This document provides background information on Midland, a global energy company with three divisions: exploration and production (E&P), refining and marketing (R&M), and petrochemicals. It discusses industry trends impacting each division and Midland's use of weighted average cost of capital (WACC) for investment decisions. The document then calculates Midland's enterprise WACC of 7.93% and recommends using both an enterprise rate and individualized divisional hurdle rates to properly evaluate investments.
This document provides an overview of Midland Energy Resources' capital budgeting case. It introduces the presenters and objectives, which are to recommend a weighted average cost of capital (WACC) for the corporate level and divisions. The steps include understanding operations, how WACC is used, computing the corporate WACC, assessing if a single hurdle rate is appropriate, and computing divisional WACCs for exploration and production, refining and marketing, and petrochemicals. Key details on each division's performance, trends, and WACC computations are presented.
This document provides background information on Midland Energy Resources, a global energy company with three business segments: oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. It then discusses the weighted average cost of capital (WACC) for the overall firm and each division. The WACC is 8.13% for the overall firm, 8.06% for E&P, 9.02% for R&M, and 6.14% for petrochemicals. Using a single WACC for the entire firm could lead to incorrect investment decisions, so the divisional WACCs should be used instead to identify the best opportunities.
The document discusses cost of capital estimates for Midland Energy Resources, a global energy company, and its divisions. It presents the company's operations, the current problem of criticism of the cost of capital estimates, and calculations of weights, betas, costs of equity/debt, and WACC for the company and one division. Issues identified include lack of rationale for analyzing some overseas projects based on equity cost alone. The document provides context, calculations, and issues for a presentation on Midland's cost of capital.
Midland Energy Resources, Inc. Cost of CapitalKivanc Ozuolmez
The document provides information to calculate the weighted average cost of capital (WACC) for various divisions within Midland corporation. It discusses how Mortensen's estimates of Midland's cost of capital are used for various purposes. It then calculates the overall corporate WACC of 8.548% and explains why Midland's choice of equity market risk premium (EMRP) of 5% is appropriate. It also recommends calculating separate WACCs for different divisions given their varying risk profiles. Separate WACCs are computed for the Exploration & Production and Marketing & Refining divisions, and a proposed method is provided for calculating the Petrochemical division's WACC.
FIN4140 Corporate Finance: Marriott corporation case study solutionNURHANI MUIS
The document discusses the cost of capital calculation for Marriott Corporation's three divisions: lodging, restaurants, and contract services. It first calculates the weighted average cost of capital (WACC) for Marriott as a whole as 11.87%. It then calculates the WACC for each division separately by determining the cost of equity using CAPM and cost of debt, weighted by the capital structure of each division. The WACC is 9.47% for lodging, 13.41% for contract services, and 13.16% for restaurants. Calculating WACC at the divisional level allows each division to use a cost of capital appropriate to its risk.
Manzana Insurance's Fruitvale branch is experiencing declining profits due to high turnaround times, uneven workload distribution, rising late renewals, increased renewal losses, inconsistent departmental priorities, and outdated completion time standards. This has allowed competitor Golden Gate to capture more market share by announcing a one-day turnaround time. Recommendations include revising how turnaround time is calculated using mean times rather than outdated standards, balancing workloads, prioritizing renewals, standardizing departmental processes, and potentially automating parts of the underwriting process.
Presentation marriott study case cost of capitalBm Hakim
This document presents a case study on Marriott Corporation and estimating its weighted average cost of capital (WACC) for 1988. It provides background on Marriott, outlines the objectives and methodology, lists assumptions, and shows the results of estimating WACC for Marriott's lodging, restaurant, and services divisions as well as for the overall company. WACC was highest for restaurants at 11.05% and lowest for services at 5.74%, with the overall company WACC estimated at 8.04%. The conclusions discuss lessons on WACC estimation and how capital structure affects cost of capital.
This document analyzes Yell, a UK-based directory services company with both UK and US businesses, as a potential leveraged buyout opportunity. It provides financial projections and assumptions for the UK and US businesses, including adjusted growth rates and margins. It also details the company's debt structure, cash flows, and currency exchange rates that would need to be considered in an LBO. Key questions addressed are whether Yell is a good LBO candidate and why BT wants to sell the business.
This document provides an overview of Midland Energy Resources' capital budgeting case. It introduces the presenters and objectives, which are to recommend a weighted average cost of capital (WACC) for the corporate level and divisions. The steps include understanding operations, how WACC is used, computing the corporate WACC, assessing if a single hurdle rate is appropriate, and computing divisional WACCs for exploration and production, refining and marketing, and petrochemicals. Key details on each division's performance, trends, and WACC computations are presented.
This document provides background information on Midland Energy Resources, a global energy company with three business segments: oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. It then discusses the weighted average cost of capital (WACC) for the overall firm and each division. The WACC is 8.13% for the overall firm, 8.06% for E&P, 9.02% for R&M, and 6.14% for petrochemicals. Using a single WACC for the entire firm could lead to incorrect investment decisions, so the divisional WACCs should be used instead to identify the best opportunities.
The document discusses cost of capital estimates for Midland Energy Resources, a global energy company, and its divisions. It presents the company's operations, the current problem of criticism of the cost of capital estimates, and calculations of weights, betas, costs of equity/debt, and WACC for the company and one division. Issues identified include lack of rationale for analyzing some overseas projects based on equity cost alone. The document provides context, calculations, and issues for a presentation on Midland's cost of capital.
Midland Energy Resources, Inc. Cost of CapitalKivanc Ozuolmez
The document provides information to calculate the weighted average cost of capital (WACC) for various divisions within Midland corporation. It discusses how Mortensen's estimates of Midland's cost of capital are used for various purposes. It then calculates the overall corporate WACC of 8.548% and explains why Midland's choice of equity market risk premium (EMRP) of 5% is appropriate. It also recommends calculating separate WACCs for different divisions given their varying risk profiles. Separate WACCs are computed for the Exploration & Production and Marketing & Refining divisions, and a proposed method is provided for calculating the Petrochemical division's WACC.
FIN4140 Corporate Finance: Marriott corporation case study solutionNURHANI MUIS
The document discusses the cost of capital calculation for Marriott Corporation's three divisions: lodging, restaurants, and contract services. It first calculates the weighted average cost of capital (WACC) for Marriott as a whole as 11.87%. It then calculates the WACC for each division separately by determining the cost of equity using CAPM and cost of debt, weighted by the capital structure of each division. The WACC is 9.47% for lodging, 13.41% for contract services, and 13.16% for restaurants. Calculating WACC at the divisional level allows each division to use a cost of capital appropriate to its risk.
Manzana Insurance's Fruitvale branch is experiencing declining profits due to high turnaround times, uneven workload distribution, rising late renewals, increased renewal losses, inconsistent departmental priorities, and outdated completion time standards. This has allowed competitor Golden Gate to capture more market share by announcing a one-day turnaround time. Recommendations include revising how turnaround time is calculated using mean times rather than outdated standards, balancing workloads, prioritizing renewals, standardizing departmental processes, and potentially automating parts of the underwriting process.
Presentation marriott study case cost of capitalBm Hakim
This document presents a case study on Marriott Corporation and estimating its weighted average cost of capital (WACC) for 1988. It provides background on Marriott, outlines the objectives and methodology, lists assumptions, and shows the results of estimating WACC for Marriott's lodging, restaurant, and services divisions as well as for the overall company. WACC was highest for restaurants at 11.05% and lowest for services at 5.74%, with the overall company WACC estimated at 8.04%. The conclusions discuss lessons on WACC estimation and how capital structure affects cost of capital.
This document analyzes Yell, a UK-based directory services company with both UK and US businesses, as a potential leveraged buyout opportunity. It provides financial projections and assumptions for the UK and US businesses, including adjusted growth rates and margins. It also details the company's debt structure, cash flows, and currency exchange rates that would need to be considered in an LBO. Key questions addressed are whether Yell is a good LBO candidate and why BT wants to sell the business.
Winfield Refuse Management is considering financing options to acquire Mott-Pliese Integrated Solutions for $125 million. The options considered are: debt with fixed principal repayments, debt, equity, and a combination of debt and equity.
Debt with fixed principal repayments of $6.25 million annually over 15 years has the lowest net present value of financing costs. It also provides the highest expected earnings per share and return on equity under likely earnings scenarios. Monte Carlo simulations show Winfield can meet debt obligations and maintain strong interest, debt, and dividend coverage ratios under varying earnings outcomes.
Therefore, the recommendation is for Winfield to finance the acquisition through the issuance of bonds with no principal repayments
This document discusses Marriott Corporation's calculation of the weighted average cost of capital (WACC) for its three divisions: lodging, restaurants, and contract services. It outlines the steps taken to determine the cost of equity using the CAPM model and leverage betas using Hamada's equation. It also discusses determining the cost of debt based on company debt premiums over government interest rates. The WACC is then calculated using the costs of equity and debt and weightings based on the capital structure. The WACC is calculated to be 7.60% for lodging, 7.32% for restaurants, 7.81% for contract services, and 7.73% for Marriott Corporation overall.
Winfield Refuse Management Inc.Raising Debt vs. Equitysubhash kalal
Winfield Refuse Management is considering financing options for a $125M acquisition of Mott-Pliese Integrated Solutions. The options considered are: 1) Debt with fixed principal repayments, 2) Debt only, 3) Equity, 4) Debt and equity. Debt only has the lowest NPV cost of financing, while equity has the highest. Debt options provide the highest expected earnings per share and return on equity under likely earnings scenarios. Monte Carlo simulations show Winfield can meet debt obligations and dividend payments under varying earnings outcomes for all financing alternatives. Winfield should finance through issuing bonds with no principal repayments.
The opportunity to explore how a company uses the Capital Asset Pricing Model (CAPM) to compute the cost of capital for each of its divisions. The use of Weighted Average Cost of Capital (WACC) formula and the mechanics of applying it are stressed.
- Ameritrade was formed in 1971 and pioneered deep-discount brokerage services. In 1997, it raised $22.5 million in its IPO.
- To calculate its cost of capital, the case study determines Ameritrade's beta using the CAPM model. It calculates a beta of 1.83 based on comparable companies.
- Using a risk-free rate of 6.61% from 30-year bonds and a market risk premium of 7.39%, the CAPM model yields a cost of equity of 20.13% for Ameritrade.
- Given Ameritrade's low debt ratio compared to competitors, the WACC is estimated to be 15.40% assuming no
Nelson Jones, owner of Jones Electrical Distribution, must decide how to improve his company's financial situation. He can pursue rapid or minimal sales growth. If pursuing rapid growth, he must decide whether to accept trade discounts and what type of financing to use. Alternatively, he can pursue minimal growth while also deciding on discounts and financing. Jones is struggling with cash flow due to ineffective inventory management and slow customer payments. A new bank has offered to extend Jones' line of credit by $100,000. An analysis of Jones' financials and business environment is needed to make recommendations.
Marriott Corporation was founded in 1927 and has grown into one of the leading lodging and food service companies in the US. The document discusses Marriott's history, brands, elements of its financial strategy including managing rather than owning assets and optimizing its capital structure. It also provides details on Marriott's three main business lines, and calculates its weighted average cost of capital (WACC) as well as the costs of equity and debt. The discussion concludes with questions and answers about how Marriott uses its cost of capital estimates to evaluate investment opportunities across its different divisions.
Linear technology case analysis dividend payout policyHimanshu Gulia
it is a presentation on case analysis of the case dividend payout policy of linear technology and about its decision whether it should pay more dividend or keep it constant
Ocean Carriers Inc. is evaluating commissioning a new capesize vessel to meet a potential charterer's needs. They must decide whether to accept the 3-year charter, register the ship in New York or Hong Kong, and operate it for 15 or 25 years. Registering in Hong Kong and operating for 25 years yields the highest NPV and IRR due to no taxation in Hong Kong. The company's current policy of operating ships for only 15 years results in significant capital losses, so operating for the full 25 years is recommended.
This document presents a case study on Dell and its business model. It summarizes Dell's history starting as a small PC company in 1984 and adopting a build-to-order model. It analyzes how Dell's low inventory model saved it significant capital compared to competitors. The document also examines how Dell funded its growth internally in the mid-1990s through increasing asset efficiency, reducing liabilities, and decreasing short-term investments. Finally, it provides a forecast for Dell's performance in 1997.
Marriott Corporation is one of the leading lodging and food service companies that began as a root beer stand. It calculates the weighted average cost of capital (WACC) for each of its divisions to evaluate investment opportunities. The WACC is calculated using the cost of equity, cost of debt, and capital structure of each division. The analysis found that the WACC for Marriott's lodging division is the highest at 9.33%, indicating more careful investment is needed there compared to other divisions like restaurants and contract services with lower WACCs. Overall, the proper calculation of WACC for each division helps Marriott evaluate projects and make optimal capital budgeting decisions.
The document analyzes Monmouth's potential acquisition of Robertson. Three consultants provide their analyses: 1) Multiple market analysis values Robertson at $26-30/share. 2) Dividend payout analysis values it at $13-20/share. 3) Discounted cash flow analysis values it at $34/share. Benefits of the acquisition are identified as reducing costs and improving earnings. A potential merger is modeled, finding Robertson's value could be $31-136/share depending on growth and discount rates. The next steps propose a 2:1 common stock swap at $48/share.
Signode Industries faces several problems including increased raw material prices and declining market share. It must decide whether to increase prices to offset costs, maintain prices, or implement a flex-pricing strategy. Maintaining prices would lead to losses while increasing prices could further reduce its market share against competitors offering discounts. A flex-pricing strategy allows selective discounting to meet competitors' prices while retaining large accounts. The recommended plan is to implement flex-pricing initially while monitoring discount levels and shifting focus to the value of Signode's services as steel strapping becomes a commodity.
1. The document provides background information on Eastboro Machine Tools Corporation, founded in 1923 and initially manufacturing metal presses and dies.
2. It discusses three proposed strategies for growth: shifting production mix, expanding internationally, and expanding through joint ventures and acquisitions.
3. It analyzes choices of action - stock buyback, advertising, and different dividend payout policies (0%, 15%, 20%, 40%, residual) - and their impact on excess cash over seven years based on sales and income projections. It concludes residual dividend policy allows reducing debt and making investments for growth.
Vodafone bids for Mannesman in an attempt to become the global leader in the mobile industry. However, Mannesman's German corporate governance structure, with stakeholder interests like workers and unions having representation, presents an obstacle. Shareholders are just one group on the supervisory board, unlike the UK and US systems where shareholders interests dominate. This difference in corporate culture complicates Vodafone's takeover attempt.
The document discusses factors to consider when evaluating Ameritrade's proposed advertising program and technology upgrades, including future cash flows, revenues, debt-to-equity ratio, and return on equity. It then provides steps and calculations for determining Ameritrade's cost of capital using the Capital Asset Pricing Model (CAPM), including estimating the risk-free rate, market risk premium, and asset beta compared to comparable companies. The estimated cost of equity for Ameritrade is 28.49%.
Apple faced shareholder concerns in 2013 over its $137 billion in cash. Shareholders wanted the cash returned rather than sitting unused. Apple analyzed various options, including issuing dividends or preferred stock. It also created a five-year financial forecast to determine how much cash it would accumulate if all was returned in 2012. This would help Apple decide whether and how much to return to shareholders.
This document discusses estimating the weighted average cost of capital (WACC) for a company. It covers the three main components needed to calculate WACC: 1) the cost of equity, 2) the after-tax cost of debt, and 3) the target capital structure weights. For the cost of equity, it describes the capital asset pricing model (CAPM) and how to estimate beta and market risk premium. Historical data and industry unlevered betas are used to improve estimates. The example shows how WACC is calculated for Home Depot using CAPM cost of equity and after-tax cost of debt weighted by targets.
- India is the second largest cement producer globally and is expected to reach 550 million tons of annual production capacity by 2020, dominated by private players. Cement demand is recovering faster than expected.
- ACC is uniquely positioned to benefit from India's cement market growth, with over 10% market share. However, high operating costs and vintage plants may hamper its growth.
- This project evaluates ACC using a discounted cash flow valuation and determines the stock is currently overvalued based on fundamental analysis. A conservative intrinsic valuation approach is used.
Winfield Refuse Management is considering financing options to acquire Mott-Pliese Integrated Solutions for $125 million. The options considered are: debt with fixed principal repayments, debt, equity, and a combination of debt and equity.
Debt with fixed principal repayments of $6.25 million annually over 15 years has the lowest net present value of financing costs. It also provides the highest expected earnings per share and return on equity under likely earnings scenarios. Monte Carlo simulations show Winfield can meet debt obligations and maintain strong interest, debt, and dividend coverage ratios under varying earnings outcomes.
Therefore, the recommendation is for Winfield to finance the acquisition through the issuance of bonds with no principal repayments
This document discusses Marriott Corporation's calculation of the weighted average cost of capital (WACC) for its three divisions: lodging, restaurants, and contract services. It outlines the steps taken to determine the cost of equity using the CAPM model and leverage betas using Hamada's equation. It also discusses determining the cost of debt based on company debt premiums over government interest rates. The WACC is then calculated using the costs of equity and debt and weightings based on the capital structure. The WACC is calculated to be 7.60% for lodging, 7.32% for restaurants, 7.81% for contract services, and 7.73% for Marriott Corporation overall.
Winfield Refuse Management Inc.Raising Debt vs. Equitysubhash kalal
Winfield Refuse Management is considering financing options for a $125M acquisition of Mott-Pliese Integrated Solutions. The options considered are: 1) Debt with fixed principal repayments, 2) Debt only, 3) Equity, 4) Debt and equity. Debt only has the lowest NPV cost of financing, while equity has the highest. Debt options provide the highest expected earnings per share and return on equity under likely earnings scenarios. Monte Carlo simulations show Winfield can meet debt obligations and dividend payments under varying earnings outcomes for all financing alternatives. Winfield should finance through issuing bonds with no principal repayments.
The opportunity to explore how a company uses the Capital Asset Pricing Model (CAPM) to compute the cost of capital for each of its divisions. The use of Weighted Average Cost of Capital (WACC) formula and the mechanics of applying it are stressed.
- Ameritrade was formed in 1971 and pioneered deep-discount brokerage services. In 1997, it raised $22.5 million in its IPO.
- To calculate its cost of capital, the case study determines Ameritrade's beta using the CAPM model. It calculates a beta of 1.83 based on comparable companies.
- Using a risk-free rate of 6.61% from 30-year bonds and a market risk premium of 7.39%, the CAPM model yields a cost of equity of 20.13% for Ameritrade.
- Given Ameritrade's low debt ratio compared to competitors, the WACC is estimated to be 15.40% assuming no
Nelson Jones, owner of Jones Electrical Distribution, must decide how to improve his company's financial situation. He can pursue rapid or minimal sales growth. If pursuing rapid growth, he must decide whether to accept trade discounts and what type of financing to use. Alternatively, he can pursue minimal growth while also deciding on discounts and financing. Jones is struggling with cash flow due to ineffective inventory management and slow customer payments. A new bank has offered to extend Jones' line of credit by $100,000. An analysis of Jones' financials and business environment is needed to make recommendations.
Marriott Corporation was founded in 1927 and has grown into one of the leading lodging and food service companies in the US. The document discusses Marriott's history, brands, elements of its financial strategy including managing rather than owning assets and optimizing its capital structure. It also provides details on Marriott's three main business lines, and calculates its weighted average cost of capital (WACC) as well as the costs of equity and debt. The discussion concludes with questions and answers about how Marriott uses its cost of capital estimates to evaluate investment opportunities across its different divisions.
Linear technology case analysis dividend payout policyHimanshu Gulia
it is a presentation on case analysis of the case dividend payout policy of linear technology and about its decision whether it should pay more dividend or keep it constant
Ocean Carriers Inc. is evaluating commissioning a new capesize vessel to meet a potential charterer's needs. They must decide whether to accept the 3-year charter, register the ship in New York or Hong Kong, and operate it for 15 or 25 years. Registering in Hong Kong and operating for 25 years yields the highest NPV and IRR due to no taxation in Hong Kong. The company's current policy of operating ships for only 15 years results in significant capital losses, so operating for the full 25 years is recommended.
This document presents a case study on Dell and its business model. It summarizes Dell's history starting as a small PC company in 1984 and adopting a build-to-order model. It analyzes how Dell's low inventory model saved it significant capital compared to competitors. The document also examines how Dell funded its growth internally in the mid-1990s through increasing asset efficiency, reducing liabilities, and decreasing short-term investments. Finally, it provides a forecast for Dell's performance in 1997.
Marriott Corporation is one of the leading lodging and food service companies that began as a root beer stand. It calculates the weighted average cost of capital (WACC) for each of its divisions to evaluate investment opportunities. The WACC is calculated using the cost of equity, cost of debt, and capital structure of each division. The analysis found that the WACC for Marriott's lodging division is the highest at 9.33%, indicating more careful investment is needed there compared to other divisions like restaurants and contract services with lower WACCs. Overall, the proper calculation of WACC for each division helps Marriott evaluate projects and make optimal capital budgeting decisions.
The document analyzes Monmouth's potential acquisition of Robertson. Three consultants provide their analyses: 1) Multiple market analysis values Robertson at $26-30/share. 2) Dividend payout analysis values it at $13-20/share. 3) Discounted cash flow analysis values it at $34/share. Benefits of the acquisition are identified as reducing costs and improving earnings. A potential merger is modeled, finding Robertson's value could be $31-136/share depending on growth and discount rates. The next steps propose a 2:1 common stock swap at $48/share.
Signode Industries faces several problems including increased raw material prices and declining market share. It must decide whether to increase prices to offset costs, maintain prices, or implement a flex-pricing strategy. Maintaining prices would lead to losses while increasing prices could further reduce its market share against competitors offering discounts. A flex-pricing strategy allows selective discounting to meet competitors' prices while retaining large accounts. The recommended plan is to implement flex-pricing initially while monitoring discount levels and shifting focus to the value of Signode's services as steel strapping becomes a commodity.
1. The document provides background information on Eastboro Machine Tools Corporation, founded in 1923 and initially manufacturing metal presses and dies.
2. It discusses three proposed strategies for growth: shifting production mix, expanding internationally, and expanding through joint ventures and acquisitions.
3. It analyzes choices of action - stock buyback, advertising, and different dividend payout policies (0%, 15%, 20%, 40%, residual) - and their impact on excess cash over seven years based on sales and income projections. It concludes residual dividend policy allows reducing debt and making investments for growth.
Vodafone bids for Mannesman in an attempt to become the global leader in the mobile industry. However, Mannesman's German corporate governance structure, with stakeholder interests like workers and unions having representation, presents an obstacle. Shareholders are just one group on the supervisory board, unlike the UK and US systems where shareholders interests dominate. This difference in corporate culture complicates Vodafone's takeover attempt.
The document discusses factors to consider when evaluating Ameritrade's proposed advertising program and technology upgrades, including future cash flows, revenues, debt-to-equity ratio, and return on equity. It then provides steps and calculations for determining Ameritrade's cost of capital using the Capital Asset Pricing Model (CAPM), including estimating the risk-free rate, market risk premium, and asset beta compared to comparable companies. The estimated cost of equity for Ameritrade is 28.49%.
Apple faced shareholder concerns in 2013 over its $137 billion in cash. Shareholders wanted the cash returned rather than sitting unused. Apple analyzed various options, including issuing dividends or preferred stock. It also created a five-year financial forecast to determine how much cash it would accumulate if all was returned in 2012. This would help Apple decide whether and how much to return to shareholders.
This document discusses estimating the weighted average cost of capital (WACC) for a company. It covers the three main components needed to calculate WACC: 1) the cost of equity, 2) the after-tax cost of debt, and 3) the target capital structure weights. For the cost of equity, it describes the capital asset pricing model (CAPM) and how to estimate beta and market risk premium. Historical data and industry unlevered betas are used to improve estimates. The example shows how WACC is calculated for Home Depot using CAPM cost of equity and after-tax cost of debt weighted by targets.
- India is the second largest cement producer globally and is expected to reach 550 million tons of annual production capacity by 2020, dominated by private players. Cement demand is recovering faster than expected.
- ACC is uniquely positioned to benefit from India's cement market growth, with over 10% market share. However, high operating costs and vintage plants may hamper its growth.
- This project evaluates ACC using a discounted cash flow valuation and determines the stock is currently overvalued based on fundamental analysis. A conservative intrinsic valuation approach is used.
This document discusses methods for calculating the cost of capital, including the cost of debt, equity, and preference shares. It outlines the Capital Asset Pricing Model (CAPM) approach for estimating the cost of equity, as well as other methods like the dividend yield plus risk premium approach and the dividend discount model. It also discusses how to calculate the weighted average cost of capital (WACC) using target capital structure weights. Additionally, it notes some issues that companies face in estimating their cost of capital and common misconceptions about the concept.
Mercer Capital | Valuation Insight | Capital Structure in 30 MinutesMercer Capital
This document provides a guide for directors and shareholders on capital structure decisions. It discusses evaluating the optimal capital structure by identifying the financing mix that minimizes the weighted average cost of capital. While debt has a lower nominal cost than equity, the relevant consideration is the marginal cost of each, which is impacted by leverage levels. The document outlines measuring a company's current capital structure, comparing it to peers, identifying a target structure, and evaluating sources and uses of funds to move towards the target.
This document provides information on estimating the cost of capital for a company. It discusses major sources of capital including common stock, preferred stock, debt through bonds or loans, and retained earnings. It then provides details on estimating the cost of debt and equity. For cost of debt, it shows an example calculation using interest rate and tax rate. For cost of equity, it discusses using the dividend growth model and the capital asset pricing model (CAPM) to estimate required rate of return. It lists some pros and cons of each approach.
This chapter discusses methods for estimating the cost of equity and debt capital for firms and calculating a weighted average cost of capital. It introduces the capital asset pricing model (CAPM) as a method to estimate the cost of equity based on the risk-free rate, market risk premium, and a stock's beta. Determinants of beta like operating and financial leverage are also covered. The chapter then discusses using the WACC to evaluate projects and value firms by discounting cash flows. It concludes by addressing flotation costs associated with raising new capital.
The consultant was hired to estimate Ameritrade's cost of capital for upcoming $100 million in technology investments and $155 million in advertising. To do so, the consultant analyzed comparable discount brokerage firms to determine Ameritrade's beta since it only recently went public. The analysis found Ameritrade's weighted average cost of capital to be 23.34%. Partially financing with long-term debt could lower the cost of capital and make the investments more attractive. The consultant recommends the investments only if expected returns exceed 23.34%, otherwise debt financing should be considered.
The document provides an overview of cost of capital concepts including the components of cost of capital (debt, preferred stock, common equity), weighted average cost of capital (WACC), and factors that affect the WACC. It then discusses various methods for calculating the cost of different capital components, including the cost of debt, cost of preferred stock, and cost of common equity using the capital asset pricing model (CAPM), dividend capitalization model, and own-bond-yield-plus-risk-premium method. Examples are provided to illustrate how to apply these methods to determine the weighted average cost of capital for a company.
This document provides an overview of the topics covered in a financial management course, including definitions of key concepts, financial statements, valuation of assets, capital budgeting, risk analysis, capital structure, dividend policy, and more. The chapters discussed methods for incorporating risk into capital budgeting decisions, such as the certainty equivalent approach, risk-adjusted discount rates, simulation, sensitivity analysis and probability trees. It also covered determining the costs of capital, including weighted average cost of capital, and using a firm's cost of capital to evaluate new investments.
The cost of capital is the rate of return required by suppliers of capital to the firm. It is estimated using the weighted average cost of capital (WACC), which weights the costs of different sources of capital according to their proportion in the target capital structure. Estimating the cost of capital is challenging as it requires estimating costs that cannot be directly observed, such as the cost of equity.
The document discusses challenges in estimating cost of capital in the current economic environment. It addresses issues with estimating the risk-free rate due to declines in Treasury bond yields, and issues with estimating the equity risk premium based on historical data, which may be too low. It also notes that betas calculated using recent historical data may be lower than expected future betas due to volatility in financial and highly leveraged stocks. The presentation recommends using a higher risk-free rate than current Treasury yields, a higher equity risk premium of 6% rather than estimates based on historical data, and adjusting betas based on the underlying risk of each company rather than purely historical estimates.
The cost of capital is the weighted average of the costs of different sources of financing like debt and equity. It represents the minimum return required by investors to compensate for the risk of the project. The document discusses various methods to estimate the costs of debt, preferred stock, and equity like using yield to maturity, bond ratings, dividend yield, CAPM, and dividend discount model. It also covers topics like taxes, weights, country risk premium, and treating flotation costs.
Evaluation of Capital Needs in Insurancekylemrotek
There are various methods to evaluate capital needs depending on the intended use and perspective. Static financial projections develop capital requirements over multiple years using regulatory factors. Dynamic financial projections simulate capital needs over time to achieve a defined outcome percentile. Regulatory regimes like Solvency II specify technical provisions, risk margin, and solvency capital requirements. Rating agencies also consider capital adequacy in their models using adjusted capital ratios like Moody's MRAC ratio.
The document discusses a capital investment project being considered by AirJet Best Parts, Inc. to purchase a new machine. It provides cash flows for the project and asks the student to calculate the net present value (NPV) using a required rate of return of 15%. It then asks the student to calculate the company's weighted average cost of capital (WACC) to use as the discount rate and recompute the NPV. The student finds the NPV is positive using 15% but is asked to recompute it using the WACC to determine if the earlier recommendation to accept the project is still adequate.
The document analyzes Intercontinental Exchange (ICE) stock using discounted cash flow (DCF) and relative valuation methods. The DCF analysis implies share prices of $69.09-81.24, above the current price. Relative valuations using industry price-to-earnings (P/E) ratios imply a price of $52.04-63.31. Considering both intrinsic and relative valuations, the analysis recommends buying ICE stock.
The document analyzes Intercontinental Exchange (ICE) stock using discounted cash flow (DCF) and relative valuation methods. The DCF analysis implies share prices of $69.09-81.24, above the current price. Relative valuations using industry price-to-earnings (P/E) ratios imply a price of $52.04-63.31. Considering both intrinsic and relative valuations, the analysis recommends buying ICE stock.
Assignment
Marginal Revenue Product
Marginal revenue product is defined as the change in total revenue that results from the employment of an additional unit of a resource. A producer wishes to determine how the addition of pounds of plastic will affect its MRP and profits. See the table below, and answer each of the questions.
Pounds of plastic (quantity of resource)
Number of assemblies (total product)
Price of assemblies ($)
0
0
-
1
15
13
2
30
11
3
40
9
4
55
7
5
58
5
a. The marginal product of the 3rd pound of plastic is ________.
b. The marginal revenue product of the 3rd pound of plastic is ______.
c. The price of plastic is $135 per pound. To maximize profit, the producer should produce
__________________.
d. The price of plastic is $135 per pound. To maximize profit, the producer should buy and use:
________________.
Grading Criteria Assignments
Maximum Points
Meets or exceeds established assignment criteria
40
Demonstrates an understanding of lesson concepts
20
Clearly presents well-reasoned ideas and concepts
30
Uses proper mechanics, punctuation, sentence structure, and spelling
10
Total
100
Case Study
C&MDS, Inc.
Some time ago, at the beginning of 2010, an entrepreneur named Richard Alestar started a small business as a sole proprietor in Oregon - a business that manufactured sensors for cameras that could be used in motion detection systems. The business was very successful and he decided to incorporate in the latter part of 2011 under the name C&MDS, Incorporated. He wanted to name it Camera and Motion Detection Systems, but his marketing manager convinced him it was too difficult to remember. Alestar’s long-term plan was to obtain public funding to support growth anticipated in about 4-6 years. In the meantime, he hired electrical engineers and a solid management team capable of building an organization that would enable the company to eventually go public. He thought his proprietary sensors and equipment could not be duplicated for a number of years. There was only one competitor in the market niche where he competed that had a significant market share, but they were a follower, not a leader. Besides, he planned to grow the market himself, based on the increased focus and attention in the public arena on crime prevention, detection and surveillance using cameras with his sensors. He also was developing a host of other potential applications.
Alestar had developed a good relationship with his investment banker Sophia Pound, and had just begun discussions with respect to obtaining additional capital required to position the company to go public. These discussions also involved the chief financial officer (CFO), Mitch O. Dinero, who had brought up the issue of the appropriate capital structure (target capital structure) that C&MDS should consider. They both thought the current mix in the capital structure was close to optimal, and that only minor changes would be necessary. However, they would defer to the investment banke ...
The document discusses capital structure and its theories. It defines capital structure as the proportion of long-term debt and equity used to finance a company's assets. It then discusses various determinants of capital structure and different capital structure theories, including the net income, net operating income, traditional, and Modigliani-Miller approaches. The document also covers the concept of point of indifference in capital structure and how to calculate earnings per share under different financing alternatives using an example company.
This document discusses capital budgeting and the capital budgeting process. It covers key steps like generating investment ideas, analyzing proposals using techniques like net present value, internal rate of return, and payback period. It also discusses types of capital projects, rules of analysis, and definitions. The second half covers cost of capital, including costs of equity, debt, and preferred stock. It provides examples of calculating these costs and weighted average cost of capital (WACC), which weights the costs based on the firm's target capital structure.
1. Case 3: Midland
Team 3 – Christie Apodaca, Mit Bhatt, Tagan Blake
Background
Midland is a global energy company with operating divisions in oil and gas exploration and
production (E&P),refining and marketing (R&M),and petrochemicals. Exploration and production
is involvedin oil and gas exploration, development and production and is Midland’s most profitable
business. With revenue of $22.4 billion and NOPATof 12.6 billion, E&P’s net margin is one of the
highest in the industry. The Refining and Marketing division is involvedwith refining oil & gas for
the automotive gasoline market. R&M is Midland’s largest business measured by revenue of $203
billion, however, due to it’s heavy commoditization,after tax earnings yield only $4 billion. The
Petrochemicalsdivision produces chemical products such as polyethylene, polypropylene,and
lubricant additives. Petrochemicals is Midland’s smallest division with revenue of $23.2 billion and
net profitof $2.1 billion.
Industry trends impacted divisions individually. For instance, with oil prices on the rise in 2007,
opportunities in E&P lend themselves to more attractivecapital investments. E&P anticipates to
exceed $8 billion in capital spending by 2008--projects that include new property purchases,
production expansion, and extraction technology improvements. In contrast, within the R&M
sector, despite high prices, gasoline is highly commoditized resulting in their razor thin margins.
With R&M’s decline in margin forover 20 years, investing in new refineries or expanding existing
ones has proven difficultto justify. Lastly, in the Petrochemicaldivision growth is projected in the
future and therefore older facilities will be divested or sold and replaced by newer, withmore
efficientcapacity.
Cost of Capital
Mortensen’s estimates of Midland’s cost of capital are used for internal analysis, asset appraisals for
capital budgeting and financial accounting, assessing performance, mergers and acquisitions, and
stockrepurchase decisions. The appropriate WACC - enterprise versus divisional - varies among
these uses. M&A, performance assessment, and projectinvestment decisions should all use
divisional cost of capital since these decisions reflectdivision-specific performance relative to the
market. However,a major M&A affectingmultiple divisions might use the corporate WACC.
Likewise, a share repurchase and an accounting calculationaffectthe overall corporate balance
sheet and so should use the corporate WACC.
When applying cost of capital to a particular division, debt is computed forby incorporating a
division-specific premium overUS Treasury securities with like maturity. This spread to treasure
premium is affectedby division operating cash flows,asset values, and and market credit
conditions. Midland may wish to adjust its debt cost of capital estimate depending on the
timeframe being examined. For example, short term projects and compensation measures may use
2. a short-term cost-of debt based on shorter Treasury maturities. Based on such distinctions, Midland
should publish its WACC calculations internally together withguidelines for use to help ensure
users are properly applying the correctrate.
Midland’s Enterprise Weighted Average Cost of Capital
Midland’s corporate weighted average cost of capital (WACC) is determined by incorporating all
business segments and applying the followingformula:
𝑊𝐴𝐶𝐶 = 𝑟_𝑑𝑒𝑏𝑡 (1 − 𝜏)𝐷/𝑉 + 𝑟_𝑒𝑞𝑢𝑖𝑡𝑦 𝐸/𝑉
Debt Costof Capital
First weconsider the debt side of the equation. Although we observe from Table 1 of the case that
Midland’s three different business segments have varied credit ratings, we also observe that
Midland’s consolidated business units have been rated A+ by Standard & Poor. This is reasonable
given the Exploration & Productiondivision’s extraordinary profitability and its A+ rating and the
even higher credit rating of the Petrochemicals division (AA-). With a spread to treasury of 1.62%
we add the 10-year yield to maturity rate forU.S. Treasury bonds (4.66% per Case Table 2) to
obtain a cost of debt of 6.28%.
Case Table 1 also gives us Midland’s consolidated debt to value ratio of 42.2%. Our final debt
variable, tax rate, is calculated by dividing 2006 taxes by income before taxes. This calculation
determines a 38.58% tax rate.
Equity Cost of Capital
Our rate of equity is determined by the Capital Asset Pricing Model (CAPM). This model estimates
the opportunity cost of capital based on a risk-adjusted equity market risk premium (EMRP):
𝑟_𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑖𝑠𝑘− 𝐹𝑟𝑒𝑒 𝑅𝑎𝑡𝑒 + 𝛽_(𝑒𝑞𝑢𝑖𝑡𝑦 ) × 𝐸𝑀𝑅𝑃
Where the EMRP represents the rate of return expected to exceed the risk-free return over a
specified period. For the risk-free market rate of return, we used the 10-year U.S. Treasury bond
interest rate: 4.66%. Midland’s previously calculatedcorporate beta and EMRP are 1.25 and 5.00%
respectively.
Considering Exhibit 6A and B values weare confident that Midland’s use of a 5.00% EMRP is
appropriate. The 5.00% reflects a balance between forward-lookingEMRP values in Exhibit 6B,
averaging about 3.3%, and the recent investment experience of the last 20 years (Exhibit 6A), which
provided excess yields of 6.4%. From Exhibit 6A, the long range average (1798 to 2006) presents a
5.1% excess return along withthe smallest standard error, and is in line with Midland’s estimate.
3. With Exhibit 6B, expert opinion surveys likely provide higher weight to short-term expectations,
whichcan experience more fluctuations. For instance, monetary policy and business cyclecan drive
excess return rates down in the short-term. Such low rates may not be appropriate for a longer
term investment forecast.
For further confirmation, we also calculated EMRP using Historical Average Realized Return. Here
we averaged historic differencebetween returns on equity market index and returns on
government debt. We used S&P 500 index from 1928-2006 and calculated premium using
arithmetic average approach, which came out to be 6.57%. We compared ranges of the past 50
years and 10 years in order to incorporate new market realities. EMRP forthe last 50 years and 10
years came out to be 5.13% and 3.54% respectively as shown in Table 1 below.
Table1:ERMP Calculation using Historical Average Realized Return
Range
S&P 500
Return Average
(A)
10-year T. Bond
Average (B)
EMRP
Arithmetic
Average (A-B)
Std. Error
1928-2006 11.77% 5.20% 6.57% 2.33%
1957-2006 11.82% 6.68% 5.13% 2.51%
1997-2006 9.90% 6.37% 3.54% 7.30%
Data obtained from: http://pages.stern.nyu.edu/~adamodar/
One limitation of historical average realized return approach is that it does not always take into
accountnew market realities. Due to this factwe decided to calculate implied risk premium that
takes a forwardlooking approach using stockprices and expected cash flow in the future. For this
we utilized online tools provided by NYU’sProfessor Damodaran. Table 2 presents our calculation
inputs while Table 3 presents resulting figures. The implied risk premium for the next 5 years was
determined to be 5.01%, also in line with Midland’s estimation.
Table2:Inputs to calculate implied risk premium
Implied Risk Premium Calculator
Enter current level of index 1418.3
Cash yield on index (Calculated number) 4.90%
Enter expected growth rate in earnings for
next 5 years for market
4.16%
Enter current long term bond rate 4.70%
Enter risk premium 5.00%
Enter expected growth rate in the long
term =
4.70%
Dividends and Buybacks (10-year
average)
69.46
Data obtained from: http://pages.stern.nyu.edu/~adamodar/
4. Table3:Calculation of implied risk premium using Solver function
Implied Risk Premium
Implied Risk Premium in current level of
Index = 5.01%
1 2 3 4 5
Expected Dividends = $72.35 $75.36 $78.49 $81.76 $85.16
Expected Terminal Value = $1,780.39
Present Value = $65.95 $62.61 $59.45 $56.44 $1,173.86
Intrinsic Value of Index = $1,418.30
Data obtained from: http://pages.stern.nyu.edu/~adamodar/
Based on these various approaches, we confirmed it was appropriate to maintain Midland’s
calculated EMRP of 5.00%. Given these variables the rate of equity is calculatedto be 10.91%.
Completing the equity side of the equation we determine an equity to value ratio to be one minus
the debt to value ratio. Given wedetermine earlier a debt to value ratio of 42.2%, our equity to
value ratio is 57.8%. This ratio is also confirmedby utilizing Midland’s actual equity market value
and solving forvalue using debt with the debt to value ratio. With all variables input Midland’s
corporate WACC is determined to be 7.93%.
Table4:Midland’s Enterprise Costs of Capital
Debt cost of capital (rdebt) 6.28%
Equity cost of capital (requity ) 10.91%
Weighted-average cost of capital 7.93%
Divisional Hurdle Rate
We advise Midland to use a corporate hurdle rate together with individualized divisional hurdle
rates. For investments that support the wholebusiness, such as a M&A impacting all divisions or an
operational investment that supports the overallenterprise, utilizing the corporate WACC of 7.93%
as their hurdle rate is the appropriate.
However,when faced with division-specific investment decisions, divisional hurdle rates allows
Midland to be more realistic in their evaluations. Divisional hurdle rates can help prevent Midland
from skewing its risk profile over time due to an inflated NPVof higher risk projects. Utilizing a
single hurdle rate across different divisions and investment decisions wouldbias investment
toward riskier divisions and increase the systemic (market-correlated) risk of the company over
time. With individualized divisional hurdle rates, alignment of Midland’s overall risk level is
advised to maintain their target risk profile. Distinct divisional hurdle rates also allows formore
5. accurate benchmarking against peers and thus are more appropriate to assess divisional
investments and compensation.
Midland’s Divisional WACCs
The divisional WACCs are calculated in the same way as the corporate WACC. The debt cost of
capital uses the synthetic credit rating to determine the risk spread over the risk-free rate (4.66%).
The equity cost of capital utilizes the same EMRP (5.00%) and risk-free rate, however,requires an
estimate of a distinct divisional beta. Finally, we need an allocationof debt and enterprise value to
the divisions to determine the debt to value ratio. Thus, to determine the divisional WACCs, we
need to determine three inputs: the risk spread to Treasuries, the divisional beta, and the debt to
value ratio.
We determine the allocation of debt tothe various divisions by their three year average investment
share, since debt is primarily used to fund investment. The allocation of enterprise value to each
division is based on the division’s three year average net income contribution share. Based on this
approach, the debt to value ratio fordivisions were calculated and are shown in Table 5 below.
E&P’s debt to value ratio of 49.80% reflects its higher contribution to Midland’s leverage.
Table5:Divisional Debt to Value Ratios
Division Debt to Value Ratio
Exploration & Production 49.80%
Refining & Marketing 33.62%
Petrochemicals 14.60%
Exploration & Production WACC
Per Case Table 1, Exploration& Production’s synthetic credit rating is A+, corresponding to a risk
spread of 1.60%. Therefore, the E&P debt cost of capital is 6.26% whichis slightly lower than the
enterprise rate. Divisional beta forE&P is calculated from peer data in Exhibit 5 where betas of the
four peers range from 0.89 to 1.39. Given the small sample size, we determine to use a median value
of 1.16 for use as E&P’s beta. Given corresponding inputs, E&P’s equity cost of capital is 10.46%,
lower than the enterprise rate.
Finally, divisional WACC forE&P,including the interest-tax shield adjustment is calculated below.
We note that E&P’sWACC of 7.17% is a lowerrate than the corporate WACC of 7.93%.
𝑊𝐴𝐶𝐶 = 𝑟_𝑑𝑒𝑏𝑡 (1 − 𝜏)𝐷/𝑉 + 𝑟_𝑒𝑞𝑢𝑖𝑡𝑦 𝐸/𝑉
WACCE&P = 6.26% x (1 - 38.58%) x 49.80% + 10.46% x (1 - 49.80%) = 7.17%.
6. Table6:Exploration & Production’sCosts of Capital
Debt cost of capital (rdebt) 6.26%
Equity cost of capital (requity ) 10.46%
Weighted-average cost of capital 7.17%
Refining & Marketing WACC
The WACC calculationfor the Refining & Marketing division followsthe same approach. The debt
risk spread in this case is 1.80%, reflecting the division’s lowersynthetic credit rating of BBB. This
gives a cost of debt of 6.46%, excluding tax effects. For bata, again, we used the median of peer
companies to calculatea bottom-up beta thereby diminishing the effectsof the heavy outliers.
Based on the sample size of seven, the median beta is 1.25 whichmatches Midland’s corporate beta.
Utilizing this beta, the equity costof capital, just as the corporate equity costof capital, is 10.91%.
Based on the debt to value ratio of 33.62% calculated above,the WACCM&R calculation is as follows.
We note that the resulting marketing and refining WACC of 8.58% is greater than the corporate
WACC of 7.93%.
WACCE&P = 6.46% x (1 - 38.58%) x 33.62% + 10.91% x (1 - 33.62%) = 8.58%.
Table7:Refining & Marketing Costs of Capital
Debt cost of capital (rdebt) 6.46%
Equity cost of capital (requity ) 10.91%
Weighted-average cost of capital 8.58%
Petrochemical WACC
There are twooptions to obtain the Petrochemicaldivision’s WACC:
1. Use the factthat the enterprise WACC is the weighted average of the divisions’ WACCs.
Since we have the enterprise, Exploration & Production, and Refining & Marketing WACCs,
we can infer the Petrochemical division’s WACC.
2. Use a bottom-up estimate using a group of peer companies.
To infer betapetrochemical, weuse the followingequation to solve for betapetrochemical.
𝛽_𝑀𝑖𝑑𝑙𝑎𝑛𝑑 = ∑_𝑖 𝑥_𝑖 𝛽_𝑖 ∀𝑖 ∈ 𝑑𝑖𝑣𝑖𝑠𝑖𝑜𝑛𝑠, 𝑤ℎ𝑒𝑟𝑒 𝑥_𝑖
= 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑖^′ 𝑠 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒
As discussed in the previous section, we used the three year average net income contribution of
each division to determine the relative proportions of enterprise value for each. These values are
shown in Table 8 below.
7. Table8:Enterprise Value Allocation by Division
Division
Share of
Enterprise Value
Exploration & Production 66.59%
Refining & Marketing 21.90%
Petrochemicals 11.51%
betapetrochemical = x-1petrochemicals x (xMidland∙betaMidland - xE&P∙ betaE&P - xR&M∙ betaR&M)
betapetrochemical = (232,031 x 0.1151)-1 x 232,031(1.25 - 0.6659 x 1.16 - 0.2190 x 1.25)
Betapetrochemical = 1.78
This first approach suggests a relatively high beta of 1.78.
For the second option, we can use the same approach as we used forthe Exploration & Production
and Refining and Marketing WACCs. The cost of debt is available using the synthetic credit rating.
Per Table 1 in the Case, the synthetic credit rating is AA-. According to Table 1 in the Case, this
corresponds to an interest rate spread of 1.35%. Based on the risk-free rate of 4.66, this
corresponds to a cost of debt of 6.01%.
The cost of equity uses the CAPM-based approach. The EMRP is the same:5.00%. Likewise,the risk-
free rate of return is same: 4.66%. All that remains is to obtain an estimate of the Petrochemical
division’s beta using the bottom-up approach. We evaluated the five peers in Table 9 to obtain an
estimate of betapetrochemicals. These peers were selected fortheir size, concentration in chemicals and
petrochemicals, and high international exposure. Since historical betas were not available, we used
Morningstar’s current betas (April 2016) and calculated an unlevered beta foreach firm as follows:
betaunlevered = betalevered / (1 + (1 - �) x D/E)1
Table 9: Peer Petrochemical Companies2
Company
Revenue
(2007 $M)
Credit Rating
(S&P)
Debt to
Equity
Ratio
Effective Tax
Rate Levered Beta*
Unlevered
Beta
BASF 57,951 A 0.36 0.38 1.19 0.97
Dow Chemical 53,513 BBB 0.39 0.29 1.31 1.03
Dupont 29,378 A- 0.55 0.20 1.85 1.28
1
Assumes debt has a beta equal to zero.
2
Note that we used current data which is not necessarily directly comparable with 2007 data but was
more easily available.
8. Mitsui Chemicals 15,208 A 0.54 0.32 -0.13 -0.10
Sumitomo Chemical 16,126 A- 0.51 0.36 0.57 0.43
Median - - - - 1.19 0.97
*Morningstar April 2016
Based on the average of the unlevered betas, weobtained a median beta of 0.97 for the
Petrochemicaldivision, much lowerthan the implied beta of 1.78 from the first method.
Finally, it is possible to estimate the equity cost of capital using CAPM and both betas:
Equity Cost of Capital = Risk-Free Rate + Betaequity x EMRP
1st approach: 4.66% + 1.78 x 5.00% = 13.56%
2nd approach: 4.66% + 0.97 x 5.00% = 9.51%
Using the first approach and a debt to value ratio of 14.60%, the WACC is 12.12%. Using the second
approach, the WACC would be 8.66%. While the first approach has the advantage of internal
consistency, the second approach has the advantage of a more realistic assessment of the beta using
the bottom-up estimation approach. Therefore, the lower 8.66% WACC for the Petrochemicals
division is our preferred value.
Based on the 0.97 beta calculated forthe Petrochemicalsdivision, we can also propose a revised
enterprise beta and WACC.
betaenterprise = x1(beta1) + x2(beta2) + x3(beta3) = 0.6659 x 1.16 + 0.2190 x 1.25 + 0.1151 x 0.97 = 1.16
This implies a recalculated cost of equity of 10.45% and a revised WACCenterprise of 7.67%. The
corporate and divisional costs of capital are shown in the table below.