Question IHow are Mortensen’s estimates of Midland’s cost of capital used?
Answer I• The Mortensen’s estimates are used for; • Asset appraisals for capital budgeting and financial accounting • performance assessments • M&A proposals • Stock repurchase decisionsAt division or business unit level as well as Corporate levelCost of capital is an essential component in WACC calculations.
Question II Calculate Midland’s overall corporate WACC. Is Midland’schoice of EMRP appropriate? If not, what recommendations would you make and why?
Answer 2 - rD• Mortensen computed the cost of dept for each division by adding a premium, or spread, over U.S. Treasury securities of a similar maturity.• To find rD, we do not use CAPM but we use the interest rate that we currently pay on the new loans.• Consolidated Spread to Treasury is given on 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%
Answer 2 - TaxTax rate is calculated based on the Exhibit 1 as averageover 2004, 2005 and 2006The tax rate =Midlands Income Taxes / Midlands Income Before TaxesAnd the Average across 2004, 2005, 2006The tax rate = 39%
Answer 2 - EMRP• However, based on the Exhibit 6, the traditional data showed aprox 6.0% EMRP, and the surveys showed lower EMRP (2.5% - 4.7%), a research over the industry with help from outsiders, who has broader industry knowledge, would result a better and up-to-date EMRP for Midland.• Researches in consultation with its professional advisors, bankers and investors, as well as Wall Street analysts covering the industry agreed on the current estimate of 5.0%.• As the analysts on the industry, bankers and investors have broader information from different companies and corporates, we conclude that the approach of outside consulting and the result of 5.0% estimate is appropriate.
Answer 2 - rEResearches in consultation with its professional advisors,bankers and investors, Midland used 5.0% as its EquityMarket Risk Premium.The corporate β is publicly available, and as it representscorporate level β, we’ll use 1.25 as it is for OverallCorporate WACC calculation.rE = rf + β(EMRP)rE = 4.98% + 1.25 (5%) = 11.23%
Question III Should Midland use a single corporate hurdle rate forevaluating investment opportunities in all of its divisions? Why or why not?
Answer 3• Midland, as a large enterprise, has diverse business units with different risks. In Exhibit 5, the Equity Beta represents the risk factor of those divisions.• As the risk profiles are different per division, the hurdle rates for those divisions should also be different, and calculated based on the β of the division.• Midland should not use single corporate hurdle rate as this will mislead evaluation of the investments, and will result on Midland invest on risky projects and will become risky a corporate by time.• On the other hand, if Midland invests on corporate level, using corporate level Wacc would be OK.• Which rate should be used when… • when buying computer for all staff, use corporate level Wacc • when investing a drilling project in Alaska, use Exploration & Production’s division hurdle rate.
Question IV Compute a separate cost of capital for the E&P andMarketing & Refining divisions. What causes them to differ from one another?
Answer 4 – E&PrE = rf + β(EMRP)rE = 4.98% + 1.15 (5%) = 10.73%rD = rf + E&P Spread to TreasuryrD = 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%
Answer 4 – R&MrE = rf + β(EMRP)rE = 4.98% + 1.20 (5%) = 10.98%rD = rf + R&M Spread to TreasuryrD = 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%
Answer 4• The business units operate on different industries therefore; - they have different risk profiles and βs - they have different credit ratings• As a result, the E&P and R&M have different Waccs (8.818% and 9.825% respectively)
Question VHow would you compute a cost of capital for the Petrochemical division?
Answer 5• To calculate cost of capital for Petrochemical, we would search for couple of companies which focus only on Petrochemical industry. And use their fact sheet and get an average on their β and D/E ratio.• In our team, none of us work in energy / oil / petrochemical industry and therefore our limited research didn’t return any sample companies we could use.• For that reason; by using the data available on Exhibit 5, we decided to use arithmetic averages on D/E ratio and β to calculate cost of capital for Petrochemical division.