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Midland Energy Resource Essay

1172 words - 5 pages

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Our team has performed thorough analysis surrounding the questions of cost of capital for Midland Energy Resources, Inc. (Midland). Here are the results of our research:
1. Ms. Mortensen estimates Midland’s cost of capital for a variety of reasons including use for capital budgeting, financial accounting, performance assessments, stock repurchase estimations, and potential “M&A” opportunities. In addition, Midland relies on the cost of capital to deliver on the financial and investment policies set forth by the Board. Finally, the cost of capital is also used in relation to expected growth and forecasted demand. To explain, if the forecasting department foresees an ...view middle of the document...

From there, we proceeded to “unlever” the Beta associated with Midland. In this step, we took the recently found “D/V” ratio and multiplied it by the the Equity Beta of 1.25 to arrive at 0.79. Next, we posted the “Target D/V” as determined by Table 1 under “Consolidated” business segments. This number is 42.2%. Subsequently, the “Target D/E” was found by taking “Target D/V” divided by “1-Target D/V.” From here, we were able to “relever” the Beta using this target capital structure. Cell M21 reflects Unlevered Beta + Target D/E multiplied by the Unlevered Beta. The next step was to determine the Cost of Equity. Our team used the CAPM formula to arrive at this answer. The second component, Cost of Debt, was determined by taking the “Spread to Treasury” for the A+ Bond under Table 1 and adding to it the 30-year U.S. Treasury yield (in accordance with how Ms. Mortensen has calculated debt previously). With our Cost of Equity and Cost of Debt, our team applied the WACC formula to arrive at 8.48%.

Midland’s choice of market risk premium of 5% does appear to be an appropriate selection in this instance. However, based on the professional opinions from the company’s bankers and auditors, as well as the Wall Street analysts, Midland is utilizing an intermediate level of EMRP. This EMRP is less than the data of stock return minus Treasury bond yield and more than the data from market survey results (as shown in Exhibit 6, A & B). We also make the recommendation that the company can narrow the risk premium rate within the range of 4.8% to 5.6%. The 4.8% represents the lowest of the higher EMRP (Exhibit 6A: 1967-2006) and the 5.6% (Exhibit 6B: Welch Survey) derives from the highest of the lower EMRP. Risk premium in this section will be reasonable for Midland Company, and at 5%, we believe it to be reasonable.

3. No, we should not use a single corporate hurdle rate for evaluating investment opportunities across all of the divisions. Because different divisions have various spread-to-treasury amounts, the target D/V and the cost of equity, will vary. These different targets and costs will lead to three different WACC amounts. One of the four pillars in 2007 is to invest in value-creating projects across all divisions. The capital...

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