The case is about the Midland Energy Resources Inc which has an operating revenue of US$ 248.5bn and operating income of US $42.2 bn. Janet Mortensen, the senior VP of project finance has to prepare annual cost estimates for the company and its 3 divisions : exploration and production , refining and marketing, and petrochemicals. She has been doing the job since 2002 but she believes that she needs to exercise greater care in her calculations.
Following questions cover the various aspects of the case :
Q1 How are Mortensen's estimates of Midland's cost of capital used? How, if at all, should these anticipated uses affect the calculations?
Capital Budgeting
The cost of capital needs to be adjusted upward/downward if the project is more/less risky in comparison to the firm risk
Financial Accounting
Performance Assessments
The cost of capital should be used in performance assessment of the firm with due consideration to factors like macroeconomic scenario, industry cost of capital, business cycle, size of the company etc.
M&A proposals
Midland is a very large company. The EMRP includes factors like size premium, liquidity premium for firms which are much smaller than Midland. The cost of raising capital for Midland will be lower due to its large size. Either the cost of capital should be adjusted downward to exclude size premium and liquidity premium or the buildup method should be used to estimate cost of capital
Stock Repurchase Decisions
The stock repurchase decisions are staggered and do not occur at the same time as the time when cost of capital was estimated. The cost of capital should therefore be calculated continuously to include the latest changes
Q2 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?
Given Data :
Treasury Rate (30 years ) = 4.98%
Spread for Treasury for debt= 1.62 %
B(levered) = 1.25
EMRP = 5%
Company D/V = 42.2 %
Parameter
Company
Cost of Debt Calculation
Treasury Rate ( 30 year)
4.98%
Spread For Treasury
1.62%
Kd
6.60%
Cost of Equity Calculation
B(levered)
1.25
Spread
5.00%
Rf
4.98%
Ke
11.23%
WACC
8.17%
Cost of Debt :
It will be calculated as the spread over the risk free treasury rate
Kd before tax= Treasury Rate + Spread for Treasury for debt
= 4.98% + 1.62%
= 6.60%
Cost of Equity :
It will be calculated using CAPM model.
Ke = Rf + B(EMRP)
= 4.98% + 1.25(5%)
= 11.23%
WACC :
It will be calculated using company assets as weights
WACC = Kd(D/V)(1-T) + Ke(1-D/V)
= 8.17%
Assumptions : Only assumption taken in the calculation is that the long term debt of the company is more than 30 years. Hence the risk free rate of treasuries of 30 years has been considered. Considering the size of the company and the investments involved in the exploration and refining business are huge, the company will be going for long time debts.
Choice of EMRP : Company has chose an EMRP of 5% which if low if compared with the last 20 years access return on US Equities over T-Bonds. However from the market survey it comes out to be higher than the range and median values given by the respondents
Q3 Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or why not?
The risk profile of each of the divisions of Midland is different. While evaluating a project within a division, Midland should use the hurdle rate specific to that division adjusted depending on the perceived riskiness of that project as compared to the divisions riskiness
If the capital is required for use for corporate affairs like setting up a new office, Midland should use the WACC as calculated above
Q4 Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from one another?
Separate cost of capital of E&P can be calculated using the comparable companies approach.
Equity
Equity
Exploration & Production:
Market Value
D/E
Beta
E/V
Weights
B(unlevered)
Jackson Energy, Inc.
57,931
11.2%
0.89
0.90
33.3%
0.80
Wide Palin Petroleum
46,089
85.4%
1.21
0.54
26.5%
0.65
Corsicana Energy Corp.
42,263
15.2%
1.11
0.87
24.3%
0.96
Worthington Petroleum
27,591
47.5%
1.39
0.68
15.9%
0.94
Average
39.8%
1.15
Refining & Marketing:
Bexar Energy, Inc.
60,356
10.3%
1.70
0.91
32.21%
1.54
Kirk Corp.
15,567
19.4%
0.94
0.84
8.31%
0.79
White Point Energy
9,204
20.9%
1.78
0.83
4.91%
1.47
Petrarch Fuel Services
2,460
-12.0%
0.24
1.14
1.31%
0.27
Arkana Petroleum Corp.
18,363
32.3%
1.25
0.76
9.80%
0.94
Beaumont Energy, Inc.
32,662
20.6%
1.04
0.83
17.43%
0.86
Dameron Fuel Services
48,796
50.3%
1.42
0.67
26.04%
0.95
In the figure Weights have been calculated using the market value of the companies.
B(unlevered) has been calculated as :
B(unlevered)=B*(E/V)
These Betas are then multiplied with the respective weights to give the final unlevered beta
This unlevered B is divided with the departments E/V ration to get the levered Beta
B(levered) = B(unlevered)/( E/V)
= B(unlevered)/( 1-D/V)
Cost of capital is then calculated using the CAPM model
The cost of debt is calculated by adding the spread to treasury of each department over the Rf
The cost of capital and cost of debt are then weighted by the D/V and E/V ratio to calculate the WACC.
Parameter
Exploration & Production:
Refining & Marketing:
Cost of Debt Calculation
Treasury Rate ( 30 year)
4.98%
4.98%
Spread For Treasury
1.60%
1.80%
Kd
6.58%
6.78%
Cost of Equity Calculation
B(levered)
1.52
2.09
Spread
5.00%
5.00%
Rf
4.98%
4.98%
Ke
12.60%
15.41%
WACC
8.62%
11.9%
Causes of Difference:
The business units operate on different industries,they have different risk profiles and β'sthey have different credit ratings.
The E&P division's profits are directly proportional to the price of crude oil whereas the profits of refining division are inversely related to the crude oil prices.
The E&P division has a higher capital expenditure as compared to that of the Marketing and Refining Division
Q5 How would you compute a cost of capital for the Petrochemical division?
Cost of capital for Petrochemicals division can be calculated using the weighted average method since the Cost of Capital of company and other 2 departments has been calculated. However this value turns out to be negative. Hence we have assumed all weights to be equal. This gives the cost of capital of Petrochemical division as 3.98%.
