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Case-Midland - C5
Case-Midland - C5
Therefore A= Total Assets, A1 = Total Assets of E&P segment, A2 = Total Assets of R&M
section, A3 = Total Assets of Petrochem, BA1 = Asset Beta of E&P segment, BA2 = Asset
Beta of R&M segment, BA3 = Asset Beta of Petrochem Segment.
2. We have used the median Asset Beta of Competitors as estimate of Asset Beta for the
segments E&P and R&M
3. We have arrived at the Asset Beta for Petrochem Division by using the formula described
above.
Since we don’t have the market capitalization and market value of debt of each of the segments,
we assume that the market value of assets (segment wise) shall be in the same proportion as the
Total Assets in each segment. We have used segment wise Total Assets because market value of
debt is usually the same as market value of debt, also the Book Value of equity consists of the Par
value of shares and accumulated surpluses and reserves. Therefore, in absence of any other
information and to avoid implications of debt, we have estimated the proportion of market values as
same as proportion of total assets (Book Values)
Limitations: The limitations of using the Book Value is that it doesn’t capture the impact of
future earnings of the company, the book value are recorded at historical costs and do not capture
the volatility and risk associated with the market. The Book value doesn’t consider the future
earning potential of the company and other growth prospects. Ideally, the intrinsic value of Equity is
calculated by discounting the available forecasted free cash flows over the relevant period use for
valuation.
If Midland uses the same cost of capital to discount cash-flows for all projects, explain what will
happen over time to:
a. The relative mix of the three business segments in Midland's operations and
b. The market value of Midland's assets and explain why.
Particulars As s et Beta Equity Beta Target D/E Cos t of Equity
Cons olidated 0.79 1.36 0.73 0.12
E&P 0.87 1.61 0.85 0.13
R&M 0.94 1.37 0.45 0.12
Petrochem -0.16 -0.27 0.67 0.04
a) Above, we have calculated the Cost of Equity using the Target D/E, Asset Beta , Risk free rate equal
to 4.9% and Market Risk Premium = 5%. Since, we are not assuming any debt, we estimate the cost
of capital as Cost of Equity. We can observe that Cost of Equity for Consolidated business and all
the segments differ and range is (4% - 13%). Therefore, if we use the same cost of capital to
discount cash flows from all the projects that the company can undertake. The Company may run
a risk of onboarding very risky projects in certain segments if a smaller hurdle rate is used to
discount the cash flows. Further, if the company uses a higher hurdle rate to discount cash
flows from the project the company may not be able to onboard any projects in segments
where cost of capital is smaller than the hurdle rate.
Therefore, we can say that if a higher hurdle rate is chosen the investments over time will flow to
business segments where industry level profitability is high and will dry out for segments where
industry level profitability is low. Also, if a lower Cost of equity is used to discount the cash
flows, the company will invest in all business segments indiscriminately and will expose itself to
excess risks.
For eg: if 4% discount rate is used, all the projects in other segments shall receive investments, also
if we use 13% discount rate is used, very limited projects would be selected for the Petrochem.
Therefore, we will not able to create the appropriate bridge between riskiness of the securities
and the expected returns.
b) The adverse selection of projects hazard that has been mentioned in Part(a) may lead to the
company onboarding very risky projects and not accepting projects which have acceptable
level of risk for the segment. As each segment has different profitability, growth rates,
profitability, capital requirements same hurdle rate cannot be used to evaluate the projects in each
segment.
If however the company uses the same hurdle rate, in the long run company may experience drop in
profitability due to onboarding risky projects and not accepting the projects which could lead to
incremental benefits to the wealth of shareholders.
Considering the above, we can conclude that in the long run, if the company uses the same hurdle
rate for all the segments the value of overall assets will since due to following reasons: 1) The drop
in revenues and profitability will be reflected in the market capitalization of company (equity
share proce will drop) 2) The debt will become more expensive due to fall in Credit ratings
over the period of time. Therefore, we can conclude that if single hurdle rate is used the market
value of the Midland’s assets will fall.