Midland Energy Resources, Inc. Case Study

Midland Energy Resources, Inc.

1.The Use of Cost of Capital

First of all, cost of capital is an essential component in WACC. WACC is composed of cost of equity and cost of debt.The Mortensen’s estimates are used in various ways including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals and stock repurchases at division ,business unit level and corporate level. 2. The Calculation for Wacc

Midland’s wacc at the corporate level is calculated based on the formula

WACC=rd*(D/V)*(1­t)+re*(E/V). We calculate the cost of debt by adding a premium over the

30­year US T­bill rate. We choose 30­year US t­bill rate because most of the large firms, such

as Midlands, usually use the long­term yield of the U.S Treasury bond to determine risk­free rate. Similarly, to estimate the cost of equity, we use the CAPM: re=rf+ beta*(EMRP). Beta for Miland is 1.25 base on commercially available database.After reviewing the recent research, Midland adopts an EMRP of 5%. The cost of debt is 6.6% while the cost of equity is 11.23% for Midland. Therefore, the wacc is 8.16% based on the estimate of 42.2% leverage and tax rate of 40%. Actual Leverage Different From Target If the actual leverage ratio is lower than 42.2%,WACC for Midland will increase. On the other hand, if the actual leverage ratio is higher than 42.2%, WACC will decrease. The key reasoning is that the cost of debt is less than the cost of equity. Consequently, the change in re*(E/V) is greater than the change in rd*(D/V). 3. Single Corporate WACC for Evaluation Purpose

We should not use a single corporate WACC for evaluating investment opportunities in all its division. The firm should value its projects using a discount rate determined by the characteristics of the risk of the project
rather than a single company­wide discount rate. Different divisions have different weighted average cost of capital. If we use the single discount rate of the company, then we will overinvest or underinvest in division whose beta is higher or lower than the firm’s core beta. 4. WACC for E&P division and marketing & refining division

First, the risk free rate and the market premium is 4.98% and 5% respectively. Second, by the rating of the two divisions and the table in 12.3, we got the cost of debt is 5.23% and 5.48% respectively. And similarly, we calculated the cost of equity, which is 10.73% and 10.98%. Then the wacc for E&P division is 7.24% and the wacc for marketing & refining division is 8.60%. WACC is different for these two divisions because of the difference in risk profiles and the operations in different industries. For example, betas and credit ratings are different depending on the divisions. Refining & Marketing division has a lower credit rating( BBB­) than Exploration & Production division (A+), as a result, its spread to treasury is higher. The higher spread leads to a higher cost of debt for Marketing & Refining division. In addition, the capital structure is different for different divisions. The D/V of Marketing & Refining is 31% while that of Exploration & Production is 46%. 5. Wacc for petrochemical industry using Comparable Method

We chose four companies which are all in the petrochemical industry and have the similar capital structure as the Midland Energy Resource Inc’s petrochemical division. These four companies are Sinopec Shanghai Petrochemical Co., Barito Pacific Tbk, Ultrapar Holdings, and TPC Group Inc. Then we got the average D/V (28.92%) and average Equity Beta ( 0.98) based on the data from Capital IQ and Bloomberg.The debt beta of Midland’s petrochemical division is 0.05 as its credit rating is AA­. As a result, the wacc of the petrochemical division is 7.17%. 6. WACC for petrochemical division based on data in the case

Based only on the data given in the case, we got the wacc of the petrochemical division equal to:

8.41%. First, from question 4, we can calculate the asset beta for E&P (asset beta=0.644), marketing & refining (asset beta=0.859) and whole company (asset beta=0.7439) using formula: asset beta=Bd*(D/V)+Be*(1­D/V), where Bd represents debt beta and Be represents equity beta. Then based on the percentage asst of each division we got the asset beta for petrochemical division (asset beta=0.85). Since the beta of the debt of petrochemical division is 5% (based on its rating), we got the equity beta that is 1.39. Using the above data, we got the rd and re of petrochemical division and then the wacc. (rd=5.23%, re=11.93%).