Corporation to be 8. 56% However, but using the values from Table 1 of a Debt and Value ratio of 42. 2%, we get a WACC for Midland Corporation of 8. 20%. This is using the same tax rate of 38. 58% that was calculated from the income statement in Exhibit 1 (see attached excel file for calculations). 3. Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions?
Why of why not? Midland has a diverse business with each division having its own rules and risks for investments opportunities. By using a systematic risk factor (? ) of 1. 25, we were able to calculate the weighted average cost of capital for the corporation level but not for the three different divisions. To gather a more accurate result, using a different systematic risk factor (? ) per division will formulate a different hurdle rate for a decision of investment. 4. Compute a separate cost of capital for the E&P and Marketing & Refining divisions.
What causes them to differ from one another? To compute the cost of capital for Exploration and Production (E&P) and Marketing and Refining (M&R) we use a different systematic risk factor value provided in Exhibit 5. Mortensen and her team calculated the beta values per division by using published betas for publicly traded companies that were comparable by each division of Midland’s business unit. By using the debt and value ratio from Table 1 and the assumption of a 30 year rate of 4. 98%, we were able to calculate the Weighted Average Cost of Capital (WACC) for E&P and M&R divisions.
Capital Asset Pricing Model (re)| | Corporation| E&P| R&M| Risk free rate (Table 2)| rf = | 4. 98%| 4. 98%| 4. 98%| systematic risk (Exhibit 5)| ? =| 1. 25| 1. 15| 1. 2| Equity Market Risk Premium (Exhibit 6)| EMRP=| 5. 00%| 5. 00%| 5. 00%| | re =| 11. 23%| 10. 73%| 10. 98%| Weighted Average Cost of Capital| | | | | Debt/Value (Table 1)| D/V| 42. 20%| 46. 00%| 31. 00%| WACC =| 8. 20%| 7. 65%| 8. 87%| 5. How would you compute a cost of capital for the Petrochemical division? 6. Vary assumed leverage up and down and recompute WACC. What is the effect of leverage on WACC?