Executive summary

Midland Energy Resources, Inc. is a global energy company that operates in oil and gas exploration and

production (E&P), refining and marketing (R&M), and petrochemicals. Midland’s most profitable

segment is its E&P division which produces 67% of the company’s net income (Exhibit 3). Its largest

division is R&M with the Petrochemical division being the smallest. The primary goals of Midland’s

financial strategy are to fund substantial overseas growth, invest in value-creating projects, achieve an

optimal capital structure, and repurchase undervalued shares. To accomplish these goals, Midland must

calculate an appropriate cost of capital that will allow reasonable valuations of their strategies. In

funding overseas growth, Midland must use its cost of capital to analyze, evaluate, and convert foreign

cash flows. In evaluating value-adding projects, the cost of capital must be used to discount project cash

flows. To optimize its capital structure, the company must continuously evaluate its ideal borrowing

based on its inherent cost. Lastly, when deciding when and how to repurchase shares, Midland’s

management has to determine the intrinsic value of its shares. This requires determining the value of
the

company using DCF techniques and an appropriate discount rate.

In the following sections we are going to answer the questions related to the cost of capital estimates.

1. How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these

anticipated uses affect the calculations?

Section 1: Estimates of cost of capital

Estimates of the cost of capital were used in many analyses within Midland, including asset appraisals

for both capital budgeting and financial accounting, performance assessments, M&A proposals, and

stock repurchase decisions. Some of these analyses were performed at the division or business unit

level, while others were executed at the corporate level.

The cost of capital needs to be adjusted if the project is more or less risky in comparison to the firm risk.

The cost of capital should be used in performance assessments of the firm, taking into consideration the

factors such as economic scenario, industry cost of capital, size of the company etc. Also, cost of capital

should be calculated in order to include the latest changes of stock prices.

2. Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions

about the various inputs to the calculations. Is Midland’s choice of EMRP appropriate? If

not, what recommendations would you make and why?

Section 2: WACC of the company

To calculate Midland’s company WACC, a 39.72% tax rate is assumed based on an average, of taxes

paid divided by income before taxes, over the last three years (Exhibit 1). The cost of debt of is

calculated as the 10-year rate (Table 2) on U.S. Treasury bonds plus the spread to Treasury (Table 1).

The 10-year risk-free rate seems more appropriate because Midland’s borrowing capacity is based

primarily on its energy reserves and long-lived assets. The short-term 1-year rate would be less for

calculating the risk. Then, 30-year rate will more applicable for a real estate companies, but not

appropriate based on the prospective changes in the production business

The new beta was calculated by un-levering the old beta of 1.25 (which was based on a D/E ratio of

59.3% seen in exhibit 5) and new levering based on the target capital structure of 57.8% equity which

corresponds to a D/E ratio of 73%. The unlevered beta for Midland is calculated as .922. In calculating

the asset beta for new levering, the beta of debt is assumed to be zero based on Midland’s consolidated

A+ credit rating (Table 1). This assumes that the company as a whole has little or no risk of default. The

ratios of debt and equity are the target ratios for the consolidated company as set by management.

Midland’s WACC is calculated at and is as follows:

Levered Beta = Unlevered beta (1+(1-T)D/E)

Levered Beta = 1.25% (exhibit 5)

D/E = 0.593 (exhibit 5)

Equity Market Risk Premium:

Exhibit 6 shows historical data on U.S. stock returns and bond yields supporting higher estimates of

EMRP. On the other hand, survey results shown in Exhibit 6 support lower figures. Midland adopted its

current estimate of 5 % after a review of recent research and in consultation with its professional

advisors, bankers and auditors, as well as Wall Street analysts covering the industry.

Tax rate is calculated according to the Exhibit 1 taking the average tax rates of 2004, 2005 and 2006.

Tax rate=Income taxes/income before taxes

(7414/17910+12830/32723+11747/30447)/3≈0.3972

Tax rate: 39.72%

Unlevered Beta (or asset beta) = 0.921

Target equity capital structure = 57.8% (from case study - table 1)

Implies new D/E ratio = 73%

Calculating new Levered Beta (for target capital structure of 42.2% debt):

New equity Beta = 0.921 (1+ (1-.3972)*.73) = 1.33

Using EMRP of 5%

R(e)

= 4.66 + 1.33 (5) = 11.31%

R(d)= 4.66 +1.62 = 6.28%

WACC

midland

= (1-t) r

(D/V) + r

(E/V)= ((1-0.3972)*0.0628*0.422)+(0.1131*0.578)

WACC

midland

= 0.08134 = 8.13%

Midland is using EMRP of 5%. Based on the historical data presented in Exhibit 6A, the average of

historical data would result in EMRP closer to 6%. Especially in the more recent time period of 1987 to

2006, the average excess return (6.4%) is higher than Midland’s projection of 5%. Giving more weight

to historical data would decrease any bias by individual viewpoints or survey results. As the economy

has been more uncertain, investors are demanding higher return to compensate for the increased risk.

Hence it would be more appropriate for Midland to use EMRP closer to 6%.
3. Should Midland use a single corporate hurdle rate for evaluating investment opportunities in

all of its divisions? Why or why not?

Section 3: Differentiating hurdle rates

If the company used the single cost of capital or hurdle rate it would assume that all divisions

are similar. Using single hurdle rate doesn’t consider each division’s different debt structures

and nature of assets. For example, Midland’s E&P division has assets of oil reserves and higher

demand for capital expenditures for development (Exhibit 3). Also, target debt ratio differs

among divisions.

For divisions, operating in different specific industries also can differentiate business risks. For

example, R&M division operates on smaller margins, so that it has more risk. However, if we

take into account that it operates long time before, the probability of decreases. Also, this

division requires not much capital taking into account its maturity in the market.

Considering the explanation given above, it is better to use different hurdle rates for each

division since it will provide company with more accurate and detailed information about the

expected riskiness.

4. Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What

causes them to differ from one another?

Section 4: Cost of capital for E&P and R&M

E&P and the Marketing and Refining divisions have different betas and target capital structures. For

E&P, the average industry unlevered beta is 0.9275 whereas the M&R division has an average industry

unlevered beta of 1.0692. This produces an equity divisional beta of 1.404 for E&P and 1.359 for M&R

taking into account their target capital structure. A 39.72% tax rate is assumed in unlevering
each

company’s beta. The risk free rate is assumed to be 4.66% (10 year treasury yield). Table 1 shows the

calculation of unlevered beta, cost of debt, cost of equity and the WACC of both the divisions.
Calculating new Levered Beta (for target capital structure of 46% debt):

Exploration & Production Division:

Unlevered Beta for E&P division: 0.9275

New levered beta is thus: Unlevered*/ (1+ (1-T)*D/E)= 1.404

Using EMRP of 5%

R(e)

= 4.66 + 1.404*5%= 11.68%

R(d)= 4.66 +1.60= 6.26%

WACC of division: R(d)*(D/V)*(1-t) + R(e)*(E/V)= 8.04%

Refining & Marketing Division:

Unlevered Beta for E&P division: 1.06

New levered beta is thus: Unlevered*/ (1+ (1-T)*D/E)= 1.359

Using EMRP of 5%

R(e)

= 4.66 + 1.36*5% = 11.46%

R(d)= 4.66 +1.80= 6.46%

WACC of division: R(d)*(D/V)*(1-t) + R(e)*(E/V)= 9.11%

Following table shows summary of calculations:

Table 1: Cost of Capital for E&P and Marketing and Refining divisions

While the cost and debt and the cost of equity does not vary much between the two divisions, the target

capital structure of the divisions influences the cost of capital. E&P is able to take advantage of a lower

cost of debt by using greater leverage (46%) compared to Refining and Marketing (31%) which results

in lower divisional cost of capital for E&P.

5. How would you compute a cost of capital for the Petrochemical division? Section 5: Cost of Capital
for Petrochemical Division For calculating the cost of capital for Petrochemical division, the weight of
each division can be found using the information about the total assets in 2006, described in
Exhibit 3. According to this information, the weights are 0.534, 0.358, 0.108 for the E&P division, R&M
division and Petrochemical division respectively. The following step is to find the unlevered asset beta
for Petrochemical division. Since we found the weights based on the assets, using unlevered beta would
be more appropriate. To find the unlevered beta for Petrochemical division, first, we should find
unlevered betas for 2 remaining divisions of company. Although the Midland Energy Resources, Inc.
does not have exact information about the sensitivity of stocks’ returns, it can define betas by looking at
competitors’ betas and analysts’

reports. For this purpose, we first need to multiply the beta of each division by respective weight. Then
we add all the products and set it equal to the total beta of the company. Finally, we find the unknown
beta for Petrochemical division from the equation we formulated. To understand the information given
above let’s see calculations

b) Calculations of beta (Petrochemicals):

The company has already calculated the levered betas for total and for each division by finding

arithmetic mean. (For E&P: 1.15; for: R&M: 1.2; for Midland: 1.25)To find unlevered ones we have

following formula:

Levered Beta = Unlevered beta* (1+ (1-T)*D/E) D/E stands for debt to equity ratio

Unlevered beta= Levered beta/ (1+ (1-T)*D/E)

Unlevered beta for E&P division: 1.15/ (1+(1-0.3972)*0.398≈0.9274

Unlevered beta for R&M division: 1.2/ (1+(1-0.3972)*0.203≈1.0692

Unlevered beta for company: 1.25/ (1+(1-0.3972)*0.593≈0.921

Note: Tax rate = 39.72% was calculated as the average of tax rates from 2004, 2005, 2006 from exhibit

Now we have equation:

0.921 = 0.5340*0.9275+0.3576*1.0692+.1084* unlevered Beta of Petrochemicals

So, from this equation we can find that unlevered beta for Petrochemicals is approximately 0.4

Using the formula above:

Levered beta= 0.4* (1+(1-0.3972)*0.6667)≈0.561

Relevering is based on the target capital structure of 60 equity which corresponds to a D/E ratio of

66.67%.

c) Then we have following information to calculate WACC for Petrochemical division:

Cost of Equity R(e): R(f)+Beta (EMRP) where R(f) is 4.66% and EMPR = 5%

R(f)-risk-free rate or treasury rate

EMRP-Equity market risk premium

Cost of equity is thus: R(e)=4.66% (10-year treasury bond)+0.561*5%≈7.46%

Cost of debt R(d): 10 year treasury rate + spread to treasury (from table 1)

Cost of debt is thus: R(d)=4.66% +1.35%=6.01%

WACC for Petrochemicals division: R(d)*(1-T)*(D/V)+ R(e)*(E/V) where D/V=0.4 and E/V=1-

D/V=0.6 (from table 1)

WACC for Petrochemicals is thus: 6.01*(1-0.3972)*0.4+7.46*0.6≈5.93

The resulting WACC of 5.93% for the Petrochemical division represents the discount rate that can be

used to value specific projects of average risk within the division.

Recommendations:

In summary, the cost of capital for each of the divisions of Midland energy varies as shown in the table

below. For Midland energy to achieve its financial goals it must deploy a sound investment strategy

that takes into account the appropriate cost of capital for each project and must continuously evaluate
this against changing business needs. It is recommended that Midland Energy undertake this exercise at

a minimum annually and also when any significant events take like that affect the capital structure of
the

division or company.

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