Posted: August 6th, 2013
Midland Energy Resources, Inc
To: President of Project Finance
From: Janet Mortensen, Vice President of Project Finance
Subject: Estimates of Costs of Capital
Date: July 16, 2012
This memo introduces the issues in estimation of costs of capital for the three divisions of the incorporation, my estimates as well as their implications on the calculations.
Currently, the company has four financial and investment policies that require estimation of cost of capital in order to undertake. The four policies include funding the growth of overseas businesses for international expansion, engaging in projects that add value to the company from all the divisions. The other policies are optimization of the company’s capital structure, and being opportunistic about purchasing of undervalued shares and stocks. These policies cannot be conducted without an estimation of the cost capital. The estimates of the cost of capital will be used in several analyses. Some of the areas they will find use include appraisal of assets before buying for capital budget and financial accounting. The other use will be assessment of performance of the company, proposals of M&A, as well as making decision on buying of stocks and undervalued shares. The estimates can be used at both corporate and business unit levels. Previously, the treasure staff has been involved in making the costs of capital estimates that have stirred a lot of controversy. Therefore, these estimates provide a better opportunity for better analyses.
The cost of capital for Exploration and Production division is 2 + 1.15(5-2) == 5.45% while cost of capital for Refining and Marketing is 2 + 1.20(5-2) == 5.6%. The difference has been caused by the different betas, where E & P division has a beta of 1.15, while the R&M division has a beta of 1.20. To calculate the cost of equity for the petrochemical division there is need to have the debt statement showing the amount of debt the division has as well as interest it pays. Additionally, to calculate the cost of equity there is need of having the beta, risk free rate of return and market return. With the above variables, the cost of capital can be calculated using the same formula used to calculate cost of capital in other divisions. To calculate the cost of capital for the petrochemical division, it requires finding out several variables such as the risk free rate of return within this industry, finding out the beta of the industry, the long-term debt and equity within this division. This would then require using the CAPM formula to calculate the cost of equity, and the Cost of debt formula to calculate the cost of debt. The two can be combined using the WACC formula to get the average cost of capital.
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