MIDLAND ENERGY RESOURCES, INC.

COST OF CAPITAL
BRUCE LARSON
BENEDICTINE UNIVERSITY

1.
1. How are Mortensen's estimates of Midland's cost of capital used? How, if at all,
should these anticipated uses affect the calculations?
The annual cost of capital used by Midland Energy Resources was calculated for Midland as
well as each of its three divisions. Midland maintains three separate divisions:
Oil and Gas Exploration and Production (E&P)

Refining and Marketing (R&M)

Petrochemicals
E&P is Midlands most profitable business unit generating 22.4 billion in revenue and total
earnings after taxes of 12.6 billion. R & M was the highest revenue producing division with
203 billion in revenue. R& M is considered a commoditized product with small historically
decreasing margins and thus was only able to realize after-tax earnings of 4 billion.
Petrochemical is midlands smallest division earning 23.2 in revenue in 2006 with after tax
earnings of 2.1 billion.
Mortensens estimates of Midlands cost of capital are used in different analysiss such as asset
appraisal for capital budgeting and financial accounting, performance assessments, Merger
and Acquisitions proposals and stock repurchase decisions. The analysis is used to make
decisions at the division and corporate level and are also used in calculating the Weighted
Average Cost of Capital (WACC).
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?
The cost of debt was determined by adding a premium or spread to US treasury securities
(table 1&2, page 4). This spread depends on different factors such as cash flow from operations,
the collateral value of assets and external political risks. Midlands debt was rated A+ by
Standard and Poor allowing the debt /value to be 42.2% and the spread to US treasury to be
1.62%.
To estimate the cost of equity Capital Asset Pricing Model (CAPM) was used. Mortensen used
published and commercial betas that were comparable to Midland Corporation. Mortensen was
unable to use betas for Midlands divisions because they did not have traded shares of stock.
Instead published betas of publicly traded comparable companies. The values used for this
calculation are from Table 2 (page 4) with a risk free rate of 4.98% assuming a maturity rate of
30 years and a systematic risk factor of 1.25 from Exhibit 5.
For the Equity Market Risk Premium (EMRP) historical data on stock returns and bond yields
that resulted in an EMRP value of 5%. The EMRP was determined after consulting with
professional advisers (bankers and auditors) as well as Wall Street analysts because Midland had

used higher EMRPs in the past (6.0-6.5) but conflicting data suggested relatively lower EMRP
estimates.
Exhibit 5 shows the equity market value to be equal to $134,114 million and the net debt value to
be $79,508 million.
Based on the figures listed above and referenced in the attached excel file (problem #2) the
WACC for Midland Corporation is calculated to be 8.56%.
If you change the debt / value ratio to 42.2% based on the values from Table 1 on page 4 based
on an A + credit rating the WACC for Midland Corporation changes to 8.20%. The supporting
figures are attached on the excel file under the tab marked problem 2A.
It appears as though Midland took a conservative EMRP given that they have used higher
EMRP's in the past as well as conducting additional due diligence through research and
consultations with professional advisers My recommendation would be to change the EMRP to
3.3%, which is the most recent EMRP estimate according the survey results in the Exhibit 6.
3. Compute a separate cost of capital for the E&P Marketing and Refining divisions. What
causes them to differ from one another?
There are a couple of different factors that contribute to the cost of capital being different
when comparing the consolidated corporate WACC with specific divisions within Midland.
First each division was assigned a different equity betas. These betas are only estimates since
actual division betas were not observable due to fact that each division does not have traded
shares of stock. The beta estimates are based on published betas for publicly traded
companies deemed comparable to the specific division being measured. Each individual
division also maintained separate debt to value ratios that were determined by corporate
executives and the board of Midland. The debt to value ratio as well as the credit rating as
measured by Standard & Poor's impacts the spread to treasury which in turn affects the cost of
debt. Both WACC are different to each other because they have different risk level, leverage
and credit rating.
The WACC for individual divisions are as follows:

Exploration and Production: 7.65% (supporting figures and calculations: attached

spreadsheet, problem 3 E & P)

Refining and Marketing: 8.87% (supporting figures and calculations: attached

spreadsheet, problem 3 R &M)

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

For Petrochemical division, there is not enough information provided to compute a Beta which
does not allow for an exact number of WACC for the division. To calculate an estimated
WACC, it would be possible to use the overall Beta as an average for three divisions and
calculate the Beta for Petrochemical division. Another option would be to take the same
approach that Mortensen relied upon to determine a beta for the other divisions with Midland.
This approach would include research into published betas of publicly traded companies that
have similar business lines to the Petrochemical division.
5. Should Midland compute a different WACC for each division, why or why not?
It would not be appropriate for Midland rely on the same WACC for all divisions. There are
three different divisions within Midland that each carry a different risk (Beta), see exhibit 5. If
midland uses same WACC for all division it could cost the company to accept risky
investments as well as setting up the possibility that Midland could inadvertently discard of
profitable investments. If at all possible, Midland should use corporate WACC only for
corporate level decision.

PROBLEM 2

6.6
11.23
$79,508.00 Taken fromExhibit 5
$134,114.00 Taken fromExhibit 5
$213,622.00
38.58% Taken fromExhibit 1

rd = Cost of debt
re = Cost of equity
D = Market value of Debt
E = Market value of Equity
V = D + E = Firms or Divisions Enterprise Value
t = tax rate
Calculating the Cost of Equity
rf = risk free rate
= systematic risk
EMRP = Equity Market Risk Premium

Spread

4.98% Table 2 page 4 based on 30 year maturity

1.25% Exhibit 5 Equity beta
5.00% Based on methodologies detailed page 6

1.62%Based on consolidated spread w/ A+spread to treasury

WACC= rd(d/v)(1-t)+re(e/v)
d/v=
0.37219
1-t=
0.614182
e/v=
0.62781
rd(d/v) 2.456455
rd(d/v)(1-t) 0.947744
re(e/v) 7.050305

Taxes
Exhibit 1
Income before taxes 30447
Taxes
11747

6.6x.37219(.614182)+11.23x.62781
6.6 0.228592
1.50871 +

7.0503048375
7.0503048375

WACC=

8.56

Cost of Equity
re=rf+b(emrp)
rf
beta
EMRP
b(emrp)
RE=

Cost of Debt
rd=rf +spread
4.98 rf=
4.98%
1.25 spread
1.62%
5 RD=
6.6
6.25
11.23

PROBLEM 2A

6.6
11.23
$79,508.00 Taken fromExhibit 5
$134,114.00 Taken fromExhibit 5
$213,622.00
38.58% Taken fromExhibit 1

rd = Cost of debt
re = Cost of equity
D = Market value of Debt
E = Market value of Equity
V = D + E = Firms or Divisions Enterprise Value
t = tax rate
Calculating the Cost of Equity
rf = risk free rate
= systematic risk
EMRP = Equity Market Risk Premium

Spread

rd(d/v)(1-t) 1.07458
re(e/v)
7.050305

30447
11747

4.98% Table 2 page 4 based on 30 year maturity

1.25% Exhibit 5 Equity beta
5.00% Based on methodologies detailed page 6

1.62%Based on consolidated spread w/ A+spread to treasury

WACC= rd(d/v)(1-t)+re(e/v)
d/v=
0.422
1-t=
0.614182
e/v=
0.578
rd(d/v)
2.7852

Taxes
Exhibit 1
Income before taxes
Taxes

6.6x0.422(0.614182)+11.23x0.578
6.6 0.259185
1.71062 +

6.49094
6.49094

WACC=

8.20

Cost of Equity
re=rf+b(emrp)
rf
beta
EMRP
b(emrp)
RE=

4.98
1.25
5
6.25
11.23

Cost of Debt
rd=rf +spread
rf=
4.98%
spread
1.62%
RD=
6.6

PROBLEM 3 E & P

6.58
10.73
$79,508.00 Taken fromExhibit 5
$134,114.00 Taken fromExhibit 5
$213,622.00
38.58% Taken fromExhibit 1

rd = Cost of debt
re = Cost of equity
D = Market value of Debt
E = Market value of Equity
V = D + E = Firms or Divisions Enterprise Value
t = tax rate
Calculating the Cost of Equity
rf = risk free rate
= systematic risk
EMRP = Equity Market Risk Premium

Spread

rd(d/v)(1-t) 1.167794
re(e/v)
6.7364

30447
11747

Cost of Equity
re=rf+b(emrp)
rf
beta
EMRP
b(emrp)
RE=

4.98
1.15
5
5.75
10.73

4.98% Table 2 page 4 based on 30 year maturity

1.15% Exhibit 5 Equitybeta
5.00% Based on methodologies detailed page 6

1.60%Based on E & P business segment spread spread w/ A+spread to treasury

WACC= rd(d/v)(1-t)+re(e/v)
d/v=
0.46
1-t=
0.614182
e/v=
0.54
rd(d/v)
3.0268

Taxes
Exhibit 1
Income before taxes
Taxes

6.58x0.46(.614182)+10.73x0.54
6.58 0.282524
1.859006 +

5.7942
5.7942

WACC=

7.65

PROBLEM 3 R & M

6.78
10.98
$79,508.00
$134,114.00
$213,622.00
38.58%

rd = Cost of debt
re = Cost of equity
D = Market value of Debt
E = Market value of Equity
V = D + E = Firms or Divisions Enterprise Value
t = tax rate
Calculating the Cost of Equity
rf = risk free rate
= systematic risk
EMRP = Equity Market Risk Premium

Spread

4.98%
1.20%
5.00%

1.80%Based on consolidated spread w/ BBB spread to treasury

WACC= rd(d/v)(1-t)+re(e/v)
d/v=
0.31
1-t=
0.614182
e/v=
0.69
rd(d/v)
2.1018
rd(d/v)(1-t) 0.810912
re(e/v)
6.893352

6.78x.0.31(.614182)+10.98x0.69
6.78 0.190396
1.290888 +

7.5762
7.5762

WACC=

8.87

Taken fromExhibit 5
Taken fromExhibit 5

Taxes
Exhibit 1
Income before taxes
Taxes

30447
11747

Taken fromExhibit 1
Table 2 page 4 based on 30 year maturity
Exhibit 5 Equity beta
Based on methodologies detailed page 6
Cost of Equity
re=rf+b(emrp)
rf
beta
EMRP
b(emrp)
RE=

4.98
1.2
5
6
10.98

Cost of Debt
rd=rf +spread
rf=
4.98%
spread
1.80%
RD=
6.78