Midland Energy Case

In-Class Questions

1. How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these
anticipated uses affect the calculations?
Cost of capital were used in analyses such as asset appraisals for capital budgeting and financial
accounting, performance assessments, M&A proposals, and stock repurchase decisions. These
anticipated uses affect the calculations as the cost of capital is an essential component of the
WACC calculations.

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?

RD = 30 year maturity(Rf) + Consolidated Spread

= 4.98% + 1.62% = 6.60% = .066

Tax Rate = Assume to be 39% = 0.39

EMRP= 5.00%

Rf = Market Risk Premium = 5.0% = .05

Beta = 1.25 (from Exhibit 5)

Re=Rf + Beta(market risk premium)

Re = 4.98% + 1.25(5%)
= .0498 + 1.25(.05) = .1123 = 11.23%

D = Market Value of Debt

E = Market Value of Equity

Enterprise Value (V) = D+E

From Exhibit 5 V = (79,508) + (134,114) = 213,622
WD = (D/V) = (79,508)/(213,622) = 0.372
WE = (E/V) = (134,114)/(213,622) = 0.628

WACC=WDRD(1-Tx)+WERE
= 0.372(.066)[1-.39] + .628(.1123)
=.372(.066)(.61) + .628(.1123)
=.08548 =8.548%
 The corporate WACC is 8.548%. We decided to use the EMRP of 5% because surveys from
researches reported a range of 2.5-4.7% for EMRP’s. Midland’s EMRP was agreed upon by
investors, bankers, etc making Midland’s EMRP appropriate because the group of people are
knowledgeable in that industry.

3. 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 corporate hurdle rate for evaluating investment opportunities in
all of its divisions because it can lead to wrong decisions. For instance, it should use the rates
appropriate to its division when making a decision about a particular business segment.
Midland’s energy resources is made up of various business divisions of which each division has
its own different risk (indicated by the Betas in Exhibit 5). Because the risk for each division is
different, the hurdle rates should be calculated using the appropriate Beta.

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

Re = Rf + beta(market risk premium)

Re = 4.98% + 1.15(5%)
= 0.1073 = 10.73%

Rd = 30 year Maturity(rf) + Consolidated Spread E&P

= 4.98% + 1.60% = 6.58% (.0658)
D= Market Value of Debt & E = Market Value of Equity
Enterprise Value (V) = D + E
= (16,349) + (43468) = 59,817
Wd = (D/V) = (16349)/(59817) = .2733
We (E/V) = (43468)/(59817) = .7270

WACC = WdRd(1-Tx) + WeRe

= .2733*.0658(1-.39) + (.727*.1073)
= .08897 = 8.897%

Cost of Capital for Marketing and Refining

Re = Rf + beta(market risk premium)

Re = 4.98% + 1.20(5%)
= 0.1098 = 10.98%

Rd = 30 year Maturity(rf) + Consolidated Spread E&P

= 4.98% + 1.80% = 6.78% or (.0678)
D= Market Value of Debt & E = Market Value of Equity
 Enterprise Value (V) = D + E
= (6864) + (26773) = 33,637
Wd = (D/V) = (6864)/( 33,637) = .2041
We (E/V) = (26773)/( 33,637) = .7959

WACC = WdRd(1-Tx) + WeRe

= .2041*.0678(1-.39) + (.7959*.1098)
= .0958 = 9.58%

These divisions have a different WACC because they are a different business segment at
Midland, meaning they have different risk profiles and different betas.

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

Corporate Beta = add up Betas for E&P, M&R, Petrochemical then divide by 3
1.25 = (1.15 + 1.20 + Petrochemical) / 3
3.75 = 2.35 + Petrochemical
Petrochemical Beta = 1.40

Re = Rf + Beta(Market Risk Premium)

= 4.98% + (1.4(5%)
= 11.98% = .1198

Rd = Rf + Consolidated Spread (Petrochemical)

= 4.98% + 1.35%
= 6.33% = .0633

Corporate D/E = add up D/E for E&P, M&R, Petrochemical then divide by 3
59.3 = (39.8 + 20.3 + Petrochemical D/E) / 3
177.9 = 60.1 + Petrochemical
Petrochemical D/E = 117.8% = 1.178

Wd = D/V = D.E/(1+D/E)
= (1.178) / (1+1.178)
= .541 = 54.11%

We = E/V = 1 – D/V
= 1 - .541
= 0.4591 = 45.91%

WACC = WdRd(1-Tx) + WeRe

= .541*.0633(1-.39) + .4591*.1198
= .0759 = 7.59%