Corporate Cost of Capital for Midland
There are a number of assumptions that have been made in order to calculate the weighted average cost of capital for Midland. All of these assumptions are stated below:
> The corporate tax rate for the company has not been provided in the case therefore, the corporate tax rate has been calculated by taking the average of the tax rate in the years 2004, 2005 and 2006. The corporate tax rate is calculated to be around 40%.
> The cost of debt for the company has been calculated by taking the 10 year rate for the US treasury bonds which is the risk free rate and the consolidated spread on the treasury has been added in order to calculate the cost of debt for the company. The cost of debt for the company is 4.66%+1.62%=6.28%.
> The reason for which the 10 year US treasury rate has been used is that the borrowing capacity of the company is primarily based upon long lived assets and energy reserves. Therefore, if we use the 30 year treasury rate it would not be appropriate since the changes that are taking in the industry rapidly in the timeframe which the company cannot model and capture in its business.
The cost of equity for the company has been calculated based on the formula of capital asset pricing model. However, before calculating the cost of equity the new levered beta according to the new target capital structure has been calculated. The current levered beta of the company of 1.25 as shown in exhibit 5 has been un-levered based on the current debt to equity ratio of 59.3%. The asset beta which is the unlevered beta calculated is 0.921. The table 1 provided in the case provides us with the target capital structure. Based on that the new debt to equity ratio has been calculated which is 73%. The levered beta of 1.33 has then been calculated using the following formula:
All the information provides us with all the inputs and finally, the weighted average cost of capital formula for the company has been calculated, which isaround 8.13%. One important thing to note here is that the market risk premium has been assumed by the company’s analysts to be equal to 5%. However, if we take the average of the historical market risk premiums then its equal to 6% . Also the recent projection in 2006 is 6.4% which is much higher than the estimate of Midland’s 5%. As the uncertainty in the industry is increasing and the investors want more return to compensate them for the increased return, therefore, it would be more appropriate for the company to use a market risk premium of 6%.
Corporate and Divisional Hurdle Rates
If the same corporate cost of capital or hurdle rate is used for all of the divisions of the company in order to evaluate the future investment opportunities, then it would be assumed that the risk and return profile of all the divisions of the company is same which cannot be true practically as each division would have a different risk profile. The company currently has three divisions and each of the three divisions has different debt to capital structure and the target debt ratio for each division is also different therefore a different cost of capital needs to be calculated for the company.
Some of the clear differences among all the three divisions are that the exploration and the production division has the highest demand for the future capital expenditure requirement as shown in exhibit 3 and the return on investment percentage of 54.23% is also highest for this division. The other division of Midland which is the petrochemicals is making most of its investments in the overseas markets therefore, it would be facing risks like foreign exchange risk, political risk and interest rate risk………………
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