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

Midland Energy Resources, Inc.: Cost of Capital: Case Solution

Introduction

Midland energy resources incorporation has been operating for about one hundred twenty years. The company falls under the umbrella of the oil and gas exploration sector and its operations are mainly divided vertically into three divisions from exploration to refining and marketing of oil and gas and petrochemicals(Heilprin, 2009). The company uses and possesses relatively advanced technology and equipment as compared to its competitors for the effectiveness of its operations. Midland energy resources incorporation has proved to be one of the biggest leading companies in the sector of oil and gas exploration because of its vertically integrated operations.

In addition to this, Midland research and manufacturing department has been a worthwhile department and it generated the income margins of 56% within the year 2006. Since the expenses of oil are at their maximum degree and exploration corporate is predicted to develop in future; hence, Midland is looking forward to a capital investment of around $ 8 billion to fulfil the growth needs. On the other hand, the refining and advertising department is the biggest department in phrases of sales technology and it established $203 billion sales within the year 2006. This department’s income ratio has been most effective at 2% in the course of the equal year and the refining corporate is predicted to stay stable, hence, no capital investment is needed for this department. At present, the natural gas department has become the micro scale department with an income ratio of 9% however, it has its importance for Midland’s usual operations. Nevertheless, the equipment used in this department is antique and had to be return, for this reason, capital investment becomes predicted for you to collect new equipment and plant.

Nevertheless, Midland is worried about respect to the value shape and value of capital for every character department, and Janet Mortensen, who has been serving as the senior chief executive officer for mission financing at Midland, and was assigned to calculate the WACC for Midland and for every of its discrete department. In addition, the value of capital is used for investment appraisal, for now, the overall performance of divisions, financial cost brought an inventory repurchase had been additionally evaluated for the use of the value of capital but, Mortensen had deliberate the value of capital and investment appraisal for every department however, she is worried about the reasonableness of the value of capital calculated wants a consumer manual for the calculation of the value of capital for every department. Since the assessment standards are primarily based totally on the value of capital, therefore, the assessment of value capital components. i.e., the value of equity and value debt, in conjunction with the variables utilized in calculating the value of capital will assist to apprehend the figures for the value of capital.

Case Analysis

To make forecasts and projections regarding the stocks and valuations, Janet Mortenson who is the vice president of Midland incorporation, determined its cost of capital and he had to deal with many questions that arose during these calculations. Following are those questions discovered during the process.

To analyze with efficiency Janet performed calculations to determine the cost of capital at the company level and not for each division specifically. In his way he was able to get clear picture of cost of capital.
He wondered on what basis the weighted average cost of capital for the company was being determined and the EMRP considered for calculating WACC appropriate?
For the evaluations of available investment opportunities in the country or around the globe, the company has been using single hurdle rate. He wondered whether it was the right approach for overall evaluations.

Quantitative Analysis

The quantitative evaluation that Mortensen needs to pay attention to is to compare the destiny funding and capacity with the aid of using calculation of WACC and fee of going back at the funding.

Correct Estimation of WACC

Mortensen, the Vice President of Midland power assets anticipated the consolidated WACC of the business enterprise. The business enterprise had three departments that are included vertically with distinct debt to equity ratios and distinct capital shape. Due to the distinct capital shape of the precise department, the price of capital calculated for the business enterprise ought to bear in mind all of the distinct capital shape of every department and the common of those prices of capital ought to be implemented to the business enterprise as an entirety whilst assessing the consolidated price of capital for the business enterprise.

Consideration of EMRP and WACC by Midland Incorporation

The equity market risk premium (EMRP), taken into consideration with the aid of using the Midland strength assets incorporation, is under the market risk premium of 2006. In 2006, the Midland Incorporation had used a market risk premium of 5% in preference to the actual market risk premium of 6% which resulted in the cost of equity is to be changed, which is calculated through the capital asset pricing model. The attention of 5% equity market risk premium reduced the price of equity which ends up in decreased weighted average cost of capital. The reduced WACC enabled the firm to estimate excessive future returns which resulted in the appreciation of estimated cash flows and above marketplace forecast rate of returns. This attention to forecasting low WACC does no longer offer a clean image of the firm’s future cash flows.

The corporation has computed consolidated weighted average cost of capital for the entire corporation which no longer offers a clean image for the three divisions that are working within the country. Due to calculation of WACC of the corporation as an entirety, the corporation used the weighted average cost of capital of 8.31% which is decreased than the average of the WACC of the three departments i.e. 9.45%. The contemplation of low WACC with the aid of using the corporation multiplied with the future predicted cash flow for the corporation which now no longer offers a clean image of the corporation and is subject to criticism.

Discount Rate Used By Midland Incorporation

The hurdle rate or bargain rate that is utilized by the Midland Incorporation is equal for all of the divisions of the organization that are additionally placed in exceptional nations of the world. Roughly greater than 70% of the sales for Midland Resources Energy Incorporation to be joined to the nations out of the United States, however, the organization makes use of America greenback denominated bargain rate for all of the departments placed in exceptional nations. The deliberation of Midland Energy Resources Incorporation of the usage of equal bargain rate for all of the departments that are placed in exceptional nations is not always correct due to the character of various political scenarios and monetary scenarios in exceptional nations. Due to the exceptional debt shape and price of debt in exceptional nations, the organization ought to take into account to apply exceptional hurdle rate or bargain rate for every department or average of every department’s bargain rate.

Consideration of Beta

The corporation makes use of the beta of 1.25 that's above the corporate average. The beta is the systematic threat related to the corporate. High beta shows excessive threat which will increase the cost of equity for the corporate and which in turn will increase the weighted average cost of capital for the corporate. The use of excessive beta with the aid of using the Midland Energy Resources Incorporation shows that the corporate is using conservative approach which resulted in the decreased estimation of future cash flows, attained with the by using the corporate via distinctive funding opportunities.

Qualitative Analysis

The Midland Energy Resources Incorporation which operated in three vertically included departments is one of the main oil and fuel line observation and Refinery Company within the industry. The vertical integration of various departments of the corporation enabled the corporation to experience above average margins in contrast with specific agencies positioned inside the identical industry. Midland Energy Resources Incorporation have been integrated for 120 years and the departments of the corporation are positioned in forty specific international locations round the arena which gave a bonus to Midland Energy Resources in gaining logo popularity and marketplace capitalization. The corporate is technologically superior which permits the corporation to benefit from aggressive gain and performance in opposition to the corporation which might be much less technologically superior within the comparable industry. In 2007 the share price of the corporate had been definitely correlated to oil costs. In 2007, the oil expenses within the international hit the height report which resulted in the extended fee of share price and value of Midland Energy Incorporation. This resulted in growth in the stock value and the market value of the corporation and the corporation’s debt capability became extended. This extended debt capability allowed the corporation to gather more debt and benefit tax shields to grow the operating cash flow of the corporation via tax gain.......

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Midland Energy Resources, Inc.: Cost of Capital Harvard Case Solution & Analysis