Financial Management Midland Energy Resources Finance Essay

In the Midland Energy Resources instance survey we see that it has its operations divided amongst three separate divisions. All these three divisions have different maps and need a separate price reduction rate to measure its undertakings. Midland uses its cost of capital for many different ways. In order to dismiss Midland ‘s hard currency flows we use the leaden mean cost of capital. Here the cost of debt is easier to cipher by taking the “ bond output plus hazard premium ” attack. The Capital Asset Pricing Model is used to cipher the cost of equity. In instance of CAPM, the computation of beta requires important judgement. We use the industry informations to cipher the beta.

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Solution 1

Mortensen ‘s estimations are used for the followers

In instance of plus assessments for capital budgeting and fiscal accounting

In instance of M & A ; A proposals

In instance of appraisal of public presentations

In instance of stock redemption determinations at different divisions and concern unit degrees.

Solution 2

Calculating rD

In this instance Mortensen computed the cost of debt for each of the three divisions by adding a premium over the US exchequer securities of a similar adulthood.

In order to happen rD, we do non utilize CAPM but we use the involvement rate that we are presently paying on the new loans.

Here we see that the amalgamate spread to exchequer is given as 1.62 %

Therefore, rD = 30 twelvemonth outputs to U.S Treasury bonds + Overall Amalgamate Spread to Treasury

rD = 4.98 % + 1.62 %

rD = 6.60 %

Calculating the Tax rate

The revenue enhancement rate is calculated on the footing on the Exhibit 1 as norm over the old ages 2004, 2005 and 2006.

Therefore the revenue enhancement rate come out to be ( Midlands Income Taxes / Midlands Income Before Taxes and the Average across 2004, 2005, 2006 ) = 39 %

Calculating EMRP

Based on the exhibit in this instance, we see that the traditional information showed is about 6.0 % EMRP and the studies show lower EMRP ( 2.5 % to 4.7 % ) based on a research over the industry with the aid from foreigners who have broader industry cognition, which would ensue in a better and up-to-date EMRP.

Researchs in audience with its professional advisers, bankers and investors, every bit good as Wall Street analysts covering the industry agreed on the current estimation of 5.0 % .

As the analysts on the industry, bankers and investors have broader information from different companies and executives, it can be concluded that the attack of outside consulting and the consequence of 5.0 % estimation is appropriate.

A Calculating rhenium

Here we use 5.0 % as its Equity Market Risk Premium.

The corporate I? is publically available, and as it represents corporate degree I? , we ‘ll utilize 1.25 as it is for Overall Corporate WACC computation.

rhenium = releasing factor + I? ( EMRP )

rhenium = 4.98 % + 1.25 ( 5 % ) = 11.23 %

Calculating WACC

Given + Deliberate information: rE 11.23 % , rD 6.60 % , revenue enhancement rate 39 % , D/E 59.3 % , E= 100units, D =59.3units, V=159.3units,

E/V= 0.62774639, D/V=0.37225361

Using the expression we get, WACC =rE ( E/V ) + rD ( D/V ) ( 1-t ) = 8.548 %

Solution 3

The company here, Midland, is a big endeavor and has diverse concern units with different hazards. In the instance here we see that the Equity Beta represents the hazard factor of those divisions. ( Exhibit 5 ) .

We besides see here that the hazard profiles and different here as per the division and the hurdle rates for those divisions should besides be different and calculated based on the I? of the division

In this instance Midland should non utilize individual corporate hurdle rate as this will misdirect rating of the investings, and will ensue on Midland invest on hazardous undertakings and will go hazardous a corporate by clip

But on the other manus if Midland invests on corporate degree utilizing the corporate degree WACC.

Solution 4

Calculating E & A ; P

rhenium = releasing factor + I? ( EMRP )

rhenium = 4.98 % + 1.15 ( 5 % ) = 10.73 %

rD = releasing factor + E & A ; P Spread to Treasury

rD = 4.98 % + 1.60 % = 6.58 %

rE =10.73 %

rD =6.58 %

revenue enhancement rate= 39 %

D/E= 39.8 %

E=100units

D=39.8units

V=139.8units

E/V =0.715308

D/V= 0.284692

WACC for E & A ; P= 8.818 %

Calculating R & A ; M

rhenium = releasing factor + I? ( EMRP )

rhenium = 4.98 % + 1.20 ( 5 % ) = 10.98 %

rD = releasing factor + R & A ; M Spread to Treasury

rD = 4.98 % + 1.80 % = 6.78 %

rE= 10.98 %

rD= 6.78 %

Tax rate= 39 %

D/E= 20.3 %

E= 100units

D= 20.3units

V= 120.3units

E/V =0.831255

D/V= 0.168745

The value of WACC = 9.825 %

The concern units all these industries of Midland operate on are different and therefore they have different hazard profiles and I? ‘s and besides different recognition evaluations.

Besides as a consequence the E & A ; P and R & A ; M have different WACC values.

Solution 5

In order to cipher the cost of capital in instance of Petrochemical, we would seek for the twosome of companies which focus merely on Petrochemical industry and so utilize their fact sheet in order to acquire an norm on their I? and D/E ratio.

By taking into history the information available to us ( exhibit 5 ) and utilizing the arithmetic norms on D/E ratio and I? we can cipher cost of capital for Petrochemical division.

Corporate I? = Average ( E & A ; P I? , R & A ; M I? , Petrochemical I? )

1.25 = Average ( 1.15, 1.20, Petrochemical I? )

Petrochemical I? = 1.40

rhenium = releasing factor + I? ( EMRP )

rhenium = 4.98 % + 1.40 ( 5 % ) = 11.98 %

rD = rf +Petrochemical Spread to Treasury

rD = 4.98 % + 1.35 % = 6.33 %

Corporate D/E = Average ( E & A ; P D/E, R & A ; M D/E, Petrochemical D/E )

59.3 % = Average ( 39.8 % , 20.3 % , Petrochemical D/E )

Petrochemical D/E = 117.8 %

rE= 11.98 %

rD= 6.33 %

Tax rate= 39 %

D/E= 117.8 %

E= 100 units

D= 117.8 units

V= 217.8 units

E/V= 0.459137

D/V= 0.540863

The value of WACC = 7.589 %

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