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Cost of Capital

Rishabh Mulani – 365 Nikhil Nair- 366 Akshat Parashari – 367 Suparna Rao – 210 Saumya Goel – 208 Pranay Jain – 209 Rishabh Golcha – 309 Rushabh Gala - 308

Midland Energy Resources

A global energy company which operated in:
i.

Exploration and production (E&P),

ii.

Refining and marketing (R&M), and
Petrochemicals

iii.

Midland Energy Resources

Used cost of capital for:
• •

Capital Budgeting Financial Accounting


• •

Performance Assessments
M&A Proposals Stock Repurchase decisions

Cost of capital prepared by- Janet Mortensen

The 3 divisions

Exploration & Production (E&P)
Refining & Marketing (R&M) Petrochemicals

3% increase over 2005 • • • Natrual Gas • 7.Division 1: Exploration & Production Oil • 2.3 Billion After-Tax earnings: $12 BIllion Forecasted capital spending: Expected to exceed $8 Billion .28 billion cubic feet per day • Nearly 1% increase over 2005 Production segment dominated E&P’s results Most profitable business for Midland Midland was one of the highest margin gainers in the industry for this segment • • • Revenue Generated: $22.1 million barrels per day • 6.

• • • . Greater expenditure anticipated in long term.Division 2: Refining & Marketing • • • • • Ownership of 40 refineries worldwide Distilled 5 million barrels a day This was the company’s largest business Severe competition due to commoditization Midland was the market leader Revenue generated: $203 Billion After Tax earnings: 4 billion Forecasted Capital Spending: Expected to remain stable in 2007-08.

Division 3: Petrochemicals • • Smallest division in Midland Had ownership & equity in 25 manufacturing facilities & 5 research centers Revenue Generated: $23 Billion After-Tax Earnings: $2 Billlion • • • Forecasted capital expenditure: Expected to grow in the short term .

The 4 pillars of Midland • To fund significant overseas growth To invest in value-creating projects across all divisions To invest in value-creating projects across all divisions To opportunistically repurchase undervalued shares • • • .

producers. & Midland was no exception” Midland acted as lead developer of projects Earnings from equity affiliates: $4.1st Pillar: Overseas Growth • “Overseas investments were the main engine of growth for most large U.S.75 Billion 77% of these earnings came from overseas investments • • • .

How did Midland measure the performance of a business division? Two ways: • • • Performance against plan (over 1. & 5-year periods) Economic Value Added (EVA) . 3.2nd Pillar: Value creating investments • To calculate the most prospective investment. Midland used discounted cash flow.

3rd Pillar: Optimize capital structure • Midland optimized its capital structure mainly by exploiting the borrowing capacity for its energy reserves & long-term productive assets like refining facilities. a corresponding spread over treasury bonds was also established to estimate divisional & corporate costs of debt. Rated A+ by Standard & Poor • • • . Debt ratings for each division had been established by Mortensen Also.

hence no large share repurchases Intrinsic value of the shares had risen as well .4th Pillar: Stock Repurchases • • Had been known for repurchasing its own undervalued shares Repurchase could be done by • • 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.

Estimation of the Cost of Capital • Used WACC WACC = rd(D/V) (1-t) + re(E/V) • Where D=Market Value of Debt E=Market Value of Equity V=Firm’s or division’s Enterprise value (V=D+E) rd=Cost of Debt re=Cost of Equity .

Treasury securities of similar maturity. • This spread depended on a variety of factors: • • • Division’s cash flow from operations Collateral value of division’s assets Overall credit market conditions • Some properties supported lesser borrowing than others .S.Estimating the cost of Debt • The cost of Debt was computed by adding a premium. or spread over U.

• . The risk premium adopted (after review & consultation) was 5%. which she felt were comparable to each division’s business.Estimating the cost of Equity • CAPM (Capital Asset Pricing Model) was used: re=rf + β(EMRP) • Mortensen was dependent on the Betas published for publicly traded companies.

COST OF CAPITAL .

Cost Of Capital • • • Required rate of return on invested funds. or WACC. . It is also referred to as a “hurdle” rate Any investment which does not cover the firm’s cost of funds will reduce shareholder wealth • Referred to as the firm’s Weighted Average Cost of Capital.

Importance Of Cost Of Capital  Designing the optimal Capital structure  Assisting in investment decisions  Helpful in evaluation of expansion projects  Helps in evaluating the financial performance of top management in formulating Dividend policy and Working capital policy  Helps  It is the firm’s required rate of return which will just satisfy all capital providers .

Components Of Cost Of Capital Bank Loans Commercial Papers COST OF DEBT COST OF CAPITAL COST OF PREFERENCE Debentures Issue of additional shares Retention earnings COST OF EQUITY .

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.Cost Of Debts   The cost of debt is the rate of return the firm’s lenders demand when they loan money to the firm. Since in most cases debt expense is a deductible expense.tax rate) .

.Cost Of Preferred Equity  The cost of preferred equity is the rate of return investors require of the firm when they purchase its preferred stock.  The cost is not adjusted for taxes since dividends are paid to preferred stockholders out of after-tax income.

 This return comes in the form of cash distributions of dividends and cash proceeds from the sale of the stock. .Cost Of Equity  The cost of common equity is the rate of return investors expect to receive from investing in firm’s stock.  Cost of common equity is harder to estimate since 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 firm’s 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 • • wD=proportion of debt rD=cost of debt tc=corporate tax rate .

Hence. we generally use book values for debt and market values for equity • . the weights should be based on observed market values. not all market values may be readily available.Determining Proportions • Proportions=target capital structure weights stated in market value terms Ideally. However.

and common equity We can calculate the weights by simply determining the proportion that each source of capital is of the total capital • . since it lists the total amount of longterm debt. preferred equity.Book-value Weights • One potential source of these weights is the firm’s balance sheet.

not current. Therefore. values • The market recalculates the values of each type of capital on a continuous basis.Market-value Weights • The problem with book-value weights is that the book values are historical. market values are more appropriate .

At some point. it will be cheaper to issue debt rather than new equity. 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. • This is because adding debt increases the default risk . • .and thus the interest rate that the company must pay in order to borrow money.Capital Structure • • Because of tax advantages on debt issuance. the cost of issuing new debt will be greater than the cost of issuing new equity. however.

) How are Mortensen's estimates of Midland's cost of capital used? .Question 1.

• • • • Asset appraisal for Capital Budgeting and Financial Accounting Performance Assessment M&A Proposals Stock Repurchase Decisions • At Division or business Level as well as Corporate Level .Answer • Mortensen’s Estimates are used for.

if at all.) How. should these anticipated uses affect the calculations? .Question 2.

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. the company may need to adjust the cost of capital by including a higher risk premium.• For a project with the same average risk as all company projects. the calculations of WACC may be affected. Conversely. EXAMPLE : For a riskier merger & acquisition proposal. • • . no effect to the cost of capital calculations. If the projects are of greater or less risk.

Mortensen collected beta estimates from several businesses with operations similar to those of Midland’s divisions and used the average to derive a beta estimate for Midlands’s divisions.• When used at the divisional rather than corporate level. Special consideration should be given to the fact that Midland’s divisions do not have individual Beta figures. • .

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? .

t = 39% D/E ratio = 39.73% .15 EMRP = 5% Tax rate.15*5 = 10.EXPLORATION AND PRODUCTION DIVISION • • • • • Given data : β = 1.98 + 1.98% • • • • Calculation of cost of equity Re = Rf + β * EMRP = 4.8% • • Maturity = Long term of 30 years Rf = 4.

Spread to treasury for E&P division = 1.• • • • Calculation of Enterprise Value We know that D/E ratio for E&P department to be 39.8% let the equity.58 % . E be 100 units and hence D is 39.8 units.8 units Calculation of Cost of debt To find Rd we use the interest rate that we currently pay for new loans.98 + 1.60% • • • • • • Rd = Rf + Spread to treasury Rd = 4.60 = 6. V = E + D = 139.

8 • 𝑊𝐴𝐶𝐶 = 8.Calculation of Cost of Capital • 𝑊𝐴𝐶𝐶 =6.58 ∗ 1 − 0.8 139.39 39.818 % .73 ∗ 100 139.8 + 10.

Marketing & Refining Division • • • • • Given data : β = 1.20 EMRP = 5% Tax rate.98 % .98% • • • • Calculation of cost of equity Re = Rf + β * EMRP = 4. t = 39% D/E ratio = 20.98 + 1.20*5 = 10.3 % • • Maturity = Long term of 30 years Rf = 4.

• V = E + D = 120. Spread to treasury for E&P division = 1.80 = 6.3 units.78 % .80% Rd = Rf + Spread to treasury Rd = 4.3 units Calculation of Cost of debt - • • • • • • To find Rd we use the interest rate that we currently pay for new loans. E be 100 units and hence D is 20.• • • Calculation of Enterprise Value We know that D/E ratio for E&P department to be 20.98 + 1.3% let the equity.

98 ∗ 100 120.3 + 10.825 % .3 • 𝑊𝐴𝐶𝐶 = 9.3 120.39 20.Calculation of Cost of Capital • 𝑊𝐴𝐶𝐶 =6.78 ∗ 1 − 0.

25=Average(1. Petrochemical β) Petrochemical β = 1. 1.98% . t = 39% D/E ratio = 20.Petrochemical Division • Given data : • • • • • • • • Corporate β =Average (E&P β . Petrochemical β) 1.3 % Maturity = Long term of 30 years Rf = 4. R&M β .15.20.40 EMRP = 5% Tax rate.

3. Petrochemical D/E) 59.8% • • • • . 20.• • • • Calculation of cost of equity Re = Rf + β * EMRP = 4.8. Petrochemical D/E) Petrochemical D/E=117.40*5 = 11.3=Average(39. R&M D/E .98 % Calculation of Petrochemical D/E Corporate D/E=Average (E&P D/E .98 + 1.

Spread to treasury for E&P division = 1.33 % .35 = 6. V = E + D = 217.8 units. E be 100 units and hence D is 117.8 units Calculation of Cost of debt - • • • • To find Rd we use the interest rate that we currently pay for new loans.• • • • Calculation of Enterprise Value We know that D/E ratio for E&P department to be 117.35% Rd = Rf + Spread to treasury • • Rd = 4.8% let the equity.98 + 1.

33*(1 .39) 117.8 217.98 * 100 217.Calculation of Cost of Capital • WACC = 6.588 % .8 • WACC = 7.8 + 11.0.

They have different values of systematic risks. The E&P and R&M divisions have different credit ratings. β. 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. A+ and BBB respectively.DIFFERENCE IN COSTS OF CAPITAL They differ from each other because – • • The business units operate on different industries. • • .

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