Midland Resources 1. How are Mortensen’s estimates of Midland’s costs of capital used? How, if at all, should these anticipated uses affect the calculations? The cost of capital is the minimum acceptable rate of return for new investments in the corporation. Estimates of Midland’s cost of capital are used in many analysis within Midland, including asset appraisal for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. These estimates are used at the divison or the business unit level and also on the corporate level. When asses the cost of capital on different levels of business, managers must invest in new ventures that have an expected rate of return higher than …show more content…
Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or why not? Each division has different business operations which has different risks. 4. Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from one another? Assume the business is on-going for a long period of time. We use 4.98% rate as Rf from 30 years U.S. Treasury bond. Rd=Rf+Spread to Treasury Cost of Debt:: E&P: Rd=4.98%+1.60%=6.5 ,8% Refining & Marketing: Rd=4.98%+1.80%=6.78% Cost of Equity: For EMRP, Midland adopted the estimate of 5.0%. We assume the Beta for Exploration & Production and Refining & Marketing is the average of the companies listed in Exhibit 5, which are 1.15 and 1.20, respectively. We also ass`ume the company’s Beta is the weighted average of the three operations an assets level, which is 1.25. Then the Beta for Petrochemicals is calculated to be 1.91 Exploration & Production: Re=4.98%+1.15(5%) =10.73% Defining & Marketing: Re=4.98%+1.20(5%) =10.98% WACC: Exploration & Production: WACC=6.58%*46.0 %*( 1-40%) +10.73 %*( 1-46.0%) =7.61% Refining & Marketing: WACC=6.78%*31.0 %*( 1-40%) +10.98 %*( 1-31.0%)
Barb Williams and Rick Thomas, while attending an executive education course at a well-known business school, came across a case which involved calculating the cost of capital for Telus Corporation (Telus). Basic data such as the Balance Sheet, Income Statement, Data on Telus’ Common Stock, Market Index, and the Average Annual Returns in North American Capital Markets were provided. In order to calculate Telus’ cost of capital we need to calculate the company’s Cost of Equity, Cost of Debt, and Tax Rate along with their weighted cost and then apply these to the Weighted
1-a How can the CAPM be used to estimate the cost of capital for a real business investment decision?
Under the base case scenario, the IRR of the project is 61%. Since the weighted average cost of capital is 14%, the project is acceptable. The estimated cash flows indicate that the project will provide a rate of return that far exceeds the hurdle rate. Even under the worst case scenario, the IRR of 51.73% far exceeds the cost of capital.
Our analysis attempts to answer the question, “What are the things a company must consider when analyzing a new investment or project?” According to the text, a firm’s first objective when deciding to take on new debt should be that its return on net assets (RONA) should be greater than its weighted average cost of capital (WACC). Since we are working with an income statement only and do not have an amount for net assets, we will instead use return on invested capital (ROIC), which measures how well a company is using its money to generate returns. Comparing a company 's return on capital (ROIC) with its cost of capital (WACC) reveals whether invested capital was used effectively. From our spreadsheet calculations we see that using our estimated operating profit provides us with a 19.9% return on invested capital with only a 7.2% weighted average cost for that same capital. If these numbers are even close to correct, George should definitely make the move.
The cost of capital is a term used in the field of financial investment to refer
The company’s had a financial strategy based on the following, to fund significant overseas growth, to capitalize in value-creating projects for all three segments, to improve its capital structure and to repurchase undervalued shares. In order to accomplish these goals the company must calculate the cost of capital to figure out the estimates for their
Calculating a firm’s cost of capital is highly important in capital budgeting as capital costs are used to determine investment opportunities, which in turn determines the profitability of the firm. This is true even if a firm knows that a particular project will be financed in a particular way. For example, with debt, the firm must use the concept of Weighted Average Cost of Capital to evaluate all of their capital investment projects. 1 The target capital structure, which determines the cost of capital, must be applied to each investment opportunity because if all the cheap (i.e. debt) capital is used for one project, only the expensive (i.e. equity) capital will be available for future consideration. A later project could be considered unprofitable if evaluated with the cost of equity, but profitable if evaluated with the Weighted Average Cost of Capital (WACC). This can become confusing for the person evaluating the projects, but there is an easier solution. The optimal capital budget results only when each investment opportunity is evaluated with the WACC. Each dollar in the capital budget is considered part debt, part preferred stock and part common equity. Of course, the equity will come from either current retained earnings or the sale of new common stock.
Part I. Estimating the cost of capital is challenging, because the cost of capital effectively puts a price on the risk of the project. If we know the risk, it would not be risk, it would be certainty. Inherently, then, there is a philosophical challenge with finding a good estimate of the firm's cost of capital. It is assumed, however, that the market view of the firm is a fairly accurate reflection of the company's risks. The main techniques for estimating the cost of capital, therefore, are market based. In general, these market based solutions are only used to determine the cost of equity with the scope of a broader weighted-average cost of capital equation.
The cost of capital is the cost of resources used for financing a business. Depending on the method of financing, the cost of capital is financed solely through equity or debt. As a result, many companies use a combination of debt and equity to finance their businesses. Since the cost of capital represents a hurdle rate that a company must overcome before it can generate value, it is extensively used in the capital budgeting process to determine whether the company should proceed with a project.
This paper examines key elements of a cost of capital policy to facilitate objective management and allocation of corporate funds. In order for a company to make long-term investments to grow, whether that is new equipment, new products or other assets, managers must be aware of the cost of acquiring any of these assets. The obvious objective for these managers is to earn more than the cost of capital and in doing so will increase their company’s market value. If they fail to adequately estimate their cost of capital and their long-term investments fall beneath the cost of capital, their company’s market value will decline as a result. This ongoing battle of managing and calculating the cost of capital and
Cost of capital tells the company its hurdle rate. The hurdle rate refers to the minimum rate of return the company must achieve to be profitable or to generate value.
The primary reason executives initiate capital investment projects is value creation for stockholders. The objective of these investments is to create a higher total return consisting of dividend income and capital gains. Our initial question in corporate finance is to assess how new capital investments, like a factory, equipment purchase, or
Financial experts express conflicting opinions as to the correct way in which the cost of capital can be measured. Irrespective of the measurement problems, it is a concept of vital importance in the financial decision making. It is useful as standard for:
1 2 3 4 5 6 7 8 9 Abstract Profitability Ratios Efficiency Ratios Liquidity ratios Financial Gearing Ratios Investment Ratios Result of the Analysis Limitations of Financial Reports References
With a small smile, he remembered the last time he had seen her alive. Eleanor was grinning. She was wearing her blue school uniform talking excitedly about how she was going to get an A on her spelling test.