MIDLAND ENERGY

Midland Energy is a global energy company with operations in oil and gas exploration and production
(E&P), refining and marketing (R&M), and petrochemicals. The primary goals of Midland’s financial
strategy are to fund substantial overseas growth, invest in value-creating projects, achieve an optimal
capital structure, and repurchase undervalued shares. To meet these goals, Midland must calculate an
appropriate cost of capital.

In funding overseas growth, Midland uses the cost of capital estimated by Mortensen to analyze, evaluate,
and convert foreign cash flows. In evaluating value-adding investments, the cost of capital is used to
discount project cash flows. In evaluating the performance of a business or division based on the economic
value added model, the capital charge is computed as the cost of capital for the business or division times
the amount of capital it employed during the period. To optimize its capital structure, Midland
continuously evaluated its ideal borrowing based on its inherent cost. Lastly when deciding when and
how to repurchase shares or evaluating M&A proposals, Midland’s management used an appropriate
discount rate while determining the value of the company or proposal using DCF techniques. The cost of
capital determined by Mortensen was also used to analyze asset appraisals in capital and financial
accounting as well as performance assessments to determine compensation.

If all anticipated uses of Midland’s cost of capital exhibited the same average risk, then no change is
required in the calculation of the cost of capital. But each of the Midland’s three division’s exhibit
different risk profiles due to their nature of business. If the projects are of greater or lesser risk, then the
calculations of WACC may be affected. For example in evaluating a risker M&A proposal presented by the
exploration and production division, the company may need to adjust the cost of capital by including a
higher risk premium. On the other hand, appraisals of certain long lived assets, cash inflows or outflows
may be at a lower risk than the company average and hence the numbers contributing to the cost of
capital should be adjusted accordingly.

Midland’s Corporate Cost of Capital

The following assumptions are made in calculating Midland’s corporate WACC:

1. The corporate tax rate is assumed to be 39.72% (which is the average of the tax rate for years
2005 to 2007)
2. The cost of debt is calculated as the 10 year rate on U.S. Treasury Bonds (Case study - table 2) plus
the spread to Treasury for the consolidated company calculated as presented in Case Study - Table
1. This makes the cost of debt as 4.66%+1.62% = 6.28%. The 10 year rate is used since Midland’s
borrowing capacity is based primarily on energy reserves and long lived assets. The 1-year rate
does not capture the assets financing the borrowing and the 30 year rate is not appropriate given
the changes that are possible in the industry in that timeframe that Midland cannot adequately
capture and model in its business.

Calculation of Cost of Equity

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 Levered Beta = UnLevered beta (1+(1-T)D/E)

Levered Beta = 1.25% (exhibit 5)

D/E = 0.593 (exhibit 5)

Tax rate = 39.72% (average of tax rates from 2004,2005,2006 from exhibit 1)

Unlevered Beta (or asset beta) = 0.921

Target equity capital structure = 57.8% (from case study - table 1)

Implies new D/E ratio = 73%

Calculating new Levered Beta (for target capital structure of 42.2% debt)

New equity Beta = 0.921 (1+(1-.3972)*.73) = 1.33

rD = 4.66 +1.62 = 6.28%

Using EMRP of 5%

rE = 4.66 + 1.33 (5) = 11.31%

WACCmidland = (1-t) rD (D/V) + rE (E/V)

= ((1-0.3972)*0.0628*0.422)+(0.1131*0.578)

WACCmidland = 0.08134 = 8.13%

Midland is using EMRP of 5%. Based on the historical data presented in Exhibit 6A, the average of
historical data would result in EMRP closer to 6%. Especially in the more recent time period of
1987 to 2006, the average excess return (6.4%) is higher than Midland’s projection of 5%. Giving
more weight to historical data would decrease any bias by individual viewpoints or survey results.
As the economy has been more uncertain, investors are demanding higher return to compensate
for the increased risk. Hence it would be more appropriate for Midland to use EMRP closer to 6%.

Divisional Cost of Capital

The use of a single corporate hurdle rate for evaluating investment opportunities in all its divisions would
assume that the risk and return for each investment would be the same across all divisions. Midland
operates 3 divisions with very different debt structures and assets within each division. Midland’s target
debt ratio for each division also varies which would change the cost of capital across divisions.
The Exploration and Production division has a higher demand for capital expenditures (exhibit 3) for
development but also offers higher margin of return (an average of 54.23% from exhibit 3). Midland’s
Petrochemicals division is investing mostly in overseas markets that carry different risks like exchange rate
risk, political risk and interest rate risk compared to the more mature Refining and Marketing business.
The Refining and Marketing division is the largest (contributing 81.67% of revenue in 2006) but also has
the lowest margin (1.99% in 2006) that is decreasing (exhibit 3). The division profits are more risky due to

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the declining margins but cash flows might be more certain due to the mature nature of business. The
R&M division also does not project any increased need for capital. This implies the amount and cost of
debt financing for the R&M division could be different from the cost of debt financing for the refining and
marketing division. Mortensen accurately assess that due to the nature of the business of each division
and their current financial position the credit rating of each division will be different. Thus using different
hurdle rates for each division would allow Midland to more accurately reflect the risks and benefits of
each investment and allow the company to make comparisons based on factors that are unique to each
industry that the divisions operate in.

Cost of Capital for E&P and Marketing and Refining Divisions

E&P and the Marketing and Refining divisions have different betas and target capital structures. For E&P,
the average industry unlevered beta is 0.9275 whereas the M&R division has an average industry
unlevered beta of 1.0692. This produces an equity divisional beta of 1.404 for E&P and 1.359 for M&R
taking into account their target capital structure. A 39.72% tax rate is assumed in unlevering each
company’s beta. The risk free rate is assumed to be 4.66% (10 year treasury yield). Table 1 shows the
calculation of unlevered beta, cost of debt, cost of equity and the WACC of both the divisions.

Table 1: Cost of Capital for E&P and Marketing and Refining divisions

Exploration and
Production Refining and Marketing
Levered Beta (of
portfolio) 1.15 1.2
D/E 39.8000% 20.3000%
Tax Rate 39.7283% 39.7283%
Unlevered Beta 0.9275 1.0692
Target Debt/Value 46% 31.00%
Target D/E 85.19% 44.93%
New Levered Equity Beta
(of division) 1.404 1.359
Cost of Debt (rD): 10 year
treasury rate + spread to
treasury 6.26% 6.46%

Cost of Equity (rE):

rf+Beta (EMRP). rf is
4.66%. EMRP = 5% 11.68% 11.45%

WACC of division: rd
(D/V)(1-t) + re(E/V) 8.04% 9.11%

While the cost and debt and the cost of equity does not vary much between the two divisions, the target
capital structure of the divisions influences the cost of capital. E&P is able to take advantage of a lower
cost of debt by using greater leverage (46%) compared to Refining and Marketing (31%) which results in
lower divisional cost of capital for E&P.

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Cost of Capital for Petrochemicals

The cost of capital for petrochemicals can be calculated by finding the unlevered asset beta for
petrochemicals and using that to calculate the equity beta for petrochemicals divisions. The equity beta
is used to calculate the cost of equity. Using data in Table 1 of the case, we can determine the cost of
debt. Subsequently the WACC of petrochemicals can be calculated.

To find the unlevered asset beta, we can assign a weight to each division based on the contribution of
assets by each division to total assets for 2006. Based on this, the weights of each division is –

Assets as % of total assets in

2006
Exploration and Production 0.5340
Refining and Marketing 0.3576
Petrochemicals 0.1084

Unlevered Beta of Midland Energy = Weight of E&P * Asset Beta of E&P + Weight of R&M * Asset Beta
of R&M + Weight of Petrochemicals * Asset Beta of Petrochemicals

0.921 = .5340*.9275+.3576*1.0692+.1084* Asset Beta of Petrochemicals

Solving, Asset Beta of Petrochemicals = 0.400083764

Table 2 below shows the calculation of Equity Beta for Petrochemicals, the cost of debt, cost of equity
and WACC for Petrochemicals division (using data from Table 1 in case)

Petrochemicals
Tax Rate 39.7283%
Unlevered Beta 0.400083764
Target Debt/Value 40%
Target D/E 66.67%
New Levered Equity Beta
(of division) 0.561
Cost of Debt (rD): 10 year
treasury rate + spread to
treasury 6.01%

Cost of Equity (rE):

rf+Beta (EMRP). rf is
4.66%. EMPR = 5% 7.46%

WACC of division: rd
(D/V)(1-t) + re(E/V) 5.93%

Thus the cost of capital for Petrochemicals division is 5.93%.

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In summary, the cost of capital for each of the divisions of Midland energy varies as shown in the table
below. For Midland energy to achieve its financial goals it must deploy a sound investment strategy that
takes into account the appropriate cost of capital for each project and must continuously evaluate this
against changing business needs. It is recommended that Midland Energy undertake this exercise at a
minimum annually and also when any significant events take like that affect the capital structure of the
division or company.

Division WACC of division Credit Target Operating

Rating Debt / Margin
Value (2006)
Exploration and 8.04% A+ 46.00% 56.16%
Production
Refining and Marketing 9.11% BBB 31% 1.99%
Petrochemicals 5.93% AA- 40% 9.04%

Midland Energy 8.134% A+ 42.20% 7.52%

(Consolidated)

As evident from the table the cost of capital of each division of the company varies based on the type of
capital structure employed, the amount of risk involved in the business of each division, the certainty of
cash flow and the capital expenditure needs of the division. Midland Energy can take advantage of the
low cost of debt for Petrochemicals to increase growth in this division to compensate for the lack of
growth exhibited by Refining and Marketing.

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