Finance -what types of decisions

From the Midland Energy case, you learned that the firms should not always use the same cost of capital of all decision making Provide guidance and be specific, as to examples (what types of decisions) when the firm level versus a division-level cost of capital should be used. *look to attachment Files .*look to attachments File The attached files should be read, based on the attached files will be answered. .*free plagiarism .
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Midland Energy Resources Cost of Capital
Overview and Assumptions
With broad array of services and products
Midland Energy Resources is one of the
major energy companies in the world. The
three divisions of Midland Energy resources
are E&P, R&M and petrochemical. With
operating income of $42.2 billion and
revenues of $248.5 billion the company is
profit making for many years. It has over
80000 employees and operating from last
120 years. Janet Mortensen who is the senior
vice president of projects of finance. She is
responsible for budgeting of Midland
Energy and also asked to calculate the
weighted average cost of capital as part of
his job. Janet Mortensen will be required to
calculate and also explains the implications
of the WACC calculations.
Three Divisions
Midland owned five research centers and
manufacturing units. More capital spending
is expected in future.
Cost of Capital at division and corporate
level:
Corporate level and divisional level cost
capital is an important factor to be
considered while making key strategic
decisions. Midland Energy is one who wants
to consider its overall cost of capital and its
three divisions. The corporate level cost of
capital is the overall cost of funding
Midland Energy. On the other hand,
Midland’s three division’s separate cost of
capital represents each division’s separate
cost to fund each division. The knowledge
of cost of capital of corporate level and
division level is vital for key decision
making.
Exploration and Production:
With highest net margins E&P is the most
proficient operation of Midland Energy.
With the increasing trend in oil prices
Midland Energy is expecting heavy
investment in the business.
The assumptions used in the calculation
are as follows:
•
30-year maturity for Exploration
and Production, Refining and
Marketing and Midland as a
whole.
Refining and Marketing:
•
The company has its interest in various
refineries worldwide. It has five million
barrels capacity of distillation a day. This
division of Midland Energy produces with
long term trend consistent small margins.
One-year maturity for
Petrochemicals.
•
Average return from time period
1798-2006 and round down to
5%.
Petrochemicals:
•
•
•
39.73% is the rate of tax.
EMRP 5%
Midland is assumed to be going
concern.
•
4.98% is the risk free rate of
return.
Petrochemicals is the division of Midland
Energy which is small as compare to other
two divisions. Despite the fact that it is the
small division but it is undervalued and
promising business part. Worldwide
•
•
•
•
•
•
Cost of debt = rd
Cost of equity = re
MV of debt is denoted with D
MV of equity is denoted with M
Company’s value V = D+E
T = Rate of tax
Calculation of re
Midland
4.98%+5%*1.25 = 11.23%
R&M
4.98%+5%*1.33 = 11.63%
Computation
?
?
WACC = ?? (? ) (1 – ?) + ?? (?)
E&P
4.98%+5%*1.41 = 12.03%
Petrochemicals
Calculation of re
4.54%+5%*0.32 = 6.14%
E&P’s rd
Now we can find WACC
4.98%+1.60 = 6.58%
WACC:
R&M’s rd
Petrochemicals
4.98%+1.80% = 6.78%
5.89%*0.4*60.27%+6.14% (1-0.4)
Petrochemical’s rd
= 5.10
4.54%+1.35% = 5.89%
E&P
Midland’s rd
6.58%*0.46*60.27%+12.03% (1-046)
4.98%+1.62% = 6.60%
= 8.32%
Now we find re using CAPM model:
R&M
?? =
??
?
? + (? – ?) ( ? )
Beta for Midland = 1.25
Beta for E&P =
0.93*(1+(1-39.73%)*85.19%) = 1.41
6.58%*0.31*60.27%+11.63% (1-0.31)
= 9.29%
Midland
6.60%*0.422*60.27%+11.23% (1-0.422)
= 9.17%
Approach to Petrochemical
Beta for R&M =
1.05*(1+(1-39.73%)*44.93%) = 1.33
Beta for Petrochemical =
1.25 = 0.51*1.41+0.37*1.33+0.12*b = 0.32
Using resources for 2006 in line with exhibit
3 an appropriate weight is calculated for
each division. The values as per exhibit 3
are 0.53, 0.11, 0.36 of E&P, Petrochemical
and E&M division respectively. The
petrochemical division’s the cost debt and
cost of equity are 5.89% and 6.1%
respectively.
User Guide & Recommendation
Each division’s cost of debt computed by
Mortensen by adding over US premium.
And the using the assumptions mentioned
above. Including tax rate and EMRP. The
Midland’s three divisions are different from
each other so it should not use for evaluating
the opportunities the sole rate of corporate
hurdle. Midland’s each of three divisions
has its own separate risks as they are
different form each other. The Cost of
capital is 5.10%, 8.32%, 9.29% for
Petrochemical, E&P and R&M divisions
respectively. The overall WACC for
Midland energy is 9.17%. For corporate
assessment the use of different corporate
hurdle rate is essential as the three divisions
has different in nature. Mortensen was given
with full information in the case and she did
a good job. As a future prospect Midland
Energy have bright future.
Name Student:
Student ID:
Midland Energy Resources Cost of Capital
Overview and Assumptions
Dealing in three global commodities,
petroleum products and other chemicals, oil
and gas exploration, refining and marketing
of the petroleum products, the company
Midland Energy Resources has gained the
reputation of global leader in fossil fuel
energy sector. The profits for the
organization have always been boosting up,
reaching magnanimous amounts of $248.5
billion in revenue generation and $42.2
billion in income. The company has
diversified work force of 8000 thousand
employees which has been serving for the
past 120 years.
5 research and development centers along
with manufacturing plants.
Assumptions used in calculations are
mentioned below:
For the Refining and Marketing, and
Exploration and production of oils and gas
sector, the time period for the maturity is
around 30 years.
Same metric for the petrochemical sector is
assumed to be 1 year.
The normalized rate of returns since the
origin of the company is expected to be 5%.
Assumed tax rate is 39.735.
EMRP 5%
Major Divisions
D, cost of debts
Oil and Gas Exploration and Production
E, equity
This sector is embarked to be the most
profitable area of the Midland energy,
contributing the maximum towards the total
income. The estimations are done for
enhanced trends towards investment in the
energy sector by looking at rising prices of
the oils and gas commodities.
MD, MV of debt
Refining and Marketing
Midland Energy is currently operating at
more than forty oil refineries across the
globe with the current distillation limit of 5
million barrels per day. The income form
this sector is generated after longer time
periods with limited profits form income.
Petrochemicals
This is considered to be the most limited
sector of the Midland and often undervalued
in terms of investment. But because of the
promising nature of the investment,
company still spent huge capital amounts for
ME, MV of equity
V = MD + ME
T, tax rate
Name Student:
Student ID:
Midland Energy Resources Cost of Capital
Recommendations:
The entire analysis is performed for
calculating the debt separately for each
section by also tackling the assumptions
made and including the financial impact of
US premium. The tax rate and EMRP have
been included in the computational analysis,
but in practical sense, these numbers are
entirely different from each other and
therefore, the results must not be sued for
taking any real life decision. It is observed
that the challenges and obstacles for every
division are entirely different from each
other. From a corporate and organizational
point of view a more varied approach must
be used for analyzing the situation of three
different sectors. It appears that every
aspects if information which was required
by Mortensen was provided and the use of
available data was quite explicit. The
observed results appear to be very profitable
for the company.

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