Midland Case

Team – Angelique, Devansh, Gerardo, Keith

1. 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 estimates of Midland’s cost of capital had a profound impact across various vertical within Midland-
including Asset Appraisals for capital budgeting and financial accounting, performance assessments, M&A proposals
and stock repurchase decisions. The influence of the estimates was at the business unit as well as the corporate unit.

Cost of Capital needs adjustment depending on the project risk factor in terms of the firm risk. Updated with the
latest changes in the stock prices, the cost of capital should be used in performance assessment of the firm, taking
into consideration economic condition, size of the firm, etc.
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?
In order to calculate Midland’s WACC, a tax rate of 39.27% is assumed based on the average of tax paid divided by income before taxes over the last 3 years. The cost of debt is
calculated on a 10 year rate on US Treasury Bond plus the spread to the Treasury. The 10 year risk is a better yardstick because Midland’s borrowing capacity is based on its energy
reserves and long term assets. 1 year would be too less to calculate the risk and 30 year will be more applicable for real estate companies.

The new beta value was calculated based on un-levering the old beta of 1.25 (based on D/E ratio of 59.3%) and new levering based on target capital structure of 57.8% equity which
corresponds to D/E ratio of 73%. The unlevered beta for Midland is 0.922. Now, Midlands rating is A+ credit rating, therefore, in calculating the asset beta for new levering, the beta
of debt is assumed to be zero. This works on the assumption that the company has low or zero risk associated.

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

Levered Beta = 1.25%
D/E = 0.593

Equity Market Risk premium

Tax Rate = 39.72%

Unlevered Beta = 0.921
Target Equity Capital Structure = 57.8%
New D/E ratio = 73%

New Levered Beta ( for Target capital structure of 42.2% debt)

New Equity Beta = 1.33
EMRP of 5%
R(e) = 4.98 + 1.33(5) = 11.31%
R(d) = 4.98 + 1.62 = 6.28%

WACC = (1-t) r(d) (D/V)+ r(e)(E/V) = 0.08134 = 8.13%

Midland’s EMRP is 5%. Historical data highlights that the EMRP is closer to 6%. Extending more weightage towards historical data would decrease any bias by individual viewpoints
or survey results. In order to compensate for higher risk with reward, Midland should 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?

Using a single cost of capital or hurdle rate would imply that Midland is
assuming that all division are equal. This methodology ignores that each
division has unique and different debt structure and nature of assests.
Debt ratio is also different between divisions. Also, divisions working in
different specific industries will also have differentiating business risks.
4. Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from
one another?

Cost of Capital for E&P and R&M

Both have different beta and target capital structure. E&P has an average industry unlevered beta of where as
M&R has 1.0692. This produces an equity divisional beta of 1.404 for E&P and 1.359 for M&R. Tax rate is 39.72%.
The risk free factor is assumed to be 4.98% ( 10 year treasury yield )

Calculating new Levered Beta ( 46% debt ):

Exploration and Production Division :
Unlevered Beta for E&P division : 0.9275
New Levered Beta = 1.26
Using EMRP = 5%

R(e) = 4.98 + 1.26*5% = 11.28%

R(d) = 4.98 + 1.6 = 6.58%

WACC of division = (1-t) r(d) (D/V)+ r(e)(E/V) = 7.91%

Marketing & Refining Division :
Unlevered Beta for E&P division : 1.07
New Levered Beta = 1.45
Using EMRP = 5%

R(e) = 4.98 + 1.45*5% = 12.24%

R(d) = 4.98 + 1.8 = 6.78%

WACC of division = (1-t) r(d) (D/V)+ r(e)(E/V) = 9.71%

While the cost and the debt and the cost of equity does not vary much, the target capital structure of the divisions
influences the cost of the capital. E&P is able to take advantage of a lower cost of debt by using greater leverage
(46%) compared to M&R which results in a lower divisional cost of capital for E&P.
5. How would you compute a cost of capital for the Petrochemical division?
For calculating cost of capital for Petrochemical division, the weight of each division needs to be found. The weights are 0.534, 0.358 and 0.108 for E&P, M&R and
Petrochemical division. Next, we find the unlevered asset beta for Petrochemical division. For this, we need to find the unlevered beta for the other two divisions.
Competitors beta and reports can be looked into as the sensitivity of stocks’ returns for Midland is unavailable.

Computation is as follows:

Calculation of weights

Division Assets
E&P 140,100
M&R 93,829
Petrochemical 28,450

Total Assets = 262,279

Weight for E&P = 0.534
Weight for M&R = 0.358
Weight for Petrochemical = 0.108

Calculation of Beta

Unlevered Beta for E&P = 0.9274

Unlevered Beta for M&R = 1.0692
Unlevered Beta for company = 0.921

Tax rate = 39.72%

Therefore, Unlevered Beta for Petrochemical is 0.4

5. How would you compute a cost of capital for the Petrochemical division?

Levered Beta = 1.04

Levering is based on the target capital structure of 60 equity which corresponds to D/E ratio of 59.30%

Calculation of WACC for Petrochemical division

R(e) =R(f) + Beta(EMRP) where R(f) = 4.98% and EMRP =5%

R(e) = 10.18%
Cost of R(d) = 4.98 + 1.35 = 6.33%

WACC of division = (1-t) r(d) (D/V)+ r(e)(E/V) = 7.63

Thus WACC for Petrochemical is 7.63%