This document provides financial information for Midland Energy Resources, including operating revenues and income for 2004-2006. It also includes details on the company's divisions and their revenues and assets. Mortensen is calculating the weighted average cost of capital (WACC) for Midland and its divisions to use in capital budgeting, asset valuation, and M&A assessments. To do this, he must determine the cost of equity, debt, and appropriate capital structures for each division. Comparable companies are analyzed to estimate betas and debt costs.

1. Midland Energy Resources Inc.
Cost of Capital
Dr. C. Bulent Aybar

2. © Dr. C. Bulent Aybar
Midland Energy: Highlights
• Midland is a global energy company with operations in oil
and gas exploration and production (E&P), refining and
marketing (R&M), and petrochemicals.
• On a consolidated basis, the firm had 2006 operating
revenue and operating income of $248.5 billion and
$42.2 billion, respectively.
• Largest fraction of assets are tied in Exploration and
Production, but largest share of revenues are produced by
Refining and Marketing.

3. Division Revenues

4. Division Assets

5. Operating Revenues and Income
Operating Results: 2004 2005 2006
Operating Revenues $201,425 $249,246 $248,518
Plus: Other Income 1,239 2,817 3,524
Total Revenue & Other Income 202,664 252,062 252,042
Less: Crude Oil & Product Purchases 94,672 125,949 124,131
Less: Production & Manufacturing 15,793 18,237 20,079
Less: Selling, General & Administrative 9,417 9,793 9,706
Less: Depreciation & Depletion 6,642 6,972 7,763
Less: Exploration Expense 747 656 803
Less: Sales-Based Taxes 18,539 20,905 20,659
Less: Other Taxes & Duties 27,849 28,257 26,658
Operating Income 29,005 41,294 42,243
Less: Interest Expense 10,568 8,028 11,081
Less: Other Non-Operating Expenses 528 543 715
Income Before Taxes 17,910 32,723 30,447
Less: Taxes 7,414 12,830 11,747
Net Income $10,496 $19,893 $18,701

6. Assets and Liabilities
Assets: 2005 2006
Cash & Cash equivalents $16,707 $19,206
Restricted Cash 3,131 3,131
Notes Receivable 18,689 19,681
Inventory 6,338 7,286
Prepaid Expenses 2,218 2,226
Total Current Assets 47,083 51,528
Investments & Advances 30,140 34,205
Net Property, Plant & Equipment 156,630 167,350
Other Assets 10,818 9,294
Total Assets 244,671 262,378
Liabilities & Owners' Equity: Column1 Column2
Accounts Payable & Accrued Liabilities 24,562 26,576
Current Portion of Long-Term Debt 26,534 20,767
Taxes Payable 5,723 5,462
Total Current Liabilities 56,819 52,805
Long-Term Debt 82,414 81,078
Post Retirement Benefit Obligations 6,950 9,473
Accrued Liabilities 4,375 4,839
Deferred Taxes 14,197 14,179
Other Long-Term Liabilities 2,423 2,725
Total Shareholders' Equity 77,493 97,280
Total Liabilities & Owners' Equity $244,671 $262,378

7. © Dr. C. Bulent Aybar
Objective: Calculation of WACC for Midland and Its Divisions
• Why Mortensen is calculating WACC for the
corporate and divisions?
• WACC is used in
– Routine capital budgeting metrics such as NPV,
– asset appraisals for financial accounting exercises such as FAS 142
impairment testing,
– Analyses of stock repurchases
– Assessment of M&A proposals.

8. © Dr. C. Bulent Aybar
WACC
• In respective applications the WACC is intended to
represent the long-term opportunity cost of funds for
Midland, one of its divisions, or an acquisition target;
• It is the discount rate, or a benchmark for the discount rate in
a discounted cash flow (DCF) analysis.
• In addition, Mortensen’s numbers likely will be used in
performance assessments at the corporate and division levels
and may well affect incentive compensation awards.

9. © Dr. C. Bulent Aybar
Capital Structure
• It is generally helpful to rearrange a GAAP balance sheet before
computing capital structure ratios to separate “operating” from
“financial” accounts and to define “capital” as it will appear in the
denominator of the capital structure ratios.
• For example, trade-related liabilities, such as payables and accruals,
should be grouped on the left side and netted against current assets; they
generally should be thought of as part of net working capital, not funded
debt.
• Likewise for long-term accruals which may be netted against other long-
term assets. In contrast, some assets—notably cash and marketable
securities— may represent excess liquidity and should be netted against
debt before the ratios are computed.

10. Rearranged Balance Sheet
NWC Financial Account
Notes Receivable 19,681 Net Debt
Inventory 7,286 Current Portion of Long-Term Debt 20,767
Prepaid Expenses 2,226 Long-Term Debt 81,078
Less Less: Cash and Equivalents $19,206
Accounts Payable & Accrued Liabilities -26,576 Restricted Cash 3,131
Deferred Taxes -5,462 Net Debt $79,508
Net Working Capital -2,845 Shareholder's Equity 97,280
Net Fixed Assets Net Capital 176,788
Investments & Advances 34,205
Net Property, Plant & Equipment 167,350
Other Assets 9,294
Less
Post Retirement Benefit Obligations 9,473
Accrued Liabilities 4,839
Deferred Taxes 14,179
Other Long-Term Liabilities 2,725
Net Fixed Assets 179,633
Net Operating Assets 176,788
Note that market value of the equity is
given as $134.1bn in Exhibit-5. This
assumes a year end share price of
$45.45 and 2.951 million outstanding
shares. This suggest a D/E ratio of
59.3% which corresponds to 37.2%
Debt/Value ratio and 62.8%
Equity/Value ratio.

11. © Dr. C. Bulent Aybar
Capital Structure and Component Weights
• In component weight calculations it is important to use market value of
debt and equity.
• In this particular case we have the data on outstanding shares and the
stock price for each quarter. We could use fourth quarter price listed in
Exhibit-4 along with the number of outstanding shares to determine the
market value of equity:
• $44.11 x 2,951=$130,160
• However this does not match the market value of equity ($134,114)
listed in Exhibit-5. Apparently stock price as of 12/31/2006 is $45.45
and this is different than the fourth quarter average of $44.11.
• In the calculation of 59.3% of D/E ratio, book value of debt (79,508) was
used (79,508/134,114=0.593)

12. Comparables (in $ millions)
Exploration & Production: Market Value Debt D/E
Equity
Beta
LTM
Revenue
LTM
Earnings
Jackson Energy, Inc. $57,931 $6,480 11.20% 0.89 $18,512 $4,981
Wide Plain Petroleum 46,089 39,375 85.40% 1.21 17,827 8,495
Corsicana Energy Corp. 42,263 6,442 15.20% 1.11 14,505 4,467
Worthington Petroleum 27,591 13,098 47.50% 1.39 12,820 3,506
Average 39.83% 1.15
Refining & Marketing:
Bexar Energy, Inc. 60,356 6,200 10.30% 1.70 160,708 9,560
Kirk Corp. 15,567 3,017 19.40% 0.94 67,751 1,713
White Point Energy 9,204 1,925 20.90% 1.78 31,682 1,402
Petrarch Fuel Services 2,460 (296) -0.1 0.24 18,874 112
Arkana Petroleum Corp. 18,363 5,931 32.30% 1.25 49,117 3,353
Beaumont Energy, Inc. 32,662 6,743 20.60% 1.04 59,989 1,467
Dameron Fuel Services 48,796 24,525 50.30% 1.42 58,750 4,646
Average 20.30% 1.20
Midland Energy Resources $134,114 $79,508 59.30% 1.25 $251,003 $18,888

13. © Dr. C. Bulent Aybar
Capital Structure
• Should we use the current capital structure, or should we
consider target capital structure in WACC calculation?

14. © Dr. C. Bulent Aybar
Cost of Equity: Risk Free Rate
• The risk-free return for U.S. dollar cash flows is
conventionally derived from returns on U.S. Treasury
obligations.
• Ideally, the maturity of the benchmark T-bond should match
the term of the subject cash flows. In theory, this implies
different risk-free rate for each cash flow whenever the yield
curve is not flat. More precisely, it suggests we use the
forward rate derived from the zero-coupon Treasury yield
curve for each discounting period in the DCF calculations.
• A far more common practice is to simply take the yield on a
long-term Treasury bond as the risk-free rate.

15. © Dr. C. Bulent Aybar
What Maturity for Risk Free Rate?
• The case gives the yield on the 1, 10 and 30-year T-bonds.
• Should the choice of maturity depend on the projection period?
• Remember that a DCF analysis of a going concern actually incorporates
a terminal value intended to reflect the value derived from cash flows
well beyond the discrete projection period.
• In other words, many projects in companies such as Midland are indeed
long-term projects, despite the fact that cash flows are not explicitly
forecasted beyond a few years.
• Accordingly, the risk-free rate still should be derived from a long-term
instrument.

16. Treasury Yields and Division Cost of Debt
Business Segment: Credit Rating Debt/Value
Spread over
Treasury
Consolidated A+ 42.20% 1.62%
Exploration &
Production A+ 46.00% 1.60%
Refining & Marketing BBB 31.00% 1.80%
Petrochemicals AA- 40.00% 1.35%
Maturity Rate:
1-Year 4.54%
10-Year 4.66%
30-Year 4.98%

17. Cost of Debt for E&P Division
Credit Debt/
Spread
to
Business Segment:
Rating Value Treasury
Consolidated A+ 42.2% 1.62%
Exploration & Production A+ 46.0% 1.60%
Refining & Marketing BBB 31.0% 1.80%
Petrochemicals AA- 40.0% 1.35%
Note: Debt/Value is based on
market values.
Since the 10 year Treasury note yield is given as 4.66%, the cost
of debt for E&P division is:
Rd= Rf+CRS
Rd= 4.66%+1.60% =0.0626 or 6.26%

18. © Dr. C. Bulent Aybar
Cost of Equity: EMRP
• A fairly concise recent review of research and practice on the EMRP is
presented by Pratt and Grabowski (2008), who review a wide variety of
methods and data to support a range for the EMRP of 3.5% to 6.0%.
Their point estimate for 2007 is 5.0% .
• This is consistent with the premia used by auditors, appraisers,
investment bankers, consultants, and other valuation specialists in real-
world settings. Academics tend to favor somewhat higher rates.
• Many practitioners derive estimates of the EMRP from data published in
Ibbotson Associates’ Annual Cost of Capital Yearbook . These data are
generally highly regarded, and used by the practitioners.

19. EMRP
Researcher Survey Subjects Dates Respondents’ Risk Premia
Welch
500+ finance &
economics Professors 2001
Median: 3.6%
Interquartile range: 2.6%-5.6%
Graham &
Harvey ~400 U. S. CFOs
Quarterly 2000-
2006
Range: 2.5% - 4.7%
Most recent survey (4Q2006): 3.3%
Greenwich
Associates
US Pension Fund
Managers 2006 Range-2%-4%

20. © Dr. C. Bulent Aybar
Cost of Equity: Beta
• Equity betas vary with leverage and Midland’s reported beta
of 1.25 reflects its current capital structure, which differs
from its (stated) target capital structure.
• If the estimated WACC is to properly reflect the target
capital structure, the cost of equity must reflect it as well.
• To adjust Midland’s beta to reflect the higher leverage
embedded in the target capital structure we need to un-lever
the current beta to remove the effect of the current capital
structure, then re-lever it to reflect the target.

21. © Dr. C. Bulent Aybar
Estimating Project Beta using Comparables
• Financial analysts use pure-play method to estimate beta for
a company or project that is not publicly traded.
• Pure - play method requires using a comparable publicly
traded company ’ s beta and adjusting it for financial
leverage differences.
• This requires a process of “ unlevering ” and “ levering ” the
beta. The beta of the comparable is first “ unlevered ” by
removing the effects of its financial leverage.
• The unlevered beta is referred to as the asset beta because
it reflects the business risk of the assets. Once we determine
the unlevered beta, we adjust it for the capital structure of the
company or project that is the focus of analysis.

22. © Dr. C. Bulent Aybar
Relationship between Asset Beta and Equity Beta
• Because a levered company’s risk is shared between
creditors and owners, we can represent the company’s risk,
basset , as the weighted average of the company ’ s creditors ’
market risk, bdebt ,and the market risk of the owners, bequity :
• Since interest on debt is deducted by the company to arrive
at taxable income, the claim that creditors have on the
company ’s assets does not cost the company the full amount
but rather the after - tax claim; the burden of debt financing
is actually less due to interest deductibility.
asset debt equity
D E
D E D E
b b b
 
 

23. © Dr. C. Bulent Aybar
Asset Beta and Equity Beta
• If we account for tax deductibility of interest, we can express
asset beta as follows:
• We generally assume that a company ’ s debt does not have
market risk; so bdebt = 0. With this assumption asset beta
reduces to the following:
(1 )
(1 ) (1 )
asset debt equity
t D E
t D E t D E
b b b

 
   
1
1 (1 )( / )
asset equity
t D E
b b

 

24. © Dr. C. Bulent Aybar
Unlevered Beta
• From Exhibit 5, we know that Midland’s current D/E ratio
is 0.593.
• The target Debt/Value ratio given in Table-1 is 42.2%. This
implies 57.8% Equity/Value or a D/E ratio of 0.73.
• If we unlever Midland’s beta by using its current capital
structure and tax rate :
• βunlevered = βlevered/[1+(1-t)D/E]. Therefore
• βunlevered = 1.25/[1+(1-0.385)(0.593)] = 0.92

25. © Dr. C. Bulent Aybar
Re-levered Beta
• If we use the target capital structure ratio to re-lever the
unlevered beta of 0.92:
• βlevered = [1+(1-t)D/E] x βunlevered
– = [1+ (1-0.385)(.73)] x 0.92 = 1.33
• This levered beta is then used above to obtain a cost of
equity of:
– ke= 4.66% + 1.33(5.00%)=11.31%
– ke= 4.66% + 1.25(5.00%)=10.91%
• Increasing the leverage towards the target capital structure
increases the cost of equity by (11.31%-10.91%)=0.4% or
40bp

26. © Dr. C. Bulent Aybar
Cost of Debt
• Ideally, the cost of debt in a calculation of WACC should be
the expected return on a traded, longterm fixed-rate
obligation of a credit quality that corresponds to the capital
structure ratios built into the WACC formula.
Credit
Spread
Cost of
Debt
Exploration &
Production: 1.60% 6.26%
Refining & Marketing: 1.80% 6.46%
Petrochemicals 1.35% 6.01%

27. © Dr. C. Bulent Aybar
Divisional WACC
• The first step in divisional WACC calculations is the
divisional beta calculations. In the case, we are given data
about comparable companies in Exploration and Production
as well as Refining and Marketing.
• We can use this data to calculate asset betas in each business
segment. We can use average asset betas in segment and
substitute these average asset betas for divisional asset betas.
• Consequently, we can re-lever asset betas to calculate
divisional equity betas by using respective capital structure
of each division.

28. Divisional Beta Calculations-Step-1
Exploration &
Production: Market Value Debt D/E Equity Beta Asset Beta
Jackson Energy, Inc. $57,931 $6,480 11.20% 0.89 0.83
Wide Plain
Petroleum 46,089 39,375 85.40% 1.21 0.80
Corsicana Energy
Corp. 42,263 6,442 15.20% 1.11 1.02
Worthington
Petroleum 27,591 13,098 47.50% 1.39 1.08
Average 39.83% 1.15 0.93
Refining & Marketing:
Bexar Energy, Inc. 60,356 6,200 10.30% 1.70 1.60
Kirk Corp. 15,567 3,017 19.40% 0.94 0.84
White Point Energy 9,204 1,925 20.90% 1.78 1.58
Petrarch Fuel
Services 2,460 (296) -0.1 0.24 0.26
Arkana Petroleum
Corp. 18,363 5,931 32.30% 1.25 1.05
Beaumont Energy,
Inc. 32,662 6,743 20.60% 1.04 0.93
Dameron Fuel
Services 48,796 24,525 50.30% 1.42 1.09
Average 20.26% 1.20 1.05
Midland Energy
Resources $134,114 $79,508 59.30% 1.25 0.92

29. Divisional Beta Calculation Step-2: Weighting by Earnings
D/E Equity Beta
Asset
Beta
Earnings
%
Consolidated 59.30% 1.25 0.92 100.00%
Exploration & Production: 85.19% 1.41 0.93 67.14%
Refining & Marketing: 44.93% 1.33 1.05 21.64%
Petrochemicals 66.67% 0.85 0.61 11.21%
While we are given data on two segments, we do not have information on
petrochemicals. We can infer asset beta from what we already know. Since
Midland’s corporate asset beta should be equal to weighted average of its
divisional asset betas, we can extract the third division beta from the
information that we have.
One practical question/issue in this approach is the determination of
weights. How should attribute divisional weights? Based on asset size?
Net income? Operating Income?

30. Weighting by Assets
Equity Asset LTM Net %
Midland Energy Resources: D/E Beta Beta Revenue Income Assets
Consolidated 59.3% 1.25 0.92 248,518 18,701 100.0% 0.923
Exploration & Production 85.2% 1.41 0.93 22,357 12,556 53.4% 0.93
Refining &
Marketing 44.9% 1.33 1.05 202,971 4,047 35.8% 1.05
Petrochemicals 66.7% 0.64 0.46 23,189 2,097 10.8% 0.46

31. Divisional WACC
Target Target Asset Equity Cost of Cost of
Midland Energy
Resources: D/E D/V Beta Beta Equity Debt WACC
Target Consolidated 73.0% 42.2% 0.92 1.33 11.30% 6.30% 8.13%
Exploration & Production 85.2% 46.0% 0.93 1.41 11.71% 6.26% 8.05%
Refining & Marketing 44.9% 31.0% 1.05 1.33 11.32% 6.46% 9.01%
Petrochemicals 66.7% 40.0% 0.46 0.64 7.85% 6.01% 6.16%
Prevailing Consolidated 37.2% 0.92 1.25 10.92% 6.62% 8.33%

32. WACC for Midland and Its Divisions
Division
Target
D/E D/V
Equity
Beta
Asset
Beta
Cost of
Equity
Cost of
Debt WACC
Consolidated 73.00% 42.20% 1.33 0.92 11.31% 6.28% 8.13%
Exploration & Production: 85.19% 46.00% 1.41 0.93 11.69% 6.26% 8.04%
Refining & Marketing: 44.93% 31.00% 1.33 1.05 11.33% 6.46% 9.02%
Petrochemicals 66.67% 40.00% 0.85 0.61 8.92% 6.01% 6.80%
Assumptions
Debt Beta 0
10-Year Treasury Bond 4.66%
EMRP 5.00%
Tax Rate 40.00%
Division Credit Spread Cost of Debt
Exploration & Production: 1.60% 6.26%
Refining & Marketing: 1.80% 6.46%
Petrochemicals 1.35% 6.01%

33. Corporate WACC vs Divisional WACC
Using a single WACC in all divisions may have two problematic implications:
1) Company invests in projects that appear positive NPV, but this happens
because discount rate is set too low, in reality these projects have negative
NPV (Type-1 errors)
2) Company rejects good projects, because WACC is set too high (Type-2 errors)
In both cases, firm underperforms.