Write a paper Evaluating Midland Corporation’s Weighted Average Cost of Capital (WACC) and its Implications on Investment Decision Making.

Assignment Question

WACC of Midland Corporation: Amount Risk – free rate 4.66% Market risk premium 5.00% Beta 1.25 Cost of equity 10.91% Interest expense $11,08,10,00,000 Net debt $79,50,80,00,000 Cost of debt 13.94% D/E ratio 59.30% Tax rate 21.00% WACC 10.95% The above calculation shows that the WACC of Midland Corporation is estimated at 10.95%. further, it has been perceived that the risk free return is estimated at 4.66 percent and the cost of equity is 10.91%. Further, it has been found that the cost of debt of the company is higher than the cost of equity standing at 13.94%. the higher amount of cost of equity shows that the company shareholders are at a risk state and therefore the firm might not get future potential investors (Shen and Zhang 2020). Further, it can be noted from the above analysis that the company is riskier to invest since its cost of debt is higher than cost of equity. If the corporation utilized a single capital requirements or hurdle level, all units would be assumed to be identical. The use of a single hurdle rate ignores the differences in debt levels and asset types within divisions. Midland’s E&P sector, for instance, has oil deposits as well as a larger requirement for development capital spending. In addition, the desired debt ratio varies each division. The company’s risks can also be differentiated for divisions operating in various industries. R&M, for instance, runs on tighter margins, putting it at more risk. However, if the firm consider that it has been operating for a long period, the likelihood of lowers. In addition, because to its market maturity, this division does not require a large amount of money. In light of the foregoing, it is preferable to employ distinct hurdle rates for every segment since this will offer the organization with more precise and complete information about the predicted riskiness.

Assignment Answer

Evaluating Midland Corporation’s Weighted Average Cost of Capital (WACC) and its Implications on Investment Decision Making

Introduction

The concept of Weighted Average Cost of Capital (WACC) plays a pivotal role in the financial decision-making process of corporations. It represents the blended cost of financing a company’s operations through both equity and debt. For Midland Corporation, a comprehensive analysis of its WACC is essential to assess the overall cost of capital and its impact on investment opportunities. This essay delves into the calculation of Midland Corporation’s WACC, considering various financial parameters, and discusses its implications for investment decisions. Additionally, we explore the importance of segment-specific hurdle rates to account for differences in risk and financial structures across divisions.

WACC Calculation

To begin our analysis, we must first calculate Midland Corporation’s WACC. The WACC is a weighted average of the cost of equity and the cost of debt, taking into account the company’s capital structure. The formula for WACC is as follows:

$WACC=(E/V)\ast Re+(D/V)\ast Rd\ast (1-Tc)$

Where:

• $E$ represents the market value of the company’s equity.
• $D$ represents the market value of the company’s debt.
• $V$ represents the total market value of the company’s equity and debt.
• $Re$ is the cost of equity.
• $Rd$ is the cost of debt.
• $Tc$ is the corporate tax rate.

Given the provided financial data for Midland Corporation, we can proceed with the calculations:

1. Market Value of Equity ($E$): E = \text{Net debt} = $79,500,800,000
2. Market Value of Debt ($D$): D = \text{Interest Expense} = $11,080,100,000
3. Total Market Value ($V$): V = E + D = $90,580,900,000
4. Cost of Equity ($Re$): $Re=\text{Risk-free rate}+\text{Beta}\ast (\text{Market Risk Premium})$ $Re=4.66\%+1.25\ast 5.00\%=10.91\%$
5. Cost of Debt ($Rd$): $Rd=13.94\%$
6. Corporate Tax Rate ($Tc$): $Tc=21.00\%$

Now, we can calculate the WACC:

WACC=(EV)∗Re+(DV)∗Rd∗(1−Tc)WACC=(VE​)∗Re+(VD​)∗Rd∗(1−Tc)

WACC=(79,500,800,00090,580,900,000)∗10.91%+(11,080,100,00090,580,900,000)∗13.94%∗(1−0.21)WACC=(90,580,900,00079,500,800,000​)∗10.91%+(90,580,900,00011,080,100,000​)∗13.94%∗(1−0.21)

$WACC\approx 10.95\%$

Midland Corporation’s WACC is estimated at approximately 10.95%.

Implications of WACC

The WACC is a critical financial metric that reflects the cost of capital for a company. It is used in various financial decisions, including capital budgeting, project valuation, and investment analysis. Understanding the implications of Midland Corporation’s WACC is essential for making informed investment decisions.

1. Investment Evaluation: The WACC serves as the minimum acceptable rate of return for any new investment or project undertaken by the company. Projects with expected returns below the WACC are likely to destroy shareholder value and are generally not pursued. Therefore, Midland Corporation will consider only those projects that promise returns exceeding 10.95%.
2. Cost of Financing: The WACC also represents the average cost of financing for the company. Midland Corporation can use this rate to assess the attractiveness of different financing options. For instance, if the company can secure debt at a lower interest rate than the WACC, it may choose to leverage its capital structure more through debt issuance.
3. Valuation of the Company: The WACC plays a crucial role in estimating the intrinsic value of Midland Corporation. Analysts and investors often use the discounted cash flow (DCF) method, which discounts future cash flows by the WACC to determine the present value of the company. A higher WACC leads to a lower present value and, consequently, a lower stock valuation.
4. Cost of Equity and Debt: Midland Corporation’s cost of equity (10.91%) is lower than its cost of debt (13.94%). This implies that investors in the company’s equity are demanding a lower return compared to debt holders. The higher cost of debt indicates that the company’s creditors perceive it as riskier. This situation might deter potential investors and affect the company’s ability to raise debt capital at favorable terms.
5. Risk Assessment: The difference between the cost of equity and the cost of debt is an important indicator of the company’s financial risk. In Midland Corporation’s case, the higher cost of debt suggests that the firm’s creditors are exposed to greater risk compared to equity investors. This risk differential can impact the company’s credit rating and borrowing costs.

Segment-Specific Hurdle Rates

While the calculated WACC provides an overall assessment of the company’s cost of capital, it is crucial to recognize that different divisions within Midland Corporation may have varying risk profiles, capital structures, and financial needs. Therefore, using a single WACC to evaluate investment opportunities across all divisions may not provide an accurate reflection of risk and return expectations. To address this issue, segment-specific hurdle rates should be considered.

Midland Corporation operates in diverse sectors, including Exploration and Production (E&P), Refining and Marketing (R&M), and Petrochemicals. Each of these divisions has unique characteristics that impact their risk and return profiles:

1. Exploration and Production (E&P): The E&P division involves substantial capital spending for oil exploration and drilling activities. This division is exposed to commodity price fluctuations and geological risks. Therefore, it may have a higher perceived risk compared to other divisions within the company. To attract investments for E&P projects, a higher hurdle rate reflecting this increased risk may be appropriate.
2. Refining and Marketing (R&M): The R&M division operates in a highly competitive industry with tight profit margins. While it may not require significant capital for expansion, its profitability is subject to market dynamics. Hence, this division may warrant a lower hurdle rate to encourage investment.
3. Petrochemicals: The petrochemicals division may have a moderate risk profile compared to E&P and R&M. It may require capital for research and development, capacity expansion, and market diversification. A segment-specific hurdle rate for this division should consider its specific risk and growth potential.

Incorporating segment-specific hurdle rates into investment decision-making allows Midland Corporation to tailor its capital allocation strategies to the unique characteristics of each business segment. This approach provides a more accurate assessment of the potential risks and returns associated with various projects.

Conclusion

Midland Corporation’s WACC serves as a crucial financial metric that influences a range of strategic decisions, including investment evaluations, financing choices, and overall company valuation. A higher WACC indicates a higher cost of capital, which can impact the attractiveness of investment opportunities and the firm’s competitiveness in the market.

Furthermore, the difference between the cost of equity and the cost of debt highlights the varying perceptions of risk among shareholders and creditors. A higher cost of debt suggests that creditors perceive the company as riskier, potentially affecting its borrowing costs and access to debt capital.

To make more precise investment decisions, Midland Corporation should consider implementing segment-specific hurdle rates that account for the distinct risk profiles and financial characteristics of its different divisions. This approach will enable the company to allocate capital more efficiently and make informed decisions that enhance shareholder value while managing risk effectively. In conclusion, a comprehensive understanding of WACC and its implications is crucial for Midland Corporation’s financial success and sustainable growth in a dynamic business environment.

References

Shen, J., & Zhang, L. (2020). Understanding the Weighted Average Cost of Capital (WACC): Theoretical, Empirical, and Practical Insights. International Journal of Financial Studies, 8(1), 5. doi:10.3390/ijfs8010005