Midland Engergy Resources Inc: Cost Of Capital Case Solution & Answer

Midland Engergy Resources Inc: Cost Of Capital Case Solution

Case Brief

The Midland Energy resources has been incorporated since 120 years, having 80,000 employees in the fiscal year 2007. The company had been engaged in its vertical divisions, including: oil and gas exploration, refining and marketing and the petrochemicals. The company had been retaining technologically advanced assets as compared to other industry players. For the past five years; the retained net margins had been highest for Midland Incorporation in comparison to its industry peers due to the vertical integration which made Midland Energy Resources Incorporation one of the leading oil exploration, refining and marketing firms in the industry(Heilprin, 2009).

In order to forecast the future projections and valuations; the Senior Vice President of the company calculated a firm wide cost of capital, which raised several questions regarding the future projections and cost of capital calculation. First of all, Janet Martensite calculated a single cost of capital as compared to individual cost of capital for each, which could give a clear picture of the future estimations. Secondly, how the cost of capital is calculated and whether the market risk premium used is appropriate. Lastly, a single hurdle rate is used to value the investment opportunities in all division, located in different countries. The question was to check whether this single rate was appropriate or not.

Question 1

The Senior Vice President “Janet Mortensen”, estimates the cost of capital for various purposes, such as:

  • Decision regarding the asset appraisals for the financial and the capital budgeting, i.e. the process of determining an asset value based on its costs; the income generated by the asset and the fair market value.
  • The cost of capital is used for performance assessments i.e. whether the project or an investment generates a return greater than the cost of the capital of the company or a particular division.
  • To decide about the mergers and acquisitions proposals, by looking at the returns or synergies generated by the M&A proposal as comparedto the cost of capital of the company’s each project division.
  • To decide about the repurchase of stocks. These estimates for WACCC are not just used at division level or business level, but are also used at corporate levels.

These anticipated used affect the calculation of the cost of capital in different ways. First of all, the cost of capital should be adjust according to the risk level associated with a project. Secondly, the cost of capital may be calculated on a division level or the whole firm, based on the nature of the project. Lastly, the cost of capital should adjusted according to the target debt ratio and the capital structures.

If the estimation of the cost of capital becomes extremely high in comparison to the true cost of capital; it would lead towards undervalued projects  and other capital budgeting or investment decisions as a high cost of capital may lead to a negative net present value as compared to the required, which would ultimately result in neglecting the investment decision. Similarly, an extremely lower estimate of the cost of capital would lead towards an overvalued investment opportunity as compared to the original value, which might lead towards a wrong investment decision being taken by the firm, ultimately leaidng to a loss over the invested. So, the cost of capital should be meticulously measured in order to make an appropriate and an accurate investment decision.

Question 2

The Vice President of Midland Energy Resources has estimated the consolidated WACC of the company. Although the company has three division which are integrated vertically with different debt to equity ratios and different capital structure; due to the different capital structure of particular divisions, the cost of capital calculated for the company must take into account all the different capital structure of each division and the average of these cost of capital should be applied to the company as a whole when estimating the company’s consolidated cost of capital……………………

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