Aspen Resources Limited is a U.S. energy company with operations in oil and gas exploration and development (E&P) and refining and marketing (R&M). It seeks an estimate of weighted average cost of capital.
The following assumptions will be made:
• The marginal tax rate (Tc ) is 40%.
• The market risk premium is 5%.
Two approaches will be used to estimate the weighted average cost of capital:
• Prevailing consolidated.
• Target consolidated.
The target consolidated debt-to-value ratio, set in consultation among division and corporate executives and the board, is 32.2% (this is the proportion of net debt to enterprise value). Use net debt in your calculations (instead of total debt) consistently throughout the entire problem!
The prevailing consolidated debt-to-value ratio is arrived at using the following data:
Current stock price: $44.11
Shares outstanding (millions): 2,950.6
Exercisable options (millions): 396.5
Weighted average strike price: $34.12
Total debt ($million) $101,845
Cash and equivalents ($million): $22,337
Enterprise value ($million): $213,620 5
(a) Demonstrate how the enterprise value is derived.
Hints:
• Enterprise value = market-value equity + market-value employee stock options + net debt
• Estimate the value of the exercisable stock options by multiplying the number outstanding by the difference between the current stock price and the weighted average strike price. Note: This is an approximation of the Black-Scholes formula.
• Employee stock options holders are equity stakeholders.
(b) What potential error exists in our estimate of net debt?
(c) What is the prevailing consolidated debt-to-value ratio? How does it compare to the target consolidated debt-to-value ratio? Give one possible explanation for the difference.
(d) Derive two estimates of r E , one based on the target consolidated debt-to-value ratio and one based on the prevailing consolidated debt-to-value ratio. Use the CAPM. Let rf = 2.8%, the 30-year U.S. Treasury bond yield. βE = 1.25 is given.
Note: βE = 1.25 is based on the prevailing consolidated debt-to-value ratio. To determine an appropriate estimate of equity beta based on the target capital structure, unlever βE = 1.25 and then relever.
Use the formulas given in the Cost of Capital note:
βU = β E / (1 + (1 – TC ) × (D / E))
β E = (1 + (1 – TC ) × (D / E)) × βU
(e) To estimate r D , use the Treasury spread approach, that is, assume that Aspen’s spread over 30-year Treasuries is 1.62%. In other words, let r D equal the current 30-year U.S. Treasury bond yield, 2.8%, plus the assumed spread. What is your estimate of r D ?
(f) Lastly, derive two estimates of r WACC, one based on the target consolidated debt-to- value ratio and one based on the prevailing consolidated debt-to-value ratio. Provide one explanation for the difference between these two rates.