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    Midland Energy Case: In-Class Questions

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    marcella roring
    The document discusses Midland Energy's cost of capital calculations for budgeting and planning purposes. It provides the following key information: 1) Midland's WACC is calculated to be 8.548% based on market values of debt and equity. 2) Divisions should have separate hurdle rates as they have different risk profiles indicated by varying betas. 3) The E&P division WACC is 8.897% and the Marketing & Refining division WACC is 9.58% due to their different debt ratios and betas. 4) The Petrochemical division's estimated WACC is 7.59%, calculated using its estimated beta of 1.4 based on the corporate average

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    Midland Energy Case: In-Class Questions

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    marcella roring
    98 views3 pages
    The document discusses Midland Energy's cost of capital calculations for budgeting and planning purposes. It provides the following key information: 1) Midland's WACC is calculated to be 8.548% based on market values of debt and equity. 2) Divisions should have separate hurdle rates as they have different risk profiles indicated by varying betas. 3) The E&P division WACC is 8.897% and the Marketing & Refining division WACC is 9.58% due to their different debt ratios and betas. 4) The Petrochemical division's estimated WACC is 7.59%, calculated using its estimated beta of 1.4 based on the corporate average

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    The document discusses Midland Energy's cost of capital calculations for budgeting and planning purposes. It provides the following key information: 1) Midland's WACC is calculated to be 8.548% based on market values of debt and equity. 2) Divisions should have separate hurdle rates as they have different risk profiles indicated by varying betas. 3) The E&P division WACC is 8.897% and the Marketing & Refining division WACC is 9.58% due to their different debt ratios and betas. 4) The Petrochemical division's estimated WACC is 7.59%, calculated using its estimated beta of 1.4 based on the corporate average

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    98 views3 pages

    Midland Energy Case: In-Class Questions

    Uploaded by

    marcella roring
    The document discusses Midland Energy's cost of capital calculations for budgeting and planning purposes. It provides the following key information: 1) Midland's WACC is calculated to be 8.548% based on market values of debt and equity. 2) Divisions should have separate hurdle rates as they have different risk profiles indicated by varying betas. 3) The E&P division WACC is 8.897% and the Marketing & Refining division WACC is 9.58% due to their different debt ratios and betas. 4) The Petrochemical division's estimated WACC is 7.59%, calculated using its estimated beta of 1.4 based on the corporate average

    Copyright:

    © All Rights Reserved
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    Download as pdf or txt
    of 3

    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%

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