Midland Engergy Resources Inc: Cost Of Capital Case Solution And Analysis, HBR Case Study Solution & Analysis of Harvard Case Studies

Midland Engergy Resources Inc: Cost Of Capital Case Solution

The equity market risk premium (EMRP) considered by Midland Company is below market risk premium of 2006. In 2006 the Midland Incorporation had used a market risk premium of 5% instead of actual market risk premium of 6% which resulted in the change in the cost of equity which is calculated through the CAPM. The consideration of 5% equity market risk premium decreased the cost of equity which results in decreases weighted average cost of capital. The decreased WACC enabled the company to forecast high future returns which resulted in the appreciation of project cash flows and above market estimated rate of returns. This consideration of estimating low WACC does not provide a clear picture of firm’s future cash flows.

Similarly, the company uses the beta of 1.25, which is above the industry average. The beta is the systematic risk associated with the company. High beta indicates towards higher risk which increases the cost of equity for the company, which in return increases the company’s weighted average cost of capital. The use of high beta by the Midland Energy Resources Incorporation indicates that the company is using conservative method, which results in the lower estimation of future cash flows attained by the company through different investment opportunities. The beta of 1.15 is used to estimate the firm wide cost of capital.

The company has calculated consolidated weighted average cost of capital for the whole company, which did not provide a clear picture for the three divisions that are operating with in the country. Due to estimating the WACC of the company as a whole; the company used the weighted average cost of capital of 8.31% which is lower than the average of the WACC of the three division i.e. 9.45%. The consideration of low WACC by the company increased the future estimated cash flow for the company which does not provide a clear picture of the company and is subject to criticism.

Question 3

The hurdle rate or discount rate which are used by the Midland Incorporation is the same for all the divisions of the company which are also located in different countries of the world. Approximately more than 70% of the revenue for Midland Resources Energy Incorporation belongs to the countries outside the USA, but the company uses the US dollar denominated discount rate for all the division located in different countries.

The consideration of Midland Energy Resources Incorporation regarding the usage of same discount rate for all the division which are located in different countries is not accurate because of the nature of different political situation and economic situation in different countries. Due to the different debt structure and cost of debt in different countries; the company should highly consider the usage of different hurdle rate or discount rate for each division or average of each division’s discount rate.

So, it is concluded that the Midland Incorporation should not adopt a single hurdle for different divisions, as all of the divisions are completely different in terms of size, investment, capital structure, margins and risk. If the company adopts a single hurdle rate; it would be assumed that all the division are entirely same, which is not possible in reality.

Question 4

In order to calculate the cost of capital for R&M and E&P divisions; the capital structure of each division is considered, i.e. the E&P division has the debt of $16,349 million and equity of $43,468 million, while the R&M division has a debt of $6,864 million and an equity of $26,773 million. The cost of debt for both the divisions are determined by adding the spread to treasury rate with the risk free rate, which resulted in a cost of debt of 6.46% for R&M division and 6.26% of E&P division. The equity market risk premium is assumed to be 6%. The beta for each division is taken according to comparable companies, such as the beta for R&M division is taken as 1.2, while the beta for E&P division is taken as 1.15, which has resulted in the cost of capital of 10.22% for R&M division and 9.44% for E&P division. There is a difference between the costs of capital for both the divisions, because:

Both the business units are operating in different industries.
These divisions have different level of risk or beta.
The credit ratings for both the divisions are different, which leads to a difference in the rate on debt required by the lenders for both division The one with lower credit rating hasto pay higher cost of debt.
The capital structure is different, i.e. the E&P division has a higher level of debt as compared to the R&M division.....................
Midland Engergy Resources Inc Cost Of Capital Case Solution

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