Midland Energy Resource keeps evaluating their cost of capital since it is investing in expanding its operations outside US, also funding its significant overseas growth and to optimize its capital structure. Therefore, it is important to calculate an accurate cost of capital.
The cost of capital was calculated by the Weighted Average Cost of Capital (WACC) formula as shown below.
Cost of debt was calculated for each division by using a 'bond yield plus risk premium' approach in which the risk premium depended on variety of factors. The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) shown below.
The beta ( for Midland Energy Resource was taken from the published data in commercially available databases and for the divisions the data were taken from similar publicly traded companies.
Question 1: How are Mortensen's estimates of Midland's cost of capital used? How, if at all, should these anticipated uses affect the calculations?
Answer -1: According to the case, Janet Mortensen's estimates are used for many analyses and decision making processes at different level. Following are few of the uses as mentioned in the case:
• Asset appraisals for capital budgeting and financial accounting
• Performance Assessments
• M&A proposals
• Stocks Repurchase Decisions
Question 2: Calculate Midland's corporate WACC. 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?
Answer-2: As mentioned in the Table 1 in the case the Spread to treasury for each division and the yields of maturity for U.S. Treasury bonds in table 2. As Janet Mortensen computed the cost of dept for each division by adding a premium, or spread, over U.S. Treasury securities of a similar maturity
So using the data and the information we get,
Consolidated Spread to Treasury = 1.62%
Yield to 30-years maturity of U.S. Treasury bonds = 4.98%
So Cost of Debt (rd) = 4.98%+1.62%
= 6.6%
Tax rate
Tax rate can be calculated based on the ratio of the Income taxes paid to the income before tax. Midland's Income Statement for years 2004, 2005 and 2006 are given in Exhibit 1.
So calculating the ratio of the Income taxes paid to the Income before tax and averaging it for the 3 years period we get the tax rate = 39%
EMRP
According to the information given in the last paragraph of the case in 2006 Midland used EMRP of 5%. In past they have used higher EMRP which is also supported by the historical data on the stock returns and bond yields (as shown in Exhibit 6). On the other hand the survey data (also shown in Exhibit 6) suggested lower value of EMRP.
After consultation with its professional advisors Midland is adopting its current estimate of 5%. This choice is appropriate as it is in consultation with the professionals and also it is in-between the higher and lower range which both affect the WACC.
Cost of Equity (re)
Cost of Equity can be calculated using the CAPM model.
Risk Free Rate of Return (rf) = 4.98% (as mentioned in Table 2)
ß = 1.25 (as given in the case)
EMRP = 5%
We get,
re = rf + ß (EMRP)
= 4.98 + 1.25*5
= 4.98 + 6.25
= 11.23%
WACC
re = 11.23%
rd = 6.6%
Tax Rate (t) = 39%
D/E = 59.3%
E = 100 units
D = 59.3 units
V = 159.3 units
Using the WACC formula we get
WACC = 6.6*59.3*0.61/ 159.3 + 11.23*100/159.3
= 8.548%
Question 3: Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or why not?
Answer 3: As mentioned in the case each division of the Midland Energy Resources has different risks associated with respect to its operations. As the E&P division has been seeing a shift in the geographic composition of output and due to high prices heavy investments are put in for acquisitions of promising properties. In R&M division the margin is shrinking and its steadily declining since last 20 years. In Petrochemicals division several older facilities were sold or retired and capital spending is expected to grow.
In Exhibit 5, the Equity Beta represents the risk factor of those divisions and as the risk profile are different per division the hurdle rate for each division should also be different and should be calculated based on the β of the division.
Midland should not use single corporate hurdle rate as this will mislead evaluation of the investments, and will result on Midland invest on risky projects and will become risky a corporate by time
If investments are done at the corporate level the Midland WACC can be considered but when the investments are at business unit levels the hurdle rate of different divisions should be considered.
Question 4: Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from one another?
Answer 4 E&P
= 4.98% + 1.15 (5%)
= 10.73%
rd = rf + E&P Spread to Treasury (as mentioned in Table 1 and Table 2)
rd = 4.98% + 1.60%
= 6.58%
=10.73%
rd =6.58%
Tax rate (t) = 39%
D/E = 39.8%
E = 100units
D = 39.8units
V = 139.8units
E/V = 0.715308
D/V = 0.284692
To calculate the cost of capital using WACC formula we get
=>WACC for E&P division = 8.818%
R&M
re = 4.98% + 1.20 (5%) = 10.98%
rd = rf + R&M Spread to Treasury (as given in Table 1 & Table 2)
rd = 4.98% + 1.80% = 6.78%
re = 10.98%
rd = 6.78%
Tax rate (t) = 39%
D/E = 20.3%
E = 100units
D = 20.3units
V = 120.3units
E/V = 0.831255
D/V = 0.168745
=>WACC for R&M division =9.825%
As already discussed the different business units operate in different environments therefore hold a different risk profiles and betas (β). Also as we see in the Table 1 of the case both the divisions have different credit ratings. As a result of which, the E&P and R&M have different WACC's (8.818% and 9.825% respectively)
Question 5: How would you compute a cost of capital for the Petrochemical division?
Answer 5: To calculate cost of capital for Petrochemical, we would search for couple of companies which focus only on Petrochemical industry. And use their fact sheet and get an average on their β and D/E ratio.
• By using the data available on Exhibit 5, and using arithmetic averages on D/E ratio and β to calculate cost of capital for Petrochemical division.
Considering that the Corporate β = Average (E&P β, R&M β, Petrochemical β)
1.25 = Average (1.15, 1.20, Petrochemical β)
Petrochemical β = 1.40
re = rf + β(EMRP)
re = 4.98% + 1.40 (5%) = 11.98%
rd = rf +Petrochemical Spread to Treasury (as given in table 1 and table 2)
rd = 4.98% + 1.35% = 6.33%
Corporate D/E = Average ( E&P D/E, R&M D/E, Petrochemical D/E)
59.3% = Average (39.8%, 20.3%, Petrochemical D/E)
Petrochemical D/E = 117.8%
re = 11.98%
rd = 6.33%
Tax rate (t) = 39%
D/E = 117.8%
E = 100 units
D = 117.8 units
V = 217.8 units
E/V = 0.459137
D/V = 0.540863
=>WACC for Petrochemical 7.589%
