Midland Energy Resources is a global energy company with operations in oil and gas exploration and
production (E&P), refining and marketing (R&M) and petrochemicals. The company had been incorporated
more than 120 years previously and in 2007 had more than 80000 employees. On a consolidated basis, the firm
had 2006 operating revenue and operating income of $248.5 billion and $42.2 billion, respectively. E&P is
Midland‟s most profitable business. However measured by revenue its refining and marketing business is its
largest. Petrochemicals is midland‟s smallest division.
Midland must calculate an appropriate cost of capital that will help them achieve an optimal capital structure.
Assumptions in our model:
The Cost of Debt assumption: The ratio of D/D+E is calculated for each of the companies. This ratio is compared with
the debt/value ratio given in Table 1 of the case. The β
D
value corresponding to the credit ratings have been calculated
from the article “Risk in capital structure arbitrage” mentioned during class discussions. For „Exploration & Production‟
division, as all the comparable firms have a debt/value ratio less than or equal to 46%, we have assumed AAA rating for
each one of them (This implies β
D
=0).
The Risk free rate Assumption: We take 4.98% as the risk free rate of return based on returns for Treasury bond for 30
years and 5% as the equity market risk premium. Because the period from 17982006 has the least standard error we are
going with the approximation of equity market risk premium of 5%.
Exploration & Production (E&P)
E&P is Midland‟s most profitable business with net margin over the previous five years among the highest in
the industry. It produces 67% of the company‟s net income. Midland must calculate an appropriate cost of
capital that will help them achieve an optimal capital structure. Capital Spending in E&P was expected to
exceed $8billion in 2007 and 2008
Using the data that we have for comparable companies in this sector, we need to calculate the unlevered cost of
capital for this division of Midland.
Based on the β
D
values we can calculate the unlevered β
separately for each similar company as per the formula –
β
u
= (E)/(D+E)x β
E
+ (D)/(D+E)x β
D
Which gives β
U.
From each individual β
U
we calculate the weighted β
W
from the given firms by weighing the assets of the
firms.
Where Assets = (Market value + Net Debt) and βw = ∑ (β
U
x Individual Assets)/ (Total Assets)
The final β
W
= 0.59
Now, we can apply CAPM and calculate the unlevered cost of capital using the formula
r
U
= r
f
+ [E(r
m
)r
f
] β
W .
Therefore r
u
= 4.98% + (0.59x5%) = 7.94% where 4.98% is the risk free rate of return.
Hence, the unlevered beta for Exploration and Production division is 0.59 and the rate of return is 7.94%.
Refining & Marketing (R&M)
In terms of revenue, Midland's refining and marketing business was the company's largest. However, its
products were highly commoditized resulting in stiff competition. After tax earnings totaled only $4million.
Midland was the market leader in this business due to its advanced technology and vertical integration.
Using the same model as the Refining and Production division, the unlevered beta for Exploration and
Production division is 1.116 and the rate of return is 10.56%.
Petrochemicals
Petrochemicals is Midland's smallest division but capital spending in petrochemicals was expected to grow in
the nearterm as several older facilities were sold or retired and replaced by more efficient capacity. Revenue
and After tax earnings in 2006 were $23.2 billion and $2.1 billion respectively
As we already have the unlevered beta for the Exploration and Refining divisions, we can use this data along
with the unlevered beta of the whole company, to find out the unlevered beta for the petrochemicals division
using the formula:
(
)
(
)
(
)
The detailed workings of the same have been shown in exhibit 3.
The unlevered beta for Petrochemical division is 0.453 and the rate of return is 7.24%.
Verdict:
The rate of returns for the Petrochemical division is the lowest at 7.24%, while it is maximum for the Refining
and Marketing division at 10.56%.
A note on Hurdle Rate
For our evaluation of Midlands, instead of using one fixed rate of return (hurdle rate) for the whole company,
we have used a separate hurdle rate for each division. This has been done because the performance of the
divisions will vary since Midland is a large enterprise. Hence different risk factors are present in different
divisions and there are different risk premiums. This is so because these divisions operate in different industries
and have a different market risk associated with them. So hurdle rates for these divisions should be calculated
separately based on the market risk of the division.
If a single hurdle rate is used all along, these problems can affect the value assessment of Midlands:
i) Midlands will allocate resources/investments improperly among the three divisions. It will invest
relatively more in poorly performing divisions resulting in wastage of assets. Similarly it will not
invest enough in divisions which are earning more profits.
Eg: If we find the single hurdle rate for the company: r
U
= 4.98% + (0.764x5%) = 8.8%
In such a case if we straight away use 8.8% for all departments, the company will overstate the risk
as well as returns for Exploration & Production as well as Petrochemical Divisions. Thus, we will
not invest much in these relatively lower risk departments, and hence, the overall volatility of the
returns for Midlands will increase, making the stock more risky.
ii) This decision will adversely affect the performance of the different divisions and hence the company
as a whole. Hence its brand equity will decrease and stock prices will also fall. Overall value of the
firm will be overstated by using one higher rate of return the risk premium will increase.
Exhibits:
Exhibit 1: Comparable companies showing debt beta and unlevered beta for “Exploration and
Production” sector.
Equity Net
Equit
y LTM LTM
Exploration
&
Production:
Ratin
g
D/D+
E
Marke
t
Value Debt D/E Beta
Revenu
e
Earning
s
Debt
beta
Unlevere
d beta
Jackson
Energy, Inc. AAA 10% 57,931 6,480
11.2
% 0.89 18,512 4,981 0 0.790
Wide Palin
Petroleum AAA 46% 46,089
39,37
5
85.4
% 1.21 17,827 8,495 0 0.176
Corsicana
Energy
Corp. AAA 13% 42,263 6,442
15.2
% 1.11 14,505 4,467 0 0.941
Worthington
Petroleum AAA 32% 27,591
13,09
8
47.5
% 1.39 12,820 3,506 0 0.730
Exhibit 2: Comparable companies showing debt beta and unlevered beta for “Refining and Marketing”
sector.
Equity Net Equity LTM LTM
Refining &
Marketing:
Ratin
g
D/D+
E
Marke
t Value Debt D/E Beta
Revenu
e
Earning
s
Deb
t
beta
Unlevere
d beta
Bexar
Energy, Inc. AAA 9% 60,356 6,200
10.3
% 1.70 160,708 9,560 0 1.542
Kirk Corp. AAA 16% 15,567 3,017
19.4
% 0.94 67,751 1,713 0 0.787
White Point
Energy AAA 17% 9,204 1,925
20.9
% 1.78 31,682 1,402 0 1.472
Petrarch
Fuel
Services AAA 14% 2,460 (296)

12.0
% 0.24 18,874 112 0 0.273
Arkana
Petroleum
Corp. A 24% 18,363 5,931
32.3
% 1.25 49,117 3,353 0.05 0.957
Beaumont
Energy, Inc. AAA 17% 32,662 6,743
20.6
% 1.04 59,989 1,467 0 0.862
Dameron
Fuel
Services BBB 33% 48,796
24,52
5
50.3
% 1.42 58,750 4,646 0.10 0.978
Exhibit 3: Calculation of Unlevered Beta and Rate of Return for Petrochemical Division of Midlands.
Enterprise value = Equity + Debt – Cash
⁄ ⁄
Where
= Unlevered beta for Midlands
E = Shareholder‟s equity
D = Long term debts
Equity beta
Equity (in
mill $) Debt beta
Total debt (in
mill $)
D+Ecash
(in mill $)
Unlevered beta
for Company
1.25 97280 0 81078 159152 0.764049462
The debt beta has been assumed as 0, because, the company’s credit rating is A+.
Now, to find the Unlevered Beta for Petrochemical Division:
Company Asset Value (in mill. $)
E & P (A1) 140100
R & M (A2) 93829
Petro (A3) 28450
Now:
(
)
(
)
(
)
Where
0.764049462,
0.59 and
1.116
From this we find,
0.453
r
U
= r
f
+ [E(r
m
)r
f
] β
A3
Where 4.98% is the risk free rate of return for Treasury bond for 30 years and 5% is the equity market risk
premium.
r
U
= 4.98%+(0.3x5%) = 7.24%