The operations of Midland Energy Resources are divided amongst three separate divisions which have different functions and need separate discount rate to evaluate its projects. The cost of capital is very critical in Midland as it used for many diverse purposes. The Weighted Average Cost of Capital (WACC) is used to discount Midland's cash flows. Cost of debt is calculated using a 'bond yield plus risk premium' approach whereas the cost of equity is calculated using the Capital Asset Pricing Model (CAPM). In CAPM, the calculation of beta requires significant judgment. Industry data is used to calculate the beta, but such data is not available for one of the divisions where an alternative method is applied.
How are Mortensen's estimates of Midland's cost of capital used? How, if at all, should these anticipated uses affect the calculations?
Mortensen's estimate of Midland's cost of capital use:
1. EMRP value of 5%
2. Cost of debt: Yield to Maturity (YTM) of treasury securities of similar maturity + spread to treasury
3. Equity Beta
4. Target D/V after consultation among division, executives and board members
These estimates are used for various purposes ranging from performance evaluation to stock repurchase.
These estimates affect the calculations as follows:
1 EMRP values differ among historical data figures and various analysts.
2 Spread to treasury might not be evaluated properly.
3 Projects are in various countries. Therefore, spread to treasury may not be the right way to account for risk associated.
4 Country risk premium should also be added.
5 Beta may change across the divisions depending upon the type of business, operating leverage, and financial leverage.
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?
Particulars
Value
Units
Assumptions
Average Stock Price for MIDLAND
$42.31
Average no. of Shares Outstanding
2951
million
Net Debt, D
$79,508
million
Tax rate
38.58%
Using 2006 : Effective Tax Rate
Equity beta
1.25
Equity market risk premium
5%
Calculation
Avg. Market value of Equity, E
$124,857
million
V = D+E
$204,365
million
D/E
0.63679346
D/V (Actual)
0.38904937
D/V (Target; for year 2007)
42.20%
Spread to Treasury
1.62%
Yield to Maturity _ 1 year
4.54%
Yield to Maturity _ 10 year
4.66%
Yield to Maturity _ 30 year
4.98%
Cost of Debt
6.4400%
50% of Long term debt has maturity period 10 years and 50% falls in the range of 30%
Cost of Equity (CAPM)
10.7900%
1 year bond YTM: Risk free rate
WACC
7.91%
Midland's choice of EMRP may not be appropriate as historical data on stock returns and bond yields supports the higher estimates of the EMRP. Other data, such as survey results suggest lower figures.
Recommendation:
Midland should use range of EMRP values to calculate a range of WACC and should use the upper, lower and most likely EMRP values to discount cash flows.
Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or why not?
Midland should not use a single hurdle rate for evaluating investment opportunities in all of its division.
The reasons for this are:
Beta depends on three factors
a) Type of business
b) Operating Leverage
c) Financial leverage
As these three divisions are not exactly in the same business and are having differential risk, therefore beta will not be same
Secondly, Operating leverage will not be same across the three divisions. Exploration and Production will have more fixed costs incurred because of its type of business
It will also have more uncertainty over the results of its projects. Therefore more the rise, higher will be the beta values.
Country risk premium has not been considered in the hurdle rate estimation. The projects being done in countries where political and economic scenario is volatile should have higher WACC taking country risk premium into account
Discrepancy in calculation of Cost of Debt: The maturity value of debt raised might not be same for every business segment. Therefore, Yield to Maturity of treasury bonds should not be taken equal, which ultimately affects the cost of debt.
Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from one another?
Exploration and Production
Equity Market Value
Net Debt
D/E
Equity Beta
LTM Revenue
LTM Earnings
Jackson energy
57931
6480
11.20%
0.89
18512
4981
Wide Plain Petroleum
46089
39375
85.40%
1.21
17827
8495
Corsicana Energy Corp.
42262
6442
15.20%
1.11
14505
4467
Worthington Petroleum
27591
13098
47.50%
1.39
12820
3506
Average Value
39.83%
1.15
WACC Calculation for Midland- E&P Division
Particulars
Value
Units
Assumptions
Effective Tax rate for all the firms
40%
Assuming it to be 40%
Avg. Debt to Equity ratio of Firms
39.83%
Average: Calculated
Average Beta_all firms
1.15
Equal Weighted Average
Debt/ Value _Target for E&P
46%
Target as given in Table 1
Marginal Tax rate of Midland E&P
38.58%
Taken for Year 2006
Spread to Treasury
1.60%
Given in the Table 1
Calculation
Unlevered Beta _ Midland E&P
0.9282
D/E_ Target for E&P
85.19%
Levered Beta
1.41
Cost of Equity_CAPM
11.61%
Cost of Debt
6.4200%
WACC
8.0828%
Refining and Marketing
Equity Market Value
Net Debt
D/E
Equity Beta
LTM Revenue
LTM Earnings
Bexar Energy Inc.
60356
6200
10.30%
1.7
160708
9560
Kirk Corp.
15567
3017
19.40%
0.94
67751
1713
White Point Energy
9204
1925
20.90%
1.78
31682
1402
Petrarch Fuel Services
2460
-296
-12.00%
0.24
18874
112
Arkana Petroleum Corp.
18363
5931
32.30%
1.25
49117
3353
Beaumont Energy Inc
32662
6743
20.60%
1.04
59989
1467
Dameron Fuel Services
48796
24525
50.30%
1.42
58750
4646
Average
20.26%
1.196
WACC Calculation for Midland- Refining and Marketing Division
Particulars
Value
Units
Assumptions
Effective Tax rate for all the firms
40%
Assuming it to be 40%
Avg. Debt to Equity ratio of Firms
20.26%
Average: Calculated
Average Beta_all firms
1.196
Equal Weighted Average
Debt/ Value _Target for E&P
31%
Target as given in Table 1
Marginal Tax rate of Midland E&P
38.58%
Taken for Year 2006
Spread to Treasury
1.80%
Given in the Table 1
Calculation
Unlevered Beta _ Midland E&P
1.0661
D/E_ Target for E&P
44.93%
Levered Beta
1.36
Cost of Equity_CAPM
11.34%
EMPR assumed to be 5%
Cost of Debt
6.6200%
WACC
9.0862%
Reasons for different WACC
Cost of Capital of both the division differs because of different debt to equity ratio of both the firms and different equity beta. We are using comparable method to compute cost of capital for both the divisions and the difference in both for other comparables firms lead to different values.
One more reason is different debt to equity ratio of both the divisions. Also for computation of cost of debt, spread to treasury is different.
How would you compute a cost of capital for the Petrochemical division?
Equity Beta Midland
1.25
Equity Beta_ E&P
1.41
Equity Beta_Ref
1.36
Operating Revenue_E&P
22357
Operating Revenue_Ref.
202971
Operating Revenue_Petro
23189
Spread to Treasury
1.35%
Marginal Tax Rate
38.58%
Debt/Value (D/V)
40%
EMRP
5%
RFR
4.54%
Calculation
Weight of E&P
0.09
Weight of Ref.
0.82
Weight of Petro
0.09
Equity beta of Petro
0.132921644
Cost of Equity_CAPM
5.20%
D/E
66.67%
Cost of Debt
6.17%
WACC
4.64%
