Midland Energy Resources
1. For what purposes does Mortensen estimate Midland’s cost of capital? What would be the potential consequences of a too high estimate compared to the firm’s “true” cost of capital? What about a too low estimate?
Estimates of the cost of capital were used in many analyses within Midland, including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. Moreover, depending on correct cost of capital, Midland will be able to make accurate financial forecast on supply, demand, and growth, and will decide their new financial and investment decision on a good direction. On one hand, when Ms Mortensen get a too high …show more content…
First, each of Midland’s division may have different equity beta. Beta is a measure of the sensitivity of individual returns to market returns. The case does not give us enough information to conclude that equity beta in each division is same.
Second, costs of debt are different. According to table 1, since different credit rating, the spread to treasury is diverse in each segment of the firm, which leads to different cost of debt.
Third, each of Midland’s divisions has its own target debt ratio. According to the case, targets are set based on considerations involving each division’s annual operating cash flow and the collateral value of its identifiable assets. With different debt ratios, the WACC of each division will become different.
Fourth, each of Midland’s division may have different growth rate of return and investments in the future. According to dividend growth model, we know that investments will effect expected growth rate and cost of equity. The future investment of each dividend is different. With oil prices at historic highs in early 2007, Midland anticipated continued heavy investment Exploration & Production division. Midland projected capital spending in refining and marketing would remain stable, without substantial growth in 2007-08. Capital spending in petrochemicals was expected to grow in the near-term as several older facilities were sold or retired and replaced by newer, more efficient capacity.
4. Compute a