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Case Study: Midland Energy Resources, Inc.

Group 7

KOMP, Christian (1155068443)

LI, Jiajie (1155066316)

LIU, Xinxing (1155070477)

LIU, Yuchen (1155066414)

NI, Jialu (1155069908)

WA, Qingjin (1155066451)

FINA 6092 FB Advanced Financial Management

Prof. H. Zhang

January 20, 2016


Practical Application of Midland’s Cost of Capital

Estimation of cost of capital is an extremely indispensable step for analysing Midland

and its three divisions, including exploration and production (E&P), refining and marketing

(R&M), and petrochemicals. Corresponding to the specific financial purposes of Midland, the

analyses should contain asset appraisals in capital budgeting, performance assessments for

compensation, merger and acquisitions proposals, and stock repurchase decisions.

Undoubtedly, the uses of cost of capital would be distinct for these five different financial


For financial accounting, the estimation of cost of capital would be used in the

preparation of financial reports and tax payables. Thus the calculation of WACC (Weighted-

average cost of capital) should be based on the actual after-tax interest rate paid on debts and

the investors’ required return on equity. At the aspect of capital budgeting, WACC would be

used in the valuation process of potential investment projects to determine whether and which

project to undertake. Specifically, WACC would be plug into the Discount Cash Flow Model,

a valuation model the company is currently utilizing, and calculate the NPVs (Net present

value) of each project. A positive NPV indicates the ability to bring future values and help the

company screen out the appropriate investments, under the assumption of a cost of capital

chosen at Midland’s discretion.

The third financial purpose of cost of capital is to assess the financial performance of the

company and individual divisions. A common practice used by the company is the EVA 1

(Economic value added) approach. EVA can be calculated as deducting the cost of capital from

EVA = NOPAT - (WACC * Capital); NOPAT = EBIT (1 - t)


the NOPAT (Net operating profit after tax) and seen as the residual wealth of the company

after paying for capital charges at a certain time point. Therefore, EVA as the criterion of

financial performance as well as growth potential, will increase as cost of capital reduces.

Furthermore, cost of capital also plays an important role in the valuation of the target firm in a

M&A proposal. Similar to investment projects, the value of the company being merged is

calculated in the form of NPV, which discounts all future cash flows of the target firm by

WACC. An appropriate valuation in M&A would definitely ensure Midland pay the right price

and help assess the benefits of the proposal.

Lastly, Midland has been always seeking the opportunity on repurchasing the

undervalued stocks. In order to find the perfect timing, WACC should be continuously

calculated in use of discounting the forecasted cash flows and then the ultimate intrinsic value

would be compared to the share price to determine whether the company is undervalued by the


As a result of the multiple application of cost of capital, the calculation of WACC could

be varied under difference circumstances. For example, in the valuation of investment projects,

risks associated with specific projects such as the effects of externalities should be taken into

account in the form of required return. In other words, if the projects have high risks, then the

company would have to adjust up the cost of capital by requiring higher risk premium.

Moreover, macroeconomic conditions such as overall performance of the industry and effects

of business cycle should be considered when estimating the cost of capital for financial

performance assessment. This consideration might or might not be appropriate to be added in

investment valuations and M&A proposals. In general, the estimation of cost of capital is a


vitally important step to analyse the company and assess its financial strategies, and it should

be estimated according to the ultimate usage by the company.

Corporate WACC and Concerns About EMRP

The calculation of the corporate’s WACC consists two parts, the cost of debt and the cost

of equity. And we will talk about these two costs separately.

a. Cost of Debt

We calculate the cost of debt by adding a spread over the U.S. Treasury securities. Using

the yields to maturity of 30-Year U.S. Treasury bonds and the corresponding spread to

Treasury, we get the cost of debt equals to 6.60%1.

b. Cost of Equity

Equity Beta

Mortensen used to use betas published in commercially available databases rather than

running their own regressions historically. However, recently the company attempts to change

its capital structure which will lead to an increase in borrowing and results a different beta.

So we calculate a more precise beta by firstly un-leveraging the existing beta under the

current corporate D/E ratio (59.3% in Exhibit 5 in the case) to get 0.922, and then re-leveraging

again, which gives an equity beta of 1.333 under the capital structure projected in 2007.

rd = 4.98% + 1.62% = 6.60%
0.92 = Levered Beta / (1 + (1 - tax rate) * D/E)
1.33 = Unlevered Beta * (1 + (1 - tax rate) * D/E)


Risk Free Rate

We use the long-term U.S. Treasury to proxy the risk free rate according to two reasons.

Firstly, the company is relative mature and has been operated stably for more than 120 years.

Secondly, their product experienced a long business turnover. So, the 30-year U.S Treasury

bond is selected.

EMRP: Equity Market Risk Premium

We think the 5% EMRP is an appropriate estimation based on these reasons. Firstly,

5.1% EMRP gives the longest time period and the smallest volatile (in Exhibit 6). The longer

the sample period is, the more market risk it can capture, which can present the market risk

premium better. Besides, the smallest standard error also makes sense for choosing a stable

proxy. Additionally, the current 5% of EMRP is a result from a number of researches and the

consultation of many professional advisors as well as Wall Street analysts. As a result of

application of all the assumptions mentioned above, a cost of equity of 11.62%1 for Midland

is being recommended in this report.

c. Weighted Average Cost of Capital

Eventually, the calculation of WACC for Midland as a whole indicates a cost of capital

of 8.39% 2. Please refer to Exhibit 2 Asset Betas for Comparable Companies in the Appendix

for more numerical details.

re = 4.98% + 1.33*5% = 11.62%
WACC = rd * (D/V) * (1 - t) + re * (E/V)


Choice of Cost of Capital for Individual Divisions

As the hurdle rate should consider the individual riskiness of a project and give the

minimum required return rate of a project, it needs to be verified, that these objectives will be

achieved. When evaluating investment opportunities, midland should distinguish different


Midland´s investments on a corporate level could be analysed using the corporate

WACC, if such an investment would not be exposed to specific risk of a certain company

domain. However, Midland is a large cooperation that has three divisions with diverse business

in different industries. Therefore, the cost of capital will differ for individual projects. Midland

should have different hurdle rates for investment opportunities of different divisions.

There are several reasons, why projects and investments that are not on a general

corporate level should be analysed with a different hurdle rate. For once, the different

industries, the company operates in, have different risk sensitivity and equity betas, as can be

seen in the peer analysis. Moreover, the Midland divisions have different credit ratings and

leverage ratios. In order to optimize the capital structure, Mortensen´s team estimated a

divisional debt rating. According to the target structure, the 2007 estimates were as follows:

“Exploration & Production” (E&P) has an A+ rating and a 46% leverage, whereas the

“Refining & Marketing” (R&M) is a BBB with 31% leverage and the Petrochemicals is AA-

rated and 40% levered.

This structure has a high impact on the assessment of projects in the different divisions

of the company as lower ratings result in higher cost for E&P and R&M divisions.

Additionally, the leverage affects the size of the tax shield and the portion if cost of equity.


Furthermore, the development of each business segment and consequently the capital

spending varies drastically. With predicted capital spending of more than $8 billion for the

E&P business and growing spending for the Petrochemicals segment, these are the expanding

segments, whereas the spending for R&M segment remains stable. The company aims to target

a certain financial structure and different debt ratings, leverage ratios and capital spending

results in different cost of capital.

Using a single hurdle rate would create misleading information and cause wrong

allocation of funds and result in an increase in uncertain profitability of projects and risky

investments. Profitability is another factor, as the profit margin deviates from 56% for E&P,

2% for R&M and 9% for Petrochemicals. Projects of different segments should therefore be

assessed according to appropriate standards.

Midland should calculate cost of capital by division to account for different debt ratios,

credit ratings and equity betas as well as enable a proper assessment and comparison project

profitability within different divisions. These benchmarks on segment level should be used as

separate hurdle rates that can further be adjusted depending on riskiness, financing structure

and investment opportunities of each project.

Cost of Capital for E&P and R&M Division

The weighted average cost of capital (WACC) consists of cost of debt and cost of equity.

The formula for calculating is as following:

𝑊𝐴𝐶𝐶 = 𝑟𝑑 ( ) (1 − 𝑡) + 𝑟𝑒 ( )


Where 𝑟𝑑 is the cost of debt; D denotes for the current or anticipating debt amount; E

denotes for the current or anticipating equity amount; t is the effective tax rate; 𝑟𝑒 is the cost of


For cost of debt, it is stated that each division has different spread to the U.S treasury

securities. Exploration & Production division pays a 1.60% spread while Refining & Marketing

division pays 1.80%. As most companies would use 30-year U.S. treasury as the benchmark,

6.58% and 6.78% should be the cost of debt for the two divisions, respectively.

For the Debt to Value ratio, it is specified in Table 1 in the case that Mortensen estimates

the ratio for 2007 to be 46.0% for Exploration & Production and 31.0% for Refining &

Marketing. Thus, Debt to Equity ratios for two divisions are 85.2%1 and 44.9%, respectively.

It’s worth emphasizing that these ratios are reasonable to be used in estimating Midland’s

future cost of capital because they are also forecasted targets rather than historical data.

For effective tax rate, it is calculated by the average tax rate from 2004-2006. It is

calculating as taxation expenses divided by income before tax, which is 39.7%.

For cost of equity, it is calculated with the CAPM model and the equity beta is calculated

with comparable companies’ betas. Three steps are followed in the estimation of equity beta –

un-levering for each comparable company’s asset beta, averaging for the industry average asset

beta and re-levering for the company’s own equity beta. Firstly, unlevered asset beta of each

D/E = Debt ratio/ (1 – Debt ratio)


comparable company 1 should be calculated as (please see Exhibit 2 Asset Betas for

Comparable Companies in the Appendix for more details):

𝛽𝑎 =
1 + 𝐸 (1 − 𝑡)

Secondly, arithmetic mean should be taken to calculate the average beta representing the

industry in which each division is within. Next, equity beta of the two divisions in Midland are

calculated by re-levering using the targeted D/V ratios provided by Mortensen in Table 1,

which follows the same formula for un-levering. By doing this, the result shows that the cost

of equity is 1.41 for Exploration & Production division, and 1.33 for Refining & Marketing

division. Finally, cost of equity is calculated by CAPM model, which is

𝑟𝑒 = 𝑟𝑓 + 𝛽𝑒 × 𝐸𝑀𝑅𝑃,

𝑤ℎ𝑒𝑟𝑒 𝐸𝑀𝑅𝑃 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑒𝑚𝑖𝑢𝑚, 𝑟𝑓 = 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒

Here market premium is 5% according to Mortensen while risk-free rate is 4.98%, the

yield of a 30-year US Treasury bond. As calculation shows, the cost of equity is 12.04% for

Exploration & Production division and 11.65% for the other division.

By plugging in all the figures calculated above, we derived the WACC for Exploration

& Production and Refining & Marketing division, which is 8.33% and 9.30% respectively. A

brief summary of calculation is shown in Exhibit 1 below,

Unlevered beta is necessary since each comparable company has different leverage, and
average of equity beta may cause bias when calculating division leveraged beta.


Exhibit 1 WACC Calculation for E&P and R&M Division

Division 𝑟𝑑 D/E 𝑟𝑒 Tax rate WACC

E&P 6.58% 85.2% 12.04% 39.7% 8.33%

R&M 6.78% 44.9% 11.65% 39.7% 9.30%

The reason why WACCs differ from the other one is because two divisions has different

leverage. Even though they have similar costs of debt and similar cost of equity, their weight

average cost of capital is different because the weights differ from the other much.

Cost of Capital for the Petrochemical Division

To calculate the cost of capital for a specific division, normally we should find the asset

beta first in order to estimate the equity beta and return. Similar to the estimations for E&P and

R&M divisions, after asset beta for a division is found, it should be re-levered in to cost of

equity to represent the Midland’s company division’s target capital structure.

However, in this case, the equity beta is not clearly observable. Therefore, for this

specific division, the method of using comparable companies to estimate the division’s asset

beta is not applicable for the Petrochemical division. Alternatively, the asset beta can be

derived from the betas already calculated for the whole company and the other company

divisions. Exhibit 3 WACC Calculations for the Whole Company and Its Divisions in the

Appendix shows the weighted average cost of capital calculations for the whole company and

its divisions. Assumptions are also listed in the table. The idea is that the asset beta should be

determined by the value-creating of assets owned by a division and thus captures the same

proportion in the company’s entire asset beta as its division earnings does in the total company


profit. The formula1 below shows this idea of calculating the asset beta for the Petrochemical


V   ( E & P)  , E & P  (R& M)  , R &M  ( P)  , P

After calculating the asset beta (0.61) for the Petrochemical division, the equity beta for

the division can be further inferred by using the target D/E ratio, debt beta, and marginal tax

rate. Then, the equity beta comes to be 0.86. By using the equity beta, the cost of equity can be

generated under the CAPM model with the risk-free rate (30-year Treasury bond yield) and

equity market risk premium, which are provided in the exhibits. On the other hand, the cost of

debt can be calculated by using the 30-year Treasury bond yield plus the spread to Treasury

rate. Finally, the weighted average cost of capital of 7.10% represents the required rate of return

for the Petrochemical division given its corresponding capital structure.

Where V, E&P, R&M, and P represent the % of earnings for the whole company and
its divisions, respectively



Exhibit 2 Asset Betas for Comparable Companies

Tax rate = 39.7% D/E Equity Beta Asset Beta

Jackson Energy, Inc. 11.2% 0.89 0.83
Wide Plain Petroleum 85.4% 1.21 0.80
Corsicana Energy Corp. 15.2% 1.11 1.02
Worthington Petroleum 47.5% 1.39 1.08
Average 0.93
E&P 1.41

Bexar Energy, Inc. 10.3% 1.7 1.60

Kirk Corp. 19.4% 0.94 0.84
White Point Energy 20.9% 1.78 1.58
Petrarch Fuel Services -12.0% 0.24 0.26
Arkana Petroleum Corp. 32.3% 1.25 1.05
Beaumont Energy, Inc. 20.6% 1.04 0.93
Dameron Fuel Services 50.3% 1.42 1.09
Average 1.05
Refining & Marketing: 1.33

Midland Consolidated (Current) 59.3% 1.25

Midland Consolidated (Target) 1.331 0.922

Corporate target equity beat is re-levered with target asset beta of 0.92 and target D/V
ratio of 42.2%.
Corporate asset beta is un-levered with current equity beta of 1.25 and current D/E ratio
of 59.3%.


Exhibit 3 WACC Calculations for the Whole Company and Its Divisions

Target % of Asset Equity Cost of Cost of

D/E Earnings1 Beta Beta Equity Debt
Consolidated 73.0% 100.0% 0.92 1.33 11.62% 6.60% 8.39%

Exploration &
85.2% 67.1% 0.93 1.41 12.04% 6.58% 8.33%
Refining &
44.9% 21.6% 1.05 1.33 11.65% 6.78% 9.30%
Petrochemicals 66.7% 11.2% 0.612 0.863 9.29% 6.33%4 7.10%

Debt Beta 0
Tax Rate 39.7%
Risk-free Rate 4.98%
EMRP 5.00%

% of Earnings = Net Income / LTM Revenue
Asset beta for Petrochemicals = (consolidated asset beta - % of earnings for E&P *
asset beta for E&P - % of earnings for R&M * asset beta for R&M) / % of Earnings for P
Equity beta for Petrochemicals = (asset beta for P * (1 + (Target D/E for P * (1 –
marginal tax rate)) – (debt beta for P * (1 + (Target D/E for P * (1 – marginal tax rate))
Cost of debt for Petrochemicals = 30-Year Treasury rate + spread to Treasury for