Case Report for Midland Energy Resources, Inc: Cost of Capital

2. Establish how the cost of equity is affected by capital structure decisions by defining financial risk and introducing the levered beta CAPM equation

We determine the amount of capital financing needed by taking line (10), after-tax net income and adding back line (16) depreciation, to determine actual capital needed given the forecast of capital expenditure. We made certain assumptions, such as, cash levels will be kept roughly in line with 1983 level of $542 million. In addition, we assumed that tax provisions were actually paid out each year, rather than accruing a liability or deferring taxes to future dates. According to our assumptions and using the forecast we have determined that MCI needs approximately $4.2 billion dollars in the next 4 years, from 1984 through 1987. After 1987 capital expenditure begins to taper off and growth in EBITDA increases to a point where it is enough to finance internally the planned capital expenditures. Over 75% of the capital requirements comes in the later 2 years, in 1986 and 1987.

The mixture of debt-equity mix is important so as to maximize the stock price of the Costco. However, it will be significant to consider the Weighted Average Cost of Capital (WACC) as well so that it can evaluate the company targeted capital structure. Cost of capital (OC) may be used by the companies as for long term decision making, so industries that faced to take the important of Cost of capital seriously may not make the right choice by choosing the right project(Gitman’s, ).

Using a single cut-off rate for the entire company has increased the overall risk of their company. The use of an acceptable range based on a company-wide average cost of capital inappropriately leads the company to invest in divisions with high risk that should possibly have a higher required rate of return or to not invest in low risk divisions that would be profitable, merely because they do not exceed the company rate. Thus, using a WACC for each division will more accurately allow the corporation to decide which projects to accept and deny based on the specific risk factors of the section instead of the risk of the entire company which has been skewed because of diversification. Based on my calculations, the company wide WACC and cut off rate that should be used is 9.94% based on CAPM or 9.8% based on Dividend-growth, and any projects that are below that percentage should not be accepted for the company as a whole.

As seen in Exhibit I below, the project’s cost of equity (COE) is calculated to be 13.487%. We found this value by using the Capital Asset Pricing Model (CAPM) formula by adding the treasury note yield with the beta value, then taking the market return rate and subtracting the treasury note yield. We then multiply those values together to attain the cost of equity value of 13.487%. This means

Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or why not?

The highly levered capital structure had a significant effect on the findings of sections B and C. First of all, the ranges which resulted from the new calculation of the break points caused the weighted average cost of capital (WACC) at all range levels to drop. The WACC is calculated by multiplying the weights of the capital structure by the costs of

The Ameritrade case study analysis brought in this paper comes to estimate the final cost of capital that should be applied to Ameritrade’s technology and marketing investment project. Allegedly, the final purpose of every WACC calculation is in helping to estimate the NPV of a project in order to make a “go\no go” decision, whether it is done by an investor or a creditor. However such a decision requires also the computation of future cash flows. Since we are missing the information regarding Ameritrade’s future cash flows, this paper has one and only goal – to evaluate and discuss the main possible alternatives for

According to the sensitivity analysis table provided in Exhibit 2, the share price should be valued between $50.92 and $55.68, whereas the current share price is $42.09 (an undervaluing of approximately 17%-24%). It should be noted however, that when re-computing the present value of the estimated future cash flows computed by Ms. Ford, the shares should be valued at $44.17; in this case the share is undervalued by 4.7%. Joanna Cohen determined the cost of capital to be 8.4% and the share price to be $69.44. According to her work the share value was undervalued by $27.35 (approximately 39%). Despite these discrepancies, according to the above analysis and Ms. Cohen’s calculations the share price is undervalued.

The task by Ms. Mortensen to compute the weighted Cost of Capital (WACC) is vital in attaining four objectives: (1) to support financial accounting and capital budgeting decisions, (2) for performance assessments, (3) to inform merger and acquisition proposals, and (4) to support stock-repurchase proposals. But the cost of capital approximations by Ms. Mortensen appears to misguide these decisions. This is because the inputs and assumptions are misleading as evidenced by criticism by the controllers and division

The students should come to realize that the return-on-capital figures should be evaluated relative to a market-based benchmark, the weighted average cost of capital. Relative to the WACC calculated in case Exhibit 2, Home Depot is beating its benchmark (12.3 percent), while Lowe’s is below its benchmark (11.6 percent). The class may comment on the justification for differences in the cost-of-capital estimates for firms that appear so similar in their risk profiles.

As we see in Exhibit B in the appendix, with an increase of 10, 20, and 30 debt to total capital, we see our ROE increase to 9.52, 10.19, and 11.05 respectively. However this increase in ROE comes at a price, as the overall risk of the company is increased with the addition of the debt obligations. In Exhibit B, we see that the beta of equity increase as we increase our debt in the capital structure, and increasing beta indicates increased systematic risk for the firm. This increase in beta is also a factor that contributes to the increased cost of equity. As shown in Exhibit B, the cost of equity increases 21 bps with the addition of 10 debt, 43 bps with the addition of 20 debt, and 67 bps with the addition of 30 debt into the capital structure. The increased basis points come as investors will begin to demand a higher rate of return on their investment as more debt is added to the structure because, as residual claimants, their claim to assets are reduced in favor of the bond holders. This increased rate will make it more difficult to raise future capital in the equity market if needed. However, by issuing debt which has a lower cost of capital at 6.16 and repurchasing equity that has a cost of capital of 13.37 (unlevered), the company can reduce its overall cost of capital, or the weighted average cost of capital (WACC). The WACC is measured by taking the weight of debt

11. Hurdle rates are the required rate of return used in capital budgeting. Simply put, hurdle rates are based on the firm’s WACC. Divisional hurdle rates are sometimes used because firms are not internally homogeneous in terms of risk.

3. Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why of why not?

This article mainly discusses the cost of capital, the required return necessary to make a capital budgeting project worthwhile. Cost of capital includes the cost of debt and the cost of equity. Theorist conclude that the cost of capital to the owners of a firm is simply the rate of interest on bonds.