Midland Energy is a global company, which operates in oil and gas exploration refining and marketing (R&M), and production (E&P) and petrochemicals sectors. The major objective of the financial strategy of midland is to invest in the projects that are valuable, to achieve an optimal structure for the capital, to fund the substation growth and repurchasing of shares that are undervalued. In addition, it is necessary to calculate the cost of capital if midland wants to meet all the objectives.
There is different level of risks for all the divisions of the midland, therefore a single corporate WACC cannot be used for estimations of all type of investment. Theretofore, it is necessary that wacc for different divisions are known to calculate the risk associated with every investment project.
Cost of capital
Cost of capital means the opportunity cost that is required for making a specific investment. It is actually the rate of return that can easily be earned by investing the same amount in the different projects of investment. For business valuation purpose, this concept is very important as every investor wishes that his investment would grow by the cost of capital at least. Cost of capital is actually a discount rate that is used to calculate the fair value of all the cash flows of investment.
WACC
Weighted average cost of capital means that the cost of capital of a company in which each division of the company is properly weighted. All the capital resources, bonds, preferred stock, common stock all type of debts are properly given weight age in WACC calculation.
CAPM
It is actually capital asset pricing model that is used to calculate the rate of return of an asset. It is represented by beta (β). CAPM actually indicates about the cost of equity capital of the investor and determined by beta. Formula for CPM is as follows.
Question I
What you use to evaluate “cost of capital”? How are Mortensen’s estimates of Midland’s cost of capital used?
Answer 1
The estimates of Mortensen are used for the following purposes.
for making Asset appraisals to compile the financial accounting and capital budgeting
for doing performance assessments
making M&A proposals
for making important Stock repurchase decisions
Cost of capital is a crucial component for division and business units level along with on corporate level in all WACC calculations.
Question II
Calculate Midland’s overall corporate WACC. Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why?
Answer 2
Mortensen has computed the cost of debt for every division by toting up a premium that may be called as spread, by U.S. Treasury securities for similar maturity.
The most important task is to find rD. In addition, to find rD, we are not going to use CAPM instead, we use the interest rate, which we at this time pay on the new loan.
The Spread for the Consolidated Treasury has given in Table 1
As 1.62%
rD = 30 year yields to U.S Treasury bonds + Overall Consolidated Spread to Treasury
rD = 4.98% + 1.62%rD
= 6.60%
The tax rate is calculated from the Exhibit 1 as average over year 2005, 2006and 2007
The tax rate =Midlands Income Taxes / Midlands Income Before Tax and the average across 2004, 2005, 2006
The tax rate = 39%
However, based upon the Exhibit 6, the traditional data showed approximately 6%
EMRP, and the survey showed some lower EMRP that is (2.5% - 4.7%), a research is being done over the industry with the help of outsiders, who have broader knowledge of industry and may give a result hat is much better and up-to-date of EMRP for the Midland.
According to the Researches in consultations with their professional advisors, investors and all bankers along with the Wall Street analysts that has power to cover the industry has been agreed on this current estimates of 5.0%
.• As these analysts of the industries, bankers and of investors have broader and authentic information from the different corporate and companies, therefore we can easily make conclusion that this approach for outside consultancy is our right decision and of course, the result of 5% estimate is suitable.
all the Researches in consultation with the professional advisors, investors and bankers, Midland used 5% as its equity market risk premium. The corporate β is available publically, and as it is representing the corporate level β, we will use 1.25 because it is for the overall Corporate WACC calculations
rE = rf + β (EMRP) rE = 4.98% + 1.25 (5%) = 11.23%
WACC
rE 11.23%
rD 6.60%
tax rate 39%
D/E 59.3%
E 100units
D 59.3units
V 159.3units
E/V 0.62774639
D/V 0.37225361
Corporate WACC = 8.548%
Question III
Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or why not?
Answer 3
Midland is a large enterprise that has different business units with its different risks.
In Exhibit no 5, the equity beta actually represents the risk factors of all those different divisions.
Risk profiles for all the different divisions are different therefore, a single corporate hurdle rate cannot be used for the evaluation purpose, as it will leads towards the miscalculation of estimates of investments. Therefore, it is necessary that we will different hurdle rate for different segments of the industry.
If midland will invest on a corporate level then it will be fine to use corporate WACC for the purpose of estimations. However, if investment is made for a certain department then it is necessary that we will use the hurdle rate of that division not to mislead the investment estimations.
Corporate level WACC rate will be used when there is a need of buying computer for all the staff. However, when there is an investment required in a drilling project of Alaska then we will use hurdle rate of Exploration & Production division.
Question IV
Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from one another?
Answer 4
E & P (Exploration & Production) rE = rf + β (EMRP)
rE = 4.98% + 1.15 (5%)
= 10.73%
rD = rf + E & P Spread to Treasury
rD = 4.98% + 1.60%
= 6.58%
rE 10.73%
rD 6.58%
tax rate 39%
D/E 39.8%
E 100units
D 39.8units
V 139.8units
E/V 0.715308
D/V 0.284692
WACC for E&P= 8.818%
R&M (Marketing & Refining) rE = rf + β (EMRP)
rE = 4.98% + 1.20 (5%) = 10.98%
rD = rf + R&M Spread to Treasury
rD = 4.98% + 1.80% = 6.78%
rE 10.98%
rD 6.78%
tax rate 39%
D/E 20.3%
E 100units
D 20.3units
V 120.3units
E/V 0.831255
D/V 0.168745
WACC for E & P = 9.825%
As this business operates in different industry sectors, therefore the risk of all profiles that is βs is different for each different profile. This is the reason that there is a difference between the WACC of E&P and R&M.
Question V
How would you compute a cost of capital for the Petrochemical division?
Answer 5
For petrochemical division calculation of cost of capital it is necessary that we will search for all those companies that do business in the petrochemical sector and then by using their data and making all the estimations and calculations, we will find out the average of β with their current debt to equity ratio.
As we have not worked in petrochemical industry so far therefore we, will use the data that is available on exhibit no five and by using those data, we calculate the averages of β and debt to equity ratio for this division.
β=?
Corporate β = Average (E&P β, R&M β, Petrochemical β) 1.25
= Average (1.15, 1.20, Petrochemical β)
Petrochemical β = 1.40
rE = rf + β (EMRP)
rE = 4.98% + 1.40 (5%) = 11.98%
rD = rf +Petrochemical Spread to Treasury
rD = 4.98% + 1.35% = 6.33%
Corporate D/E = Average (E&P D/E, R&M D/E, Petrochemical D/E) 59.3%
= Average (39.8%, 20.3%, Petrochemical D/E)
Petrochemical D/E = 117.8%
rE 11.98%
rD 6.33%
Tax rate 39%
D/E 117.8%
E 100 units
D 117.8 units
V 217.8 units
E/V 0.459137
D/V 0.540863
WACC for Petrochemical 7.589%
