FIN 620 – Business Case Assignment Midland Energy Resources Assignment: Review the Harvard Business School Case (Brief Case) - #4130, dated June 19, 2009 Consider the following in your analysis:  The main goal for this case is for Janet Mortensen to append a sort of “user guide” in her 2007 calculations;  If she did append a “user’s guide” what might be her guidance for different types of project analysis at Midland such as capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions;  how might the cost of capital numbers differ or guidance differ for divisionlevel versus corporate-level decisions;  what guidance might she provide with validating the components used to compute the WACC;  how would you compute a cost of capital for the Petrochemical division;  what ‘actual’ firm would you use now as a pure play for the Petrochemical division. 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%  Compute cost of equity using CAPM o Rs = 4.98% + 1.25(5.0%) = 11.24%  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%  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  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%  ΒL = βu [1 + (1-t)(D/E)] =.93[1 = (.60)(.852)] = 1.41  Compute cost of equity using CAPM o Rs = 4.98% + 1.41(5.0%) = 12.03%  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% 2 New Heritage Doll Overview The heritage doll company is the US established cooperation that has for long being involved in the toys and games sector since the 1980´s.Their targeted market is divided into two broad segment that is the video games segment (48%)through electronic platform whereas the rest of their markets like traditional toys and games. They produce toys that are suit for their customer’s segments. There has been a shift in their company profit from 2012 that has allowed the company to venture into the new opportunity. Investment opportunity Emily Harris who is the current organization vice president to the new heritage doll company has come up with two expansion proposal for the production sector thus will increase the way to operate. The two-brilliant entrepreneurial which is also innovative plan that she raises are; 1. “Match my Doll Clothing Line.” 2. “Design Your Own Doll”. Due to the limited resource from the company the company committee might only have one of the project done. Thus, the manager will be in a good condition to conduct some analytics of the project to see which will be feasible and will be of much impact to the company free cash flow 30000 25000 20000 15000 10000 5000 0 -5000 -10000 2011 2012 2013 MMDCL -3020 -557.18 168.97 682.19 540.95 583.29 629.99 680.31 734.7 793.4 26120 DYOD -5330 -1261 306.05 -309 -1189.6 1141 1141.38 1209.8 1282.6 1359.42 26178.89 3 5 Series 3 MMDCL evaluation will be access on the underlying fundamental assumption • their ought to be 3% working capital • The high risk of doing the operation due to innovation and start of the design your own doll to be assessed at 9.0% whereas the small risk of the 1st project to be estimated at 7.7% • the risk of Taxes assumption is at 40% • Discount rate at 8.4% • We assumed That cash flow forecast, and capital is obtained from a given operation projection The below diagram is a free cash flow statistic Table 2.3 DYOD Series 3 Table2.3 continuation in the making of the decision of which type of project that should be taken as per free cash flow will depend on the project that takes the shortest time to bring a positive return and by the data from my table below. “Match my Doll Clothing Line” will fast bring back the revenue and this will make me choose it over the others IRR evaluation based on NPV, IRR, Payback Period and PI: Internal rate of return is sometimes done and written in percentage and its where the Highers value in term of the highest proportion is accepted and in our case we ought to accepted or agreed that we will take the “Match my Doll Clothing Line” because it has a percentage of 24% and leave the other one of the “Design Your Own Doll” which has a lower percentage of 18%. years 18% 24% MMDCL DYOD Net Present Value From the table below the net present of the twoproject different from one another and the decision to choose the best method in accordance to the two is to look at the one with the higher net present value among the two Look and analyzing the table above we can see that the MMDCL has a high NPV over the DYOD: So I will accept the MMDCL over the other DYOD Sales Payback period In payback period the decision to accept a given project will primarily involve the shortest time for the project to pay back it cash and from the look of thing is that “Match my Doll Clothing Line will return 7.39year which is less than the time frame of the Design Your Own Doll which take 9.05 years which is a long time thus we will again choose the former over the later PI Profitability index will be determined by the project that is higher than the other once, and it MMDCL DYOD is more less the same to the NPV in term of its excellent characteristics. Thus why we shall choose MMDCL which has a value of above 3 and leave the other DYOD which value is roughly around 2 Recommendation With the two-project having analysis them in dark detail I would highly recommend the “Matching my doll clothing line” for the above company this is due to how less it is position in term of its finances. The project take less time to implicates and this main that the break-even period will earn and it will be first at stabilizing itself and also the project will require less of the require capital than the DYOD In term of risk assessment is that MMDCL is less risky as it has been in the market for a long time, improving the product is very easy and the company has known the market acceptance of the product over the other product which is new to the market, has high risk because the market share can reject it, this will slowly sit on the company resources