Case analysis Midland Energy
Cost of Capital Estimate for Midland Energy Resources, Inc.
In the first section of my report, I list out the main models and methods applied to estimate the cost of capital for Midland’s three divisions, general assumptions made and the corresponding justifications. In the second section, Calculations, I not only compute the cost of capital based on the general assumptions previously made, but also discuss specifics of each division and the additional adjustments or assumptions made to justify my estimates.
SECTION 1: Main models and methods applied and corresponding assumptions
1. Constant Debt-ratio Weighted Average Cost of Capital (WACC):
Assumptions:
WACC: as constant debt ratio is the underlying assumption to derive the WACC model, constant debt ratio should be reasonably assumed to be applied by Midland and its three divisions. According to the case, Midland optimizes its debt levels by regularly reevaluations against its energy price and stock price level and each division has its own target debt ratio. Although the actual capital structure sometimes deviates from the target due to factors such as market value of specific collaterals, it is safe to assume that the debt ratio averages out at the target ratio in the long run, given that the target ratios are not adjusted frequently. Therefore, the debt ratio can be viewed as a constant and thus WACC is applicable.
Capital structure: as assumed above, target debt ratio is employed in calculation.
Tax rate/t: Effective tax rate should be applied to calculate the cost of capital. The average effective tax rate (39.73%, calculated in Section 2) of that in year 2004, 2005 and 2006 is used as the estimated tax rate.
Cost of debt: I basically used the same method as Mortensen did in the case, computing the cost of debt for each division by adding a spread over U.S. treasuries with a similar maturity. I assume that the default risk measured by the spread over treasury gives a reasonable estimate on
In the first section of my report, I list out the main models and methods applied to estimate the cost of capital for Midland’s three divisions, general assumptions made and the corresponding justifications. In the second section, Calculations, I not only compute the cost of capital based on the general assumptions previously made, but also discuss specifics of each division and the additional adjustments or assumptions made to justify my estimates.
SECTION 1: Main models and methods applied and corresponding assumptions
1. Constant Debt-ratio Weighted Average Cost of Capital (WACC):
Assumptions:
WACC: as constant debt ratio is the underlying assumption to derive the WACC model, constant debt ratio should be reasonably assumed to be applied by Midland and its three divisions. According to the case, Midland optimizes its debt levels by regularly reevaluations against its energy price and stock price level and each division has its own target debt ratio. Although the actual capital structure sometimes deviates from the target due to factors such as market value of specific collaterals, it is safe to assume that the debt ratio averages out at the target ratio in the long run, given that the target ratios are not adjusted frequently. Therefore, the debt ratio can be viewed as a constant and thus WACC is applicable.
Capital structure: as assumed above, target debt ratio is employed in calculation.
Tax rate/t: Effective tax rate should be applied to calculate the cost of capital. The average effective tax rate (39.73%, calculated in Section 2) of that in year 2004, 2005 and 2006 is used as the estimated tax rate.
Cost of debt: I basically used the same method as Mortensen did in the case, computing the cost of debt for each division by adding a spread over U.S. treasuries with a similar maturity. I assume that the default risk measured by the spread over treasury gives a reasonable estimate on