The following paper examines the cost of capital for the 2007 fiscal year for both the overall company and each division individually. The WACC method yields estimate for the firm’s cost of capital of 8,17%, whilst divisional estimates are as follows: E&P 8,15%, R&M 9,03%, Petchem 6,89%. This is relatively lower in comparison to companies such as BP (11% in 2007, 10% in 2006) (BP plc 2007 Annual Report and Accounts, p58), but in line with with 2019 data on the integrated oil & gas industry (8,57%) as per Damodaran (2019).
Midland Energy Resources ("MER" or "Midland") is an integrated oil & gas company, with operations comprising exploration and production ("E&P" or "upstream"), refining and marketing ("R&M") and petrochemicals ("Petchem"). Operating revenue and income for 2006 was $248.5bn (E&P: $22,4bn, R&M: $203,0bn, Petchem: $23,2bn) and $42,2bn, respectively. As part of its annual review process, the company estimates its cost of capital. The paper is based on a Harvard Business School case study.
Table of Contents
Executive Summary
The Cost of Capital
The Cost of Debt
The Cost of Equity
Beta Estimation
Conclusion
Research Objectives and Themes
This report aims to determine the cost of capital for Midland Energy Resources for the 2007 fiscal year, evaluating both the consolidated entity and its three specific divisions: Exploration & Production, Refining & Marketing, and Petrochemicals.
- Calculation and estimation of the Weighted Average Cost of Capital (WACC)
- Evaluation of divisional hurdle rates based on specific operational risks
- Application of the Capital Asset Pricing Model (CAPM) for cost of equity
- Estimation of levered betas using comparable company analysis and proxy cash flows
- Sensitivity analysis of key financial assumptions
Excerpt from the Book
The Cost of Capital
The cost of capital (“CoC”) reflects the cost of both equity and debt to a firm, as well as its capital structure, i.e. what relative part of the firm’s capitalisation is comprised of debt or equity capital. It can be used for multiple purposes, such as discounting future cash flows, deciding which investment projects to undertake, or determining whether to implement a dividend recapitalisation. When making investment decisions, the CoC acts as a so-called “hurdle rate”, i.e. a minimum rate of return which the project must generate to be implemented, representing investors’ opportunity cost. It should be noted that as per Modigliani and Miller (1963), as the debt-to-equity ratio increases, the WACC stays constant, since the cost of equity increases with the amount of debt used, reflecting the higher risk inherent in a more levered capital structure.
There are multiple ways of calculating the CoC, namely the Miles-Ezzell (“ME”) estimation developed by Miles and Ezzell (1980), the Weighted Average Cost of Capital (“WACC”), and the Adjusted Present Value (“APV”) introduced by Myers (1974). The focus of this report will be the WACC, as it is the most widely used and well known technique, despite certain limitations as explained below. Notably, the WACC is also the method used by Midland’s management. It should further be noted that the Miles-Ezzell method has also been estimated and yields similar results for the CoC in the case of MER, however, an in-depth discussion is beyond the scope of this report.
Summary of Chapters
Executive Summary: Provides an overview of Midland Energy Resources' financial standing and presents the WACC estimates for the company and its individual divisions.
The Cost of Capital: Introduces the theoretical framework for CoC, discusses the WACC method, and acknowledges the reliance on the Capital Asset Pricing Model and its assumptions.
The Cost of Debt: Details the calculation of the tax-adjusted cost of debt, utilizing spread-to-Treasury estimates and accounting for the firm's specific capital structure and tax rates.
The Cost of Equity: Explains the determination of the cost of equity based on the risk-free rate, the equity market risk premium, and specific beta volatility factors.
Beta Estimation: Describes the methodology for calculating levered betas using the Harris-Pringle formula, incorporating comparable company analysis and cash flow proxies.
Conclusion: Summarizes the final WACC results and reaffirms the validity of the applied methodologies under the study's specific constraints.
Keywords
Weighted Average Cost of Capital, WACC, Cost of Debt, Cost of Equity, Beta Estimation, Capital Asset Pricing Model, CAPM, Hurdle Rate, Leverage, Sensitivity Analysis, Midland Energy Resources, Equity Market Risk Premium, Financial Valuation, Corporate Finance, Systematic Risk
Frequently Asked Questions
What is the primary purpose of this report?
The report aims to provide a comprehensive estimate of the cost of capital for Midland Energy Resources for the 2007 fiscal year to assist in financial decision-making and project evaluation.
What is the Weighted Average Cost of Capital (WACC)?
The WACC is the method used to determine the firm's overall cost of capital by calculating a weighted average of the costs of equity and debt based on the company's capital structure.
What methodology is used to estimate the cost of equity?
The report utilizes the Capital Asset Pricing Model (CAPM), which incorporates the risk-free rate, the equity market risk premium, and the asset's beta to calculate the required return.
How are the divisional hurdle rates determined?
Divisional hurdle rates are derived by accounting for division-specific characteristics, such as different profitability levels, leverage targets, and the relative cyclicality reflected in their respective betas.
Why is the Harris-Pringle formula used for beta estimation?
The Harris-Pringle formula was selected because it is based on the assumption that firms maintain a fixed leverage ratio target, which aligns with Midland’s corporate policy.
What are the key factors affecting the cost of debt?
The cost of debt is calculated using spreads to the 10-year Treasury rate, adjusted for the effective corporate tax rate and the firm's specific debt-to-capitalization structure.
How does the Petchem division compare to other segments?
The Petrochemicals division is identified as being significantly less cyclical than the other divisions, as indicated by its lower beta, which is less than one.
What is the significance of the sensitivity analysis?
The sensitivity analysis illustrates how variations in key inputs, such as the risk-free rate, equity market risk premium, or leverage, impact the resulting cost of capital, thereby strengthening the model's robustness.
- Arbeit zitieren
- Anonym (Autor:in), 2019, The Weighted Average Cost of Capital (WACC) Method For The 2007 Fiscal Year For Midland Energy Resources. Summary And Explanation, München, GRIN Verlag, https://www.grin.com/document/899522
