Midland Energy Resources Cost Of Capital Case Solution

Step2: cost of debt:

 The cost of debt indicates an effective rate which is paid by the company because of its current debt. It is considered as one of the important parts of the capital structure. The company has many options to raise its cost of debt such as loans, bonds and other forms of securities. In addition to this, the cost of capital is the tool used by investors to analyze the level of riskiness of the company as compared to its competitors, as higher the cost of debt, the higher the level of risk and vice versa.

The cost of debt is calculated by taking the average rate of 10 years U.S. Treasury bonds as well as the spread to treasury, which is 6.0167% as shown in the table below.

Table- Return of US equities and T-Bonds

Average excess return          
US Equities – T-Bonds          
1987-2006 1967-2006 1926-2006 1900-2006 1872-2006 1798-2006
6.40% 4.80% 7.10% 6.80% 5.90% 5.10%
avg 36.10% 6.0167%      

Step 3: cost of capital

The cost of capital is high as compared to debt financing. It is the cost which investors receive in term of compensation by making an investment in a particular company. It protects the company from the fear of bankruptcy as equity investors have no such right on the company. It also solves the problem of repayment, which is commonly found in debt financing. However, the cost of equity increases the chances of ownership dilution as investors have the right to take part in the company’s decision-making process.

The next step for the calculation of WACC is to calculate the cost of equity. According to the cost of equity, the formula is;

re = rf + β(EMRP)

Where,

rf is risk free return

β is the risk and EMRP is market risk premium.

Table- component of cost of capital

Rf= 4.1833%  
B= 1.25  
EMRP= 5%  
    0.0625
  re= 10.4333%

In the provided information, β is 1.25, the equity market risk premium (EMRP) is 5% and risk free return is 4.1833% by incorporating all these factors in the formula above.

                        re=0.04183+1.25*0.05

                        re=10.4333%

Step 4: calculation of weights:

 
 
 
15
0.372254
E/V 0.62746

Put all the values in equation 1, we get

WACC=(1-0.4) (0.06016) (0.372254) + (0.10433*0.627746)

            = 0.066839

CONCLUSION:     

The company should take certain steps for the formulation of its proper financial strategies in order to achieve its goals of maximizing shareholders’ wealth. For such purpose, the company will need to invest in more oversea projects in order to expand the company’s operations, spend on more valuable projects, utilize the borrowing capacity and repurchase the stocks if it realizes that the stock price is undervalued.

Midland uses more equity financing as compared to equity financing by the ratio of 67% and 37% respectively. However, the cost of paying for equity is higher than the cost paid for the debt, which indicates that equity is expensive for the company rather than debt. Thus, the company should increase the weight of debt from its total value of financing as well as it should repurchase its shares from the market as it might result in the loss of control from the management. This would not only save the company’s cost in term of less cost of equity however, it would also provide the tax benefit while debt financing would be selected…………………..

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