Midlend Energy Res Case Study (Wacc)

1) Why are we computing the Cost of Capital? Why is it important? A “Firm” will want to know the overall or average required rate of return on its aggregate investments. The Cost of capital allows us to set a benchmark that new projects need to meet in order to be viable. In the case of a “Project” it is a way to calculate the minimum required rate of return for an investment depending on its riskiness of its cash flow therefore it is a way to; a) Evaluate the Investment Decision b) Decide on a debt policy c) Appraise the performance of top managers ) Compute the corporate WACC. Be sure to state all your assumptions to get the various inputs to the WACC. r_e=r_f+ ? (EMRP) WACC= r_e (E/V)+ r_d (D/V)(1-t) E=Midland’s Equity Market Value D=Midland’s Net Debt (E/V)= Weight for the cost of equity (D/V)= Weight for the cost of V (E+D)= Midland’s total Market Value r_e =Equity cost of capital r_f =risk-free rate r_d= Cost of Debt.

t= tax rate of the company The inputs for the computation are derived from the case. r_f = 4. 66% The appropriate risk-free rate is 4. 66% which is the rate of 10-year U. S.

Treasury bonds in 2007 as specified in Table 2. The US Treasury bill was a good benchmark We needed to use a rate that provided non default risk and no re-investment risk and. Our horizon was long thus and the 10-year Bond rate was determined best to use as the majority of large firms and financial analysts report using long-term yields for bonds to determine the risk-free rate . EMRP= 5. 1% We considered 3 alternatives in determining this EMRP. First option was the data provided by surveys, but it can be misleading as it portrays what people think based on past information.

The results of the survey than then lead to results being ‘reactive’ to what is happening today, disjointed from reality and can represent what people hope the risk premium would be. The second method to determine the EMRP was to look at the implied premium. This is a very good way to measure risk but due to lack of information on index return yield and market stock repurchase it will result in an inaccurate number. The final method of using historical premium gives more accurate results in comparison to the other two methods and thus we took the longest period available to reduce the Std Error and the excess amount over 200 years =5.

%. r_d = 4. 66 + 1. 62=6. 28% The cost of debt was calculated by adding the risk free rate and the spread over treasury bonds. The reason being the spread shows the riskiness of holding Midland`s debt as derived by the market`s perception of it`s level of risk.

? =1. 25 While the dividend discount model to calculate r_e is highly inaccurate for an individual firm and can be more reasonable for the overall market, the CAPM can give the best estimation because Beta better captures the market risk of a security. We took the beta computed by Janet Mortensen.It was sufficient that she got the beta for Midland using beta’s of commercially available companies with similar operations. t=39. 46% The tax rate was calculated using the average of the three years tax rates, by taking the ratio of Taxes to the Income Before Taxes.

This rate was thought to be most appropriate because the corporate rate was not provided. This rate is used for the divisional computational purposes also. E= $134,114,000 This value is provided in Exhibit 5 D= $79,508,000 This value is provided in Exhibit 5 V = $213,622,000 D/V = 0. 3722 E/V = 0. 6278 r_e=4. 66+ 1.

25(5. 1) = 11. 035 WACC= 0. 1035(134,114,000/213,622,000)+ 0.

0628(79,508,000/213,622,000)(1-0. 3946) =8. 35% 3) Compute divisional WACC`s. Make sure you show how you derived the inputs.

You will need asset beta`s. In order to determine the Beta`s that should be used in calculating the Equity cost of Capital for each division, we must find the unlevered Beta from comparable companies with comparable debt/equity ratio’s and then use the following formula’s to calculate the levered Beta (? _L) for our respective division, which in turn can be used to calculate the r_e per division using the CAPM. Unlever: ?_U=? _L/((1+(1-t) D/E)) Lever: _L=Bu*1/((1+(1-t) D/E)) Exploration and Production Worthington Petroleum is a comparable company with similar D/E and has a high Beta. Since the Exploration division is going to have major expansions and will have large capital expenditures, which in turn means their fixed costs are going to increase, operating leverage is high. Its profitability is a determinant of the current high oil prices and political risk is also relatively high for this division due to a major portion of its operations in foreign unstable political economies.

Therefore a high beta of 1. 39 is acceptable to use for this division. ?_U=1. 39/((1+(1-0. 946)0. 475)) = 1.

08 ?_L=1. 081/((1+(1-0. 3946)0. 46)) = 1. 38 r_e = 4.

66% + 1. 38 (5. 1%) = 11. 7% r_d = 4.

66% +1. 6% (The spread to treasury is provided in the case, it’s an appropriate premium) = 6. 26% WACC= 0. 117(134,114,000/213,622,000)+ 0. 0626(79,508,000/213,622,000)(1-0.

3946) = 8. 76% Refining and Marketing Due to the very low margin and the intense competition from firms, this is a very risky division as small changes in revenues can lead to unprofitably. We need a high beta to reflect this riskiness but also we will add a 2% to the risk premium to compensate for the Political and Country risk.This is a reasonable risk premium based on survey’s done reflected in exhibit 6.

Bexer energy looks similar in size although they are not similar in terms of leverage but beta of 1. 7 is reasonable in comparison to the other companies’ beta’s ?_U=1. 70/((1+(1-0. 3946)0. 103)) = 1.

6 ?_L=1. 60 1/((1+(1-0. 3946)0. 31)) = 1. 90 r_e = 4.

66% + 1. 38 (5. 1%+ 2%) {the 2% is political + Country margins r very little Op rev to Np less than 2 % } = 18. 10% r_d = 4. 66% +1.

80% = 6. 46% WACC= 0. 181(134,114,000/213,622,000)+ 0. 0646(79,508,000/213,622,000)(1-0.

3946) 12. 8% Petrochemicals Since there are no comparable companies there are two main ways to value the cost of capital for thedivision. One is to look at the whole company Beta =1. 25 and use it since this is the smallest division it will likely have a smaller effect on the total weight. But we will use a different approach.

Since Petrochem has a very close movement in revenue to exploration division as to market during the past three years and since Midland is going to invest heavily in Petro's CAPEX it is likely to have similar movement to market and same risks.Hence we can use the same beta as the Exploration and Production Div r_e = 4. 66% + 1. 38 (5. 1%) = 11. 7% (Same as the Exploration and Production department) r_d = 4.

66% +1. 35% = 6. 00% WACC= 0. 117(134,114,000/213,622,000)+ 0. 06(79,508,000/213,622,000)(1-0.

3946) = 8. 70% 4) What are your concerns about the quality of the comps available? CAPM method concerns- The values assigned to the variables of CAPM have some limitations: Risk Free rate: Although its default risk free, its subject to interest rate risk unless we select the maturity equal to our investments.The value is changing on daily basis, so it’s necessary to use a short term average to average out the volatility. Historical risk premium: Constrained with the period of investment same as the risk free rate. Standard error of estimation is large no matter how long the history.

Backward looking (history) cannot ensure that the data are representative of the current expectations. Alternative to Risk premium historical data is the constant growth rate model. However this model highly inaccurate for an individual company. Beta:Its Difficult to choose a proxy beta since its hard to find a company that relays on one business line. Proxy Company’s beta uses capital structure that is not easily readable. Some companies uses very complex structure, with many different source of finances.

Issues that we faced are that although we are risk averse doing this in a group showed that we look at risk differently and can interpret small but very important information differently that will result in a huge difference in outcome. But never the less there are assumptions which are subjective and some estimations can vary from different point of View e. • Risk free rate we know that we have to match duration but is 30 years or 10 years better • Risk Premium although we would’ve preferred to use the implied yield we opted for historical • Extra risk (Country + Political or liquidity for example) how much % should we add to risk premium is another assumption We lacked information on the market in general it would ve been helpful if we had an idea of the proxy portfolio and the general economic and financial situation to grasp better the correlation of our beta specially the company one. 5) Sum Ups ) WACC= 0. 11035(134,114,000/213,622,000)+ 0. 0628(79,508,000/213,622,000)(1-0.

3946) =8. 35% b) Division WACC 1- EXPO WACC= 0. 117(134,114,000/213,622,000)+ 0. 0626(79,508,000/213,622,000)(1-0. 3946) = 8.

76% 2- Refin & Marketing WACC= 0. 181(134,114,000/213,622,000)+ 0. 0646(79,508,000/213,622,000)(1-0. 3946) = 12.

8% 3- Petro WACC WACC= 0. 117(134,114,000/213,622,000)+ 0. 06(79,508,000/213,622,000)(1-0. 3946) = 8. 70% 1- Corporate Finance, Jonathan Berk, Peter DeMarzo, Second edition Pearson (Ch10-12&18) 2- From Risk & Return Models to Hurdle Rates, Aswarth Damodaran 2011