BU393L09 Cost of Capital II (July 19)

BU393L09 Cost of Capital II (July 19) - Note > >...

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1 © Copyright 2010, A. Marshall 1 Lecture 9 Lecture 9 Divisional & Project-specific Hurdle Rates © Copyright 2010, A. Marshall 2 Note Note > In the following examples, we shall ignore underwriting costs for simplicity > Alternatively, you could assume that the debt is bank debt (no issue costs) and all equity will be internally generated > In the following examples, the t-bill rate (r f ) is 7.5% and the market risk premium is 5%. © Copyright 2010, A. Marshall 3 Blue Bird Packages Blue Bird Packages > Consolidated Petroleum and Wildcat Oil & Gas are two competing firms > Both have been invited to bid on several parcels of Blue Bird Explorations, which is being wound up and dissolved. > The parcels are described on the next slide. The ‘cost’ figure is CoPeCo’s expected price and is the project cost used to estimate the IRR. © Copyright 2010, A. Marshall 4 Blue Bird Parcels Blue Bird Parcels Parcel Cost (Millions) IRR (%) A $10.0 13.8 B 7.5 18.2 C 5.0 15.3 D 12.5 16.4 E 15.0 20.5
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2 © Copyright 2010, A. Marshall 5 Wildcat Oil & Gas Wildcat Oil & Gas > Wildcat Oil & Gas is an moderate size exploration and development company > The -coefficient for Wildcat is 1.6 > Like most exploration and development companies, Wildcat is an all-equity firm © Copyright 2010, A. Marshall 6 Consolidated Petroleum Consolidated Petroleum > Consolidated Petroleum is an integrated oil and gas company with exploration, refining, retailing and pipeline divisions. > The -coefficient for Consolidated’s equity is 1.1. The market value of the equity is $12 billion [r E = 7.5% + 1.1(5%) = 13%] > The Market Value of Consolidated’s debt is $4 billion, with a cost of 8.125% before taxes of 40% [8.125%(1-0.4) = 4.875%] © Copyright 2010, A. Marshall 7 CoPeCo CoPeCo ’s WACC WACC Item MV Weight Cost (%) Debt 4.0 0.25 4.875 1.21875 Equity 12.0 0.75 13.000 9.75000 Total 16.0 1.00 WACC 10.96875 We will round this to 11% © Copyright 2010, A. Marshall 8 CoPeCo CoPeCo ’s Decision Decision > If Consolidated uses its WACC of 11%, it would accept, or be willing to bid up the prices of, all the Blue Bird parcels:
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3 © Copyright 2010, A. Marshall 9 CoPeCo CoPeCo ’s Decision Decision 13.8 20.5 $15MM $7.5 MM 18.2 16.4 15.3 11% A $12.5MM $5 MM $10MM EB D C © Copyright 2010, A. Marshall 10 Wildcat Wildcat ’s Decision s Decision > Wildcat’s WACC is the same as its cost of equity, r E = 7.5% + 1.6(5%) = 15.5% > Therefore, Wildcat would only find the best three projects, E, B and D, acceptable > Wildcat would reject C and A © Copyright 2010, A. Marshall 11 Wildcat Wildcat ’s Decision s Decision $12.5MM $5 MM $10MM D C 15.5% 13.8 20.5 $15MM $7.5 MM 18.2 16.4 15.3 11% A © Copyright 2010, A. Marshall 12 Prairie Pipeline Packages Prairie Pipeline Packages > Consolidated Petroleum and Cross Canada Pipeline are two competing firms which have been invited to bid on several pipelines from Prairie Pipeline Service, which is selling off non-core assets. > The pipelines are described on the next slide. The ‘cost’ CoPeCo’s expected winning bid price is the cost used to estimate the IRR. All have “normal” pipeline risk
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4 © Copyright 2010, A. Marshall 13 Prairie Pipeline Lines Prairie Pipeline Lines Parcel Cost (Millions) IRR (%) P $60.0 6.8 Q 90.0 11.2 R 75.0 10.3 S 50.0 9.4 T 80.0 8.5 © Copyright 2010, A. Marshall 14 Cross Canada Pipeline Cross Canada Pipeline >
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BU393L09 Cost of Capital II (July 19) - Note > >...

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