Case Discussion Points 16422

Discussion notes Midland Energy Resources Inc- Cost of capital

Factors affecting the cost of capital   

Capital structure policy Dividend policy Investment policy

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Uncontrollable factors affecting the cost of capital Level of interest rates Level of tax rates

Question 1: How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations?

Strategies

Uses of cost of capital 

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Asset appraisals for capital budgeting and financial ing –Help in achieving the strategy using the cost of capital to invest in value creating projects – For example, you are doing an investment in short term project. You may use short term rates for debt/risk free rate and risk . To that extent, the calculations will vary. Calculations also vary based on the risk of the project. If the project is risky, you may choose a higher COC Performance assessments- cost of capital depends on the DCF which is related to the performance of the company. Rates vary depending the length of the going concern assumption and other factors – use of debt free cash flows discounted at cost of equity. Beta is dependent upon the stock prices. Capital structure. Divisional EVA. Evaluation of EVA M&A proposalsStock repurchase plans

Question 2: Reasons for choosing ERMP 5.1% Chosen due to longest period and lowest standard error. This is used at the corporate level and across various divisions. 5% is not selected since there is no basis behind the same and it cannot be chosen due to analyst estimates. Question 3: Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or why not?

Why to use different hurdle rates    

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Beta is different for different divisions, risk profile is different for different divisions They have different credit ratings Hurdle rate is different for different divisions Should not use a single hurdle rate as it will mislead the evaluation of investments and will result in Midland investing in risky projects which is risky in the perspective of the corporate nature They have different target debt/equity ratio and different weights, different target capital structure CF/revenues and different collateral value of identiable assets

4. Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from one another?

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The various business units operate on different industries They have different risk profiles and different beta They have different credit ratings Therefore it is appropriate to calculate cost of capital for each if its divisions

5. How would you compute a cost of capital for the Petrochemical division?

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No data given form the beta and the D/E related to the petrochemical companies Using the data available on exhibit 5, we decided to use arithmetic averages on D/E ratio and beta to calculate the cost of capital for the petrochemical division. Corporate Beta= Average (E&P beta, R&M Beta, petrochemical Beta) Corporate Beta= Average (E&P D/E, R&M D/E, petrochemical D/E)

Effect of change in the capital structure     

An increase in the debt means higher risk of bankruptcy Firms can deduct interest expense Debtholders have prior claims on cash flows as compared to stockholders Additional dent can affect the behavior of managers Net impact on WACC-

Details of the divisions of Midland Exploration and production: Questions for the case discussion posted in D2L 1. How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations? 2. Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations. Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why? 3. Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or why not? 4. Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from one another? 5. How would you compute a cost of capital for the Petrochemical division?