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ii.
iii.
Performance Assessments
M&A Proposals Stock Repurchase decisions
The 3 divisions
Natrual Gas
7.28 billion cubic feet per day Nearly 1% increase over 2005
Production segment dominated E&Ps results Most profitable business for Midland Midland was one of the highest margin gainers in the industry for this segment
Division 3: Petrochemicals
Overseas investments were the main engine of growth for most large U.S. producers, & Midland was no exception
Midland acted as lead developer of projects Earnings from equity affiliates: $4.75 Billion 77% of these earnings came from overseas investments
To calculate the most prospective investment, Midland used discounted cash flow.
How did Midland measure the performance of a business division? Two ways:
Performance against plan (over 1, 3, & 5-year periods) Economic Value Added (EVA)
Midland optimized its capital structure mainly by exploiting the borrowing capacity for its energy reserves & long-term productive assets like refining facilities.
Debt ratings for each division had been established by Mortensen Also, a corresponding spread over treasury bonds was also established to estimate divisional & corporate costs of debt. Rated A+ by Standard & Poor
Purchasing a small number of shares from the open market Purchasing large blocks of shares via self-tenders
Had a high share price since 2002, hence no large share repurchases Intrinsic value of the shares had risen as well
Used WACC
Where
D=Market Value of Debt E=Market Value of Equity V=Firms or divisions Enterprise value (V=D+E) rd=Cost of Debt re=Cost of Equity
The cost of Debt was computed by adding a premium, or spread over U.S. Treasury securities of similar maturity.
Divisions cash flow from operations Collateral value of divisions assets Overall credit market conditions
Mortensen was dependent on the Betas published for publicly traded companies, which she felt were comparable to each divisions business. The risk premium adopted (after review & consultation) was 5%.
COST OF CAPITAL
Cost Of Capital
Helps
It
is the firms required rate of return which will just satisfy all capital providers
COST OF DEBT
COST OF CAPITAL
COST OF PREFERENCE
Debentures
Issue of additional shares Retention earnings
COST OF EQUITY
Cost Of Debts
The cost of debt is the rate of return the firms lenders demand when they loan money to the firm. Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity
After tax= Before tax ( 1- tax rate)
investors require of the firm when they purchase its preferred stock.
The cost is not adjusted for taxes since dividends are
income.
Cost Of Equity
The cost of common equity is the rate of return
common stockholders do not have a contractually defined return similar to the interest on bonds or dividends on preferred stock.
WACC
WACC incorporates the required rates of return of the firms lenders and investors and the particular mix of financing sources that the firm uses. Multiply specific cost of each source of financing by its proportion in capital structure and add weighted values WACC=wErE+wprp+wDrD(1-tc) WACC=weighted average cost of capital wE=proportion of equity rE=cost of equity wp=proportion of preference rp=cost of preference
Determining Proportions
Book-value Weights
One potential source of these weights is the firms balance sheet, since it lists the total amount of longterm debt, preferred equity, and common equity
We can calculate the weights by simply determining the proportion that each source of capital is of the total capital
Market-value Weights
The market recalculates the values of each type of capital on a continuous basis. Therefore, market values are more appropriate
Capital Structure
Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity.
At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity.
This is because adding debt increases the default risk - and thus the interest rate that the company must pay in order to borrow money.
Management must identify the "optimal mix" of financing the capital structure where the cost of capital is minimized so that the firm's value can be maximized.
Question 1.)
Answer
Question 2.)
For a project with the same average risk as all company projects, no effect to the cost of capital calculations.
If the projects are of greater or less risk, the calculations of WACC may be affected. EXAMPLE : For a riskier merger & acquisition proposal, the company may need to adjust the cost of capital by including a higher risk premium. Conversely, in appraisals for certain long-lived assets, the numbers contributing to the cost of capital should be adjusted accordingly since the risk is very low.
When used at the divisional rather than corporate level, Special consideration should be given to the fact that Midlands divisions do not have individual Beta figures. Mortensen collected beta estimates from several businesses with operations similar to those of Midlands divisions and used the average to derive a beta estimate for Midlandss divisions.
QUESTION
Compute a separate cost of capital for Exploration & Production division and Marketing & Refining and Petrochemicals divisions. What causes them to differ from one another?
Given data : = 1.15 EMRP = 5% Tax rate, t = 39% D/E ratio = 39.8%
Calculation of Enterprise Value We know that D/E ratio for E&P department to be 39.8% let the equity, E be 100 units and hence D is 39.8 units. V = E + D = 139.8 units Calculation of Cost of debt To find Rd we use the interest rate that we currently pay for new loans. Spread to treasury for E&P division = 1.60%
Rd = Rf + Spread to treasury
Rd = 4.98 + 1.60 = 6.58 %
=6.58 1 0.39
39.8 139.8
+ 10.73
100 139.8
= 8.818 %
Given data : = 1.20 EMRP = 5% Tax rate, t = 39% D/E ratio = 20.3 %
Calculation of Enterprise Value We know that D/E ratio for E&P department to be 20.3% let the equity, E be 100 units and hence D is 20.3 units.
V = E + D = 120.3 units
Calculation of Cost of debt -
To find Rd we use the interest rate that we currently pay for new loans.
Spread to treasury for E&P division = 1.80% Rd = Rf + Spread to treasury Rd = 4.98 + 1.80 = 6.78 %
=6.78 1 0.39
20.3 120.3
+ 10.98
100 120.3
= 9.825 %
Petrochemical Division
Given data :
Calculation of cost of equity Re = Rf + * EMRP = 4.98 + 1.40*5 = 11.98 % Calculation of Petrochemical D/E Corporate D/E=Average (E&P D/E , R&M D/E , Petrochemical D/E) 59.3=Average(39.8, 20.3, Petrochemical D/E) Petrochemical D/E=117.8%
Calculation of Enterprise Value We know that D/E ratio for E&P department to be 117.8% let the equity, E be 100 units and hence D is 117.8 units. V = E + D = 217.8 units Calculation of Cost of debt -
To find Rd we use the interest rate that we currently pay for new loans.
Spread to treasury for E&P division = 1.35% Rd = Rf + Spread to treasury
Rd = 4.98 + 1.35
= 6.33 %
WACC
= 6.33*(1 - 0.39) 117.8 + 11.98 * 100 217.8 217.8
WACC = 7.588 %
The business units operate on different industries. Case clearly states that the risk was most apparent in the E&P division as the productive assets and proven reserves were located in politically volatile countries. They have different values of systematic risks, . The E&P and R&M divisions have different credit ratings, A+ and BBB respectively.