Why does Mortensen attempt to estimate separate WACCs for each of Midland’s divisions? Shouldn’t the relevant cost of capital be based on the cost for the entire firm (i.e. the combined divisions)?

            Of all the future investment opportunities are evaluated on the basis of the single cost of capital then it would mean that the return and the risk profile of all the three business divisions of the company is same. However, this cannot be true as each division belongs to different areas and has its own risk profile. Midland Energy Resources Inc currently has three business divisions and the target debt ratio, the credit rating and the target capital structure of all the three divisions is different. Therefore, different weighted average cost of capitals needs to be calculated for all the three divisions. There are also many other differences among the three divisions of the company. For instance, if we talk about the exploration and the production division then this division has higher requirements for future capital expenditures.

            The petrochemical division of the company would also be facing a range of other types of risks such as interest rate risk, political risk and the foreign exchange risk since its main operations are in the overseas market. Finally, the third division of the company which is refining and the marketing division is the highest revenue generator for the company but its profit margins are low. Therefore, if a single cost of capital is used for the entire firm as well as its individuals divisions then it would not reflect the risks appropriately. This is the reason due to which Mortensen estimated separate WACCs for all three divisions.

  1. Suppose Midland executives were to only use the company wide WACC for capital budgeting purposes. How would this likely affect the company’s performance?

            If the executives of the Midland Company were to use a single cost of capital for the capital budgeting purposes, then they might be making inappropriate decisions regarding the acceptance and rejection of different projects. For instance, the exploration and the production division have a higher target debt to capitalization ratio as compared to the refining and marketing division. So if the capital budgeting projects within the exploration and production division are valued using a companywide WACC which would be much higher than the cost of capital for this particular division, then it might be accepting projects with negative NPVs and it might be accepting projects with positive NPVs.

            Overall, the impact on the performance of the company would not be good and the profitability along with the value of the shareholders would decline since the management would be investing into unprofitable projects. Mortensen also assumes that the credit ratings for all the divisions and the company as a whole are significantly different because the nature of the business and the current financial position for each division is also different and it would also be different in the next year. Therefore, in order to accurately reflect the right risks and benefits for each of the three divisions and the company as a whole, using separate cost of capitals for all the three divisions for Midland would be more appropriate and this would also enhance the company to make comparisons with other businesses in the same sector and also allowing the divisions to invest only in the favorable capital budgeting projects................

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