6. 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) [1] 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) [1] What potential error exists in our estimate of net debt?

(c) [3] 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) [4] 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. E = 1.25 is given.

Note: E = 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 E = 1.25 and then relever.

Use the formulas given in the Cost of Capital note:

U = E / (1 + (1 TC ) (D / E))

E = (1 + (1 TC ) (D / E)) U

(e) [1] To estimate r D , use the Treasury spread approach, that is, assume that Aspens 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) [3] 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.