Carlson School of Management &e here at Fig Financial Consulting ha"e re"ie'ed the current (nancial and economic situation of Midland Energy Resources, Inc. and ha"e presented our (ndings )elo'.
Included in our analysis are the methods 'e used for our
calculations. *lease )e ad"ised that these calculations are not +one si$e (ts all and that there may )e signi(cant conse-uences if a single calculation 'ere to )e used across the company as a 'hole as the three operating di"isions are inherently dierent in their operations, and ha"e dierent risks associated 'ith them. /ur (rst task 'as to determine the consolidated &0CC for the (rm. In order to do this 'e re"ie'ed current practices in con1unction 'ith historical and sur"ey data. 2he (rst element in de"eloping the (rm3s &0CC 'as to determine the proper risk free rate, and in our estimation this rate should )e set at 4.567. 2his is currently the rate on the longest a"aila)le rate 'ith a negligi)le default risk, and is the current 89 year t)ond rate. /ur calculation of the EMR* signi(cantly factored in historical a"erages, and 'as set at ;.<7. &e understand that much of the history considered in these calculations is not directly applica)le to current market conditions, ho'e"er 'ith a smaller standard error 'e more con(dent that it 'ould )e a )etter appro=imation that a more current historical estimate 'ith a larger standard error. In addition, your (rm has )een using ;7 in recent years )ased on a +re"ie' of recent research and consultation 'ith its professional ad"isors and did not ha"e su>cient e"idence to suggest a ma1or change in the EMR*. In regards to the consolidated capital structure, 'e did make some ad1ustments )ased on recent data. &e sa' signi(cant "ariation in the de)t ratio from ?99; to ?99@A these ratios 'ere 44.
targeted
consolidated
de)t
ratio
of
4?.?7
is ele"ated,
and
our
recommendation is to lo'er this ratio to 497. /ur de)t ratio calculations can )e seen in the ta)le )elo'.
Carlson School of Management
ue to the capital structure ad1ustment, 'e are no longer a)le to use the (rm3s historical )eta of <.?;A the change in structure causes a change in risk and this must )e factored into the ne' )eta. &e ad1usted your historical )eta )y unle"ering and rele"ering it 'ith the structure in mind. %ased on our calculations, the (rm3s ne' consolidated )eta is <.?
&ith the ne' )eta and ad1usted and our recommendations for the riskfree rate and EMR*, 'e ha"e estimated the (rm3s consolidated cost of e-uity to )e <<.<57. 0long the same lines, 'e estimate that the (rm3s cost of de)t is currently @.@7A this 'as calculated )y adding the (rm3s target spread to treasury of <.@?7 to the risk free rate. &ith these ne' de)t and e-uity costs 'e 'ere then a)le to calculate the
(rm3s ne' &0CC to )e 6.87. /ur calculations are )elo', please note that the &0CC. r u= wd∗r d ( 1 −t ) + we∗r e
ru
is
Carlson School of Management
r u
=[ .066 ∗( 1 −.4 ) ]∗.4 +( .1119∗.6 )
r u= 8.3
*lease )e mindful that this num)er is only useful for the (rms consolidate operations.
&e understand that you intend to create +users guide of sorts for
further use )y your di"isions. 2o help you in this process, 'e ha"e analy$ed the E=ploration and *roduction di"ision separate from the rest of the (rm. Dou should )e a)le to follo' the steps in this process in the creation of your guide. It is clear that this di"ision re-uires signi(cantly more capital on a yearly )asis that the other di"isions, and conse-uently 'e do not consider the de)t ratio for the consolidated (rm to )e a su>cient target for the E=ploration and *roduction di"ision. 2he (rm uses a target de)t ratio for this di"ision of 4@7, and 'e agreed that this 'as a reasona)le target.
2he ma1or issue in analy$ing this di"ision
separate from the 'hole is that 'e ha"e no information on a di"isional )eta. In this case 'e ha"e systematically estimated this )eta using compara)le (rms 'ith pu)lished )etas.
&e unle"ered the )etas four compara)le (rms using the same
process as 'e used for the consolidated operations, then a"eraged these unle"ered )etas to get an estimated di"isional )eta of .58??.
sing this a"erage )eta in con1unction 'ith the target capital structure for E=ploration and *roduction 'e calculated a rele"ered di"isional )eta for the di"ision of <.4<9?. sing the same process from earlier, 'e calculated the di"isional cost of
Carlson School of Management e-uity and de)t to )e
*lugging the di"isional
num)ers into the &0CC formula from earlier, 'e get a di"isional &0CC of 6.857.
