Midland Energy Inc. Case Solution
Therefore, it is suggested to use different corporate hurdle rates in order to avoid the misleading in the evaluations of the investments as well as it would result in investment of risky projects and that they may become risky projects by time.
If the company wants to use one hurdle rate, then it should use WACC, in situations where the company purchases some computers, then it should use corporate level WACC whereas, if the company is investing, then it should use exploration and production division hurdle rate because it provides the expectation of continued global and economic growth. The rate of refinery and marketing can be used however,it would result in low profits and it would remain the same for the upcoming periods as it has credit rating of BBB and 31% leverage. Petrochemicals has AA- credit rating with 40% leverage, and it is assumed that capital spending would increase for a short period of time as well as it would provide global expansion opportunities.
Therefore, single hurdle rate would be inadequate to use as the cost of each project varies in each division, whereas the use of single equity beta is not enough to be used in different risks and sensitive projects. Lastly, each division has separate capital structure.
Thus, it is recommended that the company should calculate different hurdle rates based on the WACC. The cost of capital would result in minimum hurdle rate after which it should be adjusted based on risk, and the amount invested for each project.
1. Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from one another?
With a specific end goal to identify the Cost of Debt of the company,we used this equation: rd. = RF + spread. While breaking down the risk free rate, we selected the rate of 4.66%. As shown in exhibit 1, this rate is compared to the growth on US Treasury obligations of 10 years. Thereas on behind selecting this is that it has medium length of time to maturity. Over here,by undertaking Midland Energy Corporate, or one of its divisions, the span of that venture would be extended as well as this rate would be the most secure and most precise suspicion. Proceeding towards the next part of the condition, we have to locate the spread. As shown in exhibit 2, we were given novel spread to treasury for the united business as well as for every division.
For the following part of the WACC equation, we focused on the Cost of Equity. Again dissecting this equation requires the risk free rate, which as we just clarified above was 4.66%. This number will be held all through the length of this task. Proceeding onwards to the following some portion of this condition identifies the EMRP and the Beta. First of all, we started with the Beta.
Looking at Exhibit 3, a variety of Market Risk Premiums accessible in light of “noteworthy US stock returns short Treasury security yields” can be seen as well as it shows the risk premium study comes about because of the Researching Companies. Out of the considerable number of alternatives accessible, we selected 5.10% as our EMRP due to having the longest time frame along with a low standard blunder. Also, this EMRP will be steady through every fundamental figuring. By looking at the Beta, exhibit 4 shows the Beta for Corporate, E&P and R&M, however it does not provide the Beta to Petro division. In order to settle on the most precise choice, the unlevered beta is calculated of both the divisions and has anticipated the beta of petrochemicals division, which has resulted in 1.4 times……………..
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