Midland Energy Resources Case – Information to compute ... - Studypool

Midland Energy Resources Case – Information to compute WACC based upon different capital structures I.

Example 1 – Compute WACC of the Consolidated Resources using current capital structure

Assumptions (from case):    

Debt beta = 0 30-year T-bond = 4.98% Equity Market Risk Premium (EMRP) = 5.0% Tax rate = 40%

Using Exhibit #5, equity beta = 1.25 and D/E ratio = 59.3%  Compute βu = βL / [1 + (1-t)(D/E)] = 1.25 / [1+ (.60)(.593)] = .92 

Compute cost of debt o Using table 1, Rd = 4.98% + 1.62% = 6.60%

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Compute cost of equity using CAPM o Rs = 4.98% + 1.25(5.0%) = 11.24%

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Compute weights of debt and equity using Exhibit #5 o V = D + E, where V = 134,114 + 79,508 = $ 213,622 o So, wd = D/V = $79,508/$213,622 = 37.2% and ws = E/V = $134,114/$213,622 = 62.8%

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Compute WACC o WACC = wd (Rd)(1-T) + ws (Rs) o So, WACC = 0.372(6.6%)(.60) + 0.628(11.24%) = 8.53%

II. Example 2 – Compute WACC of the Exploration & Production division using target capital structure (repeat this process for other divisions and consolidated resources using the target capital structure)  

Using Exhibit #5, compute unlevered beta, βu = βL / [1 + (1-t)(D/E)], so, βu = .89 / [1 + (.60)(.112)] = 0.83 for comparable companies For each βL (equity beta) and D/E ratio, compute the corresponding βu (asset beta), where βL  βu: o 0.89  0.83 o 1.21  0.80 o 1.11  1.02 1

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o 1.39  1.08 Use the average of the four (4) competitor firms’ βu (asset beta), to compute βL (equity beta) for the target D/V ratio from table 1 o So, first need to obtain the D/E ratio from target D/V value from table 1. Therefore, D/V = 46% has an E/V = 54%. 𝐸 𝐷 𝑉 𝑉 𝐷 Recall: D + E = V; therefore, + = ; − 1 = 𝐸 𝐸 𝐸 𝐸 𝐸 o So, D/E = 85.2%

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ΒL = βu [1 + (1-t)(D/E)] =.93[1 = (.60)(.852)] = 1.41

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Compute cost of equity using CAPM o Rs = 4.98% + 1.41(5.0%) = 12.03%

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Using target weights, compute WACC o WACC = wd (Rd)(1-T) + ws (Rs) = .46(6.58%)(.60) + .54(12.035) = 8.31%

III. Example 3 – perform analysis to determine whether the firm’s target capital structure for the Exploration & Production division is also the optimal capital structure  Compute WACC for different capital structures (debt to equity ratios); The suggested ratios to use are: Other Target debt Other Target equity 25% 75% 30% 70% 35% 65% 40% 60% 45% 55% 50% 50% 55% 45%  Typically, the bond rating would change and cost of debt would increase with more debt.  Therefore, using a 30% debt and 70% equity capital structure, compute the βL (equity beta), as ΒL = βu [1 + (1-t)(D/E)] =.93[1 = (.60)(.429)] = 1.17  Using this new βL (equity beta), compute the new cost of equity using CAPM, as Rs = 4.98% + 1.17(5.0%) = 10.83% 

Using new target weights, cost of debt, and cost of equity, compute WACC o WACC = wd (Rd)(1-T) + ws (Rs) = .30(6.60%)(.60) + .70(10.83%) = 8.77%

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