Midland Energy Resources, Inc.:
Cost of Capital
May 28, 2014
1. For what purposes dose Mortensen estimated 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 Midland’s cost of capital are used in many analyses, including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. They were performed at division of business unit level as well as corporate level. In addition, the estimated cost of capital is an essential component in WACC and ...view middle of the document...
From Exhibit 5, we can derive that
MV of Equity = $113,114, thus DV=62.8%
MV of Debt = $79,508, thus EV=37.2%
V = D+E = $213,662
It is said in the case that Mortensen computed the cost of debt for each division by adding a premium or spread over U.S. Treasury securities of a similar maturity. Although Midland didn’t provide us an exact maturity period to calculate the cost of debt, we assume that large company like Midland would use long-term asset and debt to project cash flows. Therefore we use 30-year maturity U.S. Treasury bonds as risk free rate. Moreover, from Table 1 we get spread to treasury is 1.62% thus we get rd=4.98%+1.62%=6.6%.
From the article we know that Mortensen used CAPM to calculate Cost of Equity, which is
As mentioned above, we use 30-year bond yield as for risk free rate which is 4.98%. Then we get β=1.25 and EMRP = 5.0% from article. So we can calculate that re=11.23%.
Above all, we get all the numbers to calculate WACC, through calculate we get WACC= 8.54%.
We think the 5% of market risk premium that Midland is using seems to be the appropriate choice. We think it is reasonable to look at the historical date for recent 40 years because the global energy market changes so quickly with time goes by so data earlier than 40 years ago means less than recent years’. Form table A of Exhibit 6 we can see that for recent 40 years the EMRP would be closer to 5%. Moreover, Midland adopted its estimate of 5.0% after review of recent research and also in consultation with its professional advisors as well as Wall Street analysts covering the industry. Since the analytical data covering the industry contributes to the 5.0% estimate, we believe this is a reasonable figure because the industry analysis is more related.
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?
The hurdle rate is the minimum rate of return on a project or investment required by a company. In general, the riskier is the project, the higher is the hurdle rate. Midland, as a large enterprise, has diverse business units with different risks and each division contains its own unique set of risks. As the risk profiles are different per division, the hurdle rates for those divisions should also be different in order to reflect a more accurate corporate assessment.
Based on the above, Midland should...