Unformatted text preview: 1 ESE 540/ Case Study Report: Midland Preliminary 1 2 ESE 540/ Case Study Report: Midland Preliminary This report is to express our opinion on the matter of estimating the cost of capital for Midland Energy Resources, Inc. in the fiscal year of 2007. In this report, we discussed appropriate risk-‐ free rate ( ! ) tax rate (t), equity market risk premium (EMRP), and appropriate hurdle rate (i.e., minimum attractive rate of return) to be used to estimate he Weighted Average Cost of Capital (WACC); value of un-‐levered asset beta is estimated from historical data; Midland’s consolidated cost of equity and WACC is then estimated based on the recommended value. The effect of target capital structure on the company’s investment choices in the future is also discussed in this report. Cost of debt According to our client’s instruction, cost of debt for Midland is estimated for each division as well as consolidated by adding a premium, or spread, over U.S. Treasury securities of a similar maturity. Based on the yields to maturity for U.S. Treasury bonds as in January 2007, we recommend the use of rate 4.98% with maturity of 30 years as the risk-‐free rate ( ! ) for Midland giving the following considerations: • • One of Midland’s financial strategies in 2007 is to optimize its capital structure by prudently exploiting the borrowing capacity inherent in its energy reserves and in long-‐ lived productive assets. Due to the historical high price for oil and other energy in 2007, the stock price of Midland is also at its historical peak, which increases the borrowing capacity of Midland to a new level – an opportunity to help the company to shield additional profits from taxes. Therefore the substantial new high level of borrowing capacity attracts the company to have more long-‐term debts in its capital structure. In order to estimate the cost of debt prudently, we recommend using the highest U.S. Treasury bond rate to evaluate the cost of debts in worst case scenario. The rate of 4.98% with maturity of 30 years is the highest bond rate available. Using rate 4.98% as risk-‐free rate ( ! ), the cost of debts for Midland consolidated and its three operating divisions are calculated in Table 1. Table 1. Cost of debt for Midland is estimated for each division as well as consolidated by adding a spread over U.S. Treasury securities of a similar maturity. The rate of 4.98% with maturity of 30 years is used here. Consolidated E&P R&M Petrochem Spread to Treasury (%) 1.62% 1.60% 1.80% 1.35% 2 Cost of debt (rd)(%) 1.62%+4.98%= 6.60% 1.60%+4.98%= 6.58% 1.80%+4.98%= 6.78% 1.35%+4.98%= 6.33% 3 ESE 540/ Case Study Report: Midland Preliminary Note that the values of cost of debt are different. Refer to the estimated credit rating1 of Midland consolidated and its three operation divisions, we find that, Petrochemicals (Petrochem), with the highest credit rating as AA-‐, corresponds to the lowest cost of debt; while Midland consolidated and the Exploration & Production (E&P) division, with the second highest credit rating as A+, have similar cost of debt which is higher than that of Petrochem division; the Refining & Marketing (R&M) division, with the lowest credit rating as BBB, has the highest cost of debt. Looking into the nature of each business operation, we find that the different values of cost of debt is also corresponding to the riskiness of the operation unit – • • • • For the Petrochem division, Midland owned outright equity interests in 25 manufacturing facilities and five research centers all over the world. In addition, the company’s product in this division is well diversified. All these factors contribute to Petrochem division’s low risk of business operation, and therefore high credit rating and low cost of debt. For the E&P division, it was Midland’s most profitable business, and its net margin over the previous five years was among the highest in the industry, and the continued global population and economic growth is also expected to rise demand for products of this division. However, the increasing fraction of energy production from non-‐traditional sources and shifting geographic composition of energy output is also posting a threat to shrink the market for the E&P division. Therefore the E&P division is more risky than the Petrochem division, and therefore has a lower credit rating and higher cost of debt. The R&M division is facing stiff competition in its field with a declining margin over the past 20 years. Therefore it is the most risky division in Midland, with the lowest credit rating, and highest cost of debt. Last but not least, the Midland consolidated is evaluated overall three divisions as a whole, therefore it presents an average credit rating of A+ and average cost of debt of 6.60%. * credit rating1 : A credit rating is an evaluation of the credit worthiness of a debtor, especially a business (company) or a government, but not individual consumers. 3 4 ESE 540/ Case Study Report: Midland Preliminary Cost of Equity The cost of equity is estimated using the Capital Asset Pricing Model (CAPM), re = rf + ∗ in which r, denotes the risk-‐free rate of return, b is a measure of systematic risk, and EMRP denotes the equity market risk premium. Tax rate is calculated by using taxes divided by Income before taxes. Refer to Exhibit 1, the income before tax and cost of tax in 2004, 2005, and 2006 is given respectively. Therefore the tax rate for 2004, 2005, and 2006 is shown as Table 2. Table 2. Tax Rate is calculated by using taxes divided by income before taxes. Taxes ($ in million) 2004 2005 2006 7,414 12,830 11,747 Income Before Taxes ($ in million) 17,910 32,723 30,447 Tax Rate 7,414/17,910 = 41.40% 12,830/32,723 = 39.21% 11,747/30,447 = 38.58% In order to estimate the WACC in 2007, we recommend the use of tax rate of 38.58% in 2006 to conduct the cost of equity estimation. The result is calculated by using 11,747 divide 30,447. Since there is a decreasing trend of tax rate from 2004 to 2006, the average tax rate over three years is not likely reflect the tax rate in 2007.On the other hand, the data input that is used in this report such as spread to treasury and credit rating is based on historical data in year 2006, it is reasonable to assume that the tax rate in 2006 is the closest reflection of tax rate in 2007 among these three years. As instructed by our client, 5% is used as EMRP for the estimation of WACC. We consider that it is reasonable to use the 5% as the EMRP for the following reason. Refer to Exhibit 6 Table A, the historical data on U.S. stock returns minus Treasury bond yields ranges from 4.8% to 7.1%. On the other hand, according to Table B, the overall range of risk premium survey is between 2% and 5.6%. So 5% is included in the range and it gives a reasonable value to indicate the equity market risk premium. The CAPM model is used to estimate the cost of equity for Midland consolidated. It shows a trade-‐off between the time value of money represented by ! , and the additional risk of investment represented by ∗ . 4 5 ESE 540/ Case Study Report: Midland Preliminary As analyzed in the previous section, ! is considered to have the same rate as the 30-‐year maturity U.S. Treasury bonds, ! =4.98%. Using betas published in commercially available databases in Exhibit 5, !"#$%& = 1.25. Current estimates of the EMPR = 5.0% is adopted. re = rf + !"#$%& *Market Risk Premium = 4.98% + 1.25*5% = 11.23% Thus we estimated Midland’s consolidated cost of equity to be 11.23%. 5 6 ESE 540/ Case Study Report: Midland Preliminary Weighted Average Cost of Capital (WACC) The estimation of cost of capital for Midland is based on the formula for WACC shown below. In this expression, D and E are the market values of the debt and equity respectively. Similarly, ! and ! are the costs of debt and equity, respectively, and t is the tax rate. WACC is a model to calculate cost of capital, in which each category of capital is proportionately weighted. The capital consists of two parts, equity and debt. = ∗ (1 − ) ∗ r! + (1 − ) ∗ r! The weight of debt or leverage is, = (D/E)/(1+D/E)=37.23%. The Midland’s Consolidated has a spread to Treasury equals 1.62% according to Table 1. Then the Cost of debt is, ! = ! + ∗ = 4.98%+1.62%=6.6%. Tax rate t is assumed to be 38.59%, the same as Year 2006. Then, the after-‐tax WACC is , = ∗ (1 − ) ∗ r! + (1 − ) ∗ r! = 37.23%*6.6% *(1-‐38.58%)+ (1-‐37.23%)*11.23% = 8.56% Thus we have Midland’s consolidated WACC as 8.56% at this time. We also want to determine the un-‐levered asset beta given the historical data from Exhibit 5 for further estimation of Midland’s cost of capital. The un-‐levered asset beta is the beta of a company without any debt, which is given by, βasset = βequity*(1 -‐ λ)= 1/(1+D/E)* βequity It is given in Exhibit 5 that D/E = 59.3%, and βequity = 1.25, for the consolidated company. Plugging in these data, we have, βasset = βequity*(1 -‐ λ)= (1-‐37.23%)*1.25 = 0.785 The unlevered asset beta for the consolidated company is therefore 0.785. 6 7 ESE 540/ Case Study Report: Midland Preliminary Future Direction In order to predict the company’s future investment direction, we have done some evaluation putting Midland in its future target capital structure. Under the consolidated company’s future target capital structure in Table 1, its λ! = D/V = 0.422 And as mentioned in previous section, Midland’s consolidated Asset Beta is β! !""#$ = 0.784683. Thus, the Equity Beta after re-‐levering is β!,! = β! 0.784683 !""#$ = = 1.3576 1 − λ! 1 − 0.422 Using the CAPM model – r! = r! + β!,! ∗ (Risk Premium), in which Risk Premium = 5% as instructed by our client, the Cost of Equity of the future target capital structure of the consolidated company is r! = r! + β!,! ∗ ( Risk Premium) = 4.98% + 1.3576 ∗ 5% = 11.77% With a tax rate of t = 0.3859 and Cost of Debt of ! = 6.60%, we can calculate the WACC of the targeted structure of the consolidated company: WACC! = λ! ∗ 1 − t ∗ ! + 1 − λ ∗ r! = 0.422 ∗ 1 − 0.3859 ∗ 6.60% + 1 − 0.422 ∗ 11.77% = 8.39% The target WACC is lower than that of before (8.85%). In other words, the company has a lower cost of capital. So the MARR of the company may be adjusted to a lower value than pervious value. Under the targeted WACC, the company may accept investments of lower rates of return, which they may not accept under current WACC. These investments may have a lower risk. We have also graph the consolidated company’s cost of equity and WACC as a function of its debt fraction (D/V, or, D/D+E) over a range from no debt to 100% debt. Sensitivities of both variables to changes in the debt fraction is discussed, and practical considerations and constraints to the extremes of the range of debt fractions is considered at the end of this discussion to give some projection of Midland’s borrowing capacity. 7 8 ESE 540/ Case Study Report: Midland Preliminary ! Cost of Equity and WACC, as functions of debt fraction (!!!, or λ), can be calculated as follows, 1. r! = r! + β!,! ∗ (Risk Premium) = 0.0498 + β! 0.039234 !""#$ ∗ 0.05 = 0.0498 + 1 − λ! 1−λ 2. WACC = λ ∗ (1 − t) ∗ r! + (1 − λ) ∗ r! = λ ∗ 0.6027 ∗ 0.066 + (1 − λ) ∗ (0.0498 + 0.78468 ∗ 0.05/(1 − λ) = 0.089034 − 0.01002λ As λ varies from 0 to 1, with a step of 0.05, Cost of Equity and WACC of the consolidated company change accordingly. Graphing data is given in Figure 1. 0.5 0.45 0.4 0.35 0.3 CoEquity 0.25 WACC 0.2 0.15 0.1 0.05 0 0 0.2 0.4 0.6 0.8 1 Figure 1. Relationship of Cost of Equity and WACC with Debt Fraction. From the graph we can see that Cost of Equity is more sensitive to the change of Debt fraction than WACC. And the sensitiveness of Cost of Equity increases as λ grows from 0 to 1. And Cost of Equity increases as λ increases. However, the sensitiveness of WACC remains the same as λ varies from 0 to 1. And WACC decreases as λ increases. We can further explain the changes and relations of Cost of Equity and WACC at extreme points, namely λ = 0 and λ = 1, from a practical point of view. 8 9 ESE 540/ Case Study Report: Midland Preliminary ! 1. As λ approaches 0 (!!! → 0), the only component of cost of capital is the cost of equity. So we have: WACC = Cost of Equity. Note that this can also be seen from the graph, as the two curves tend to overlap as λ is near 0, the company thus bear no debt in this case. ! 2. As λ approaches 1 (!!! → 1), the only component of cost of capital is the cost of debt. Practically, if a company were to have only debt and no equity, the company’s WACC will become the after tax Cost of Debt, or (1 − t) ∗ Kd = 0.6027 ∗ 0.066 = 3.98% in this cast. However, the re-‐levered Beta of Equity is calculated from the estimated Asset Beta, which is calculated though: β! !""#$ = (1 − λ) ∗ β! . And such method will not work when λ is around 1, as, apparently, 1 − λ ≈ 0 and such approximation method is not longer reliable. So, both values and curves of Cost of Equity and WACC in the graph as λ approaches 1 are not reliable. So, Practically, at extreme point λ = 1, the company bears no Cost of Equity and the WACC of the company can be calculated as follows: WACC = λ ∗ 1 − t K ! + 1 − λ K ! = 1 ∗ 0.6027 ∗ 0.066 + 0 = 3.98% ; Increasing debt fraction indicates increasing risk for not being able to pay off all the debts for the company. Nevertheless, an extremely low debt fraction is not good for the company’s health either, as it means the company has very weak execution power on its investments and it do not have enough accessible resource. To project Midland’s current position in its field, we also analyze the asset betas for comparable companies with data given in Exhibit 5. To calculate the leverage λ, we use the formula λ = !/! !/!!! where D/E were given. We then calculate βasset for each company using the βequity given using the equation βasset = βequity*(1 -‐ λ). Estimated data for the comparable companies is given in Table 3 below. 9 10 ESE 540/ Case Study Report: Midland Preliminary Table 3. Debt Fraction and Beta for comparable companies Organization Jackson Energy, Inc. Wide Plain Petroleum Corsicana Energy Corp. Worthington Petroleum Exploration & Petroleum Bexar Energy, Inc Kirk Corp. White Point Energy Petrarch Fuel Services Arkana Pertoleum Corp. Beaumont Engergy, Inc. Dameron Fuel Services Refining & Marketing D/E 0.1120 0.8540 0.1520 0.4750 0.1030 0.1940 0.2090 -‐0.1200 0.3230 0.2060 0.5030 λ 0.1007 0.4606 0.1319 0.3220 0.46 0.0934 0.1625 0.1729 -‐0.1364 0.2441 0.1708 0.3347 0.31 βequity 0.89 1.21 1.11 1.39 1.5551 1.7 0.94 1.78 0.24 1.25 1.04 1.42 1.4131 βasset 0.8004 0.6526 0.9635 0.9424 0.8397 1.5413 0.7873 1.4723 0.2727 0.9448 0.8624 0.9448 0.9751 Refer to Table 3, the average asset beta for Exploration & Production Group was 0.8397. Since the Midland’s target leverage λ for the Exploration & Production division is 0.46, we can derive that the βequity of Midland by: Average λ = β!"#$%& ×(1 − λ !"#$%& ) => 0.8379 = β!"#$%& (1 − 0.46) The equity beta is thus β !!"#$% = 1.5551. Since the market risk premium is instructed by our client as 5%. And we have chosen the risk-‐ free rate to be rf = 4.98% in the cost of debt section. The cost of equity is then re= rf + βequity * Market Risk Premium = 4.98% + 1.5551*5% = 12.76% In order to calculate WACC we first need to figure out the rd. rd = rf + Spread to treasury rd = 4.98% + 1.60% = 6.58% 10 11 ESE 540/ Case Study Report: Midland Preliminary The WACC is then given by, = ∗ (1 − ) ∗ r! + (1 − ) ∗ r! = 0.46 * (1-0.3859)*0.0658 + 0.1276*(1-0.46) = 8.75% Using the similar approach, the average asset beta for the Refining & Marketing group is 0.9751 from Table 3. The leverage λ was given as λ = 0.31. 0.9751 = !"#$%& ∗ (1 − 0.31) The equity beta is thus !"#$%& = 1.4131. The Cost of Equity is determined by re = rf + βequity*5% = 4.98% + 1.4131*5% = 12.05% The spread to treasury for the M&R division was given as 1.8%. rd = 4.98% + 1.8% = 6.78% = ∗ (1 − ) ∗ r! + (1 − ) ∗ r! = 0.31 * (1-0.3859)*0.0678 + 0.1205*(1-0.31) = 9.60% According to the future capital structure in Table 1, the WACC for the Exploration & Production group is 8.75% and the WACC for the Refining & Marketing group is 9.60%. These WACC are higher than the consolidated WACC 8.48%. If these division WACCs are used instead of the consolidated WACC, both E&P and M&R divisions for Midland would operate with higher WACC, the MARR for the company is therefore adjusted to higher values for both division, and they need to choose projects with high risks in order to fulfill the higher MARR. In future evaluation of cost of capital for Midland, we recommend the use of different hurdle rate with respect to different division. Since the investment behavior for different division will only reflects the capital structure and cost of capital with respect to that specific division, each division should only accept projects with return rates higher than its own division hurdle rate. Using a single consolidated company hurdle rate sometimes cannot provide accurate project evaluation for all of its divisions. 11 ...
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2015 Instructor: Elmir Musayev Written by: Asgarova Farida Hasanov Jeyhun Mammadli Turac Mehdiyev Calil Quluzade Orxan Case Study: Midland Energy Resources, Inc.: Cost of Capital Executive summary Midland Energy Resources, Inc. is a global energy company that operates in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. Midland’s most profitable segment is its E&P division which produces 67% of the company’s net income (Exhibit 3). Its largest division is R&M with the Petrochemical division being the smallest. 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 accomplish these goals, Midland must calculate an appropriate cost of capital that will allow reasonable valuations of their strategies. In funding overseas growth, Midland must use its cost of capital to analyze, evaluate, and convert foreign cash flows. In evaluating value-adding projects, the cost of capital must be used to discount project cash flows. To optimize its capital structure, the company must continuously evaluate its ideal borrowing based on its inherent cost. Lastly, when deciding when and how to repurchase shares, Midland’s management has to determine the intrinsic value of its shares. This requires determining the value of the company using DCF techniques and an appropriate discount rate. In the following sections we are going to answer the questions related to the cost of capital estimates. 1. How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations? Section 1: Estimates of cost of capital Estimates of the cost of capital were used in many analyses within Midland, including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. Some of these analyses were performed at the division or business unit level, while others were executed at the corporate level. The cost of capital needs to be adjusted if the project is more or less risky in comparison to the firm risk. The cost of capital should be used in performance assessments of the firm, taking into consideration the factors such as economic scenario, industry cost of capital, size of the company etc. Also, cost of capital should be calculated in order to include the latest changes of stock prices. 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? Section 2: WACC of the company To calculate Midland’s company WACC, a 39.72% tax rate is assumed based on an average, of taxes paid divided by income before taxes, over the last three years (Exhibit 1). The cost of debt of is calculated as the 10-year rate (Table 2) on U.S. Treasury bonds plus the spread to Treasury (Table 1). The 10-year risk-free rate seems more appropriate because Midland’s borrowing capacity is based primarily on its energy reserves and long-lived assets. The short-term 1-year rate would be less for calculating the risk. Then, 30-year rate will more applicable for a real estate companies, but not appropriate based on the prospective changes in the production business. The new beta was calculated by un-levering the old beta of 1.25 (which was based on a D/E ratio of 59.3% seen in exhibit 5) and new levering based on the target capital structure of 57.8% equity which corresponds to a D/E ratio of 73%. The unlevered beta for Midland is calculated as .922. In calculating the asset beta for new levering, the beta of debt is assumed to be zero based on Midland’s consolidated A+ credit rating (Table 1). This assumes that the company as a whole has little or no risk of default. The ratios of debt and equity are the target ratios for the consolidated company as set by management. Midland’s WACC is calculated at and is as follows: Levered Beta = Unlevered beta (1+(1-T)D/E) Levered Beta = 1.25% (exhibit 5) D/E = 0.593 (exhibit 5) Equity Market Risk Premium: Exhibit 6 shows historical data on U.S. stock returns and bond yields supporting higher estimates of EMRP. On the other hand, survey results shown in Exhibit 6 support lower figures. Midland adopted its current estimate of 5 % after a review of recent research and in consultation with its professional advisors, bankers and auditors, as well as Wall Street analysts covering the industry. Tax rate is calculated according to the Exhibit 1 taking the average tax rates of 2004, 2005 and 2006. Tax rate=Income taxes/income before taxes (7414/17910+12830/32723+11747/30447)/3≈0.3972 Tax rate: 39.72% 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 Using EMRP of 5% R(e) = 4.66 + 1.33 (5) = 11.31% R(d)= 4.66 +1.62 = 6.28% 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%. 3. Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or why not? Section 3: Differentiating hurdle rates If the company used the single cost of capital or hurdle rate it would assume that all divisions are similar. Using single hurdle rate doesn’t consider each division’s different debt structures and nature of assets. For example, Midland’s E&P division has assets of oil reserves and higher demand for capital expenditures for development (Exhibit 3). Also, target debt ratio differs among divisions. For divisions, operating in different specific industries also can differentiate business risks. For example, R&M division operates on smaller margins, so that it has more risk. However, if we take into account that it operates long time before, the probability of decreases. Also, this division requires not much capital taking into account its maturity in the market. Considering the explanation given above, it is better to use different hurdle rates for each division since it will provide company with more accurate and detailed information about the expected riskiness. 4. Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from one another? Section 4: Cost of capital for E&P and R&M 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. Calculating new Levered Beta (for target capital structure of 46% debt): Exploration & Production Division: Unlevered Beta for E&P division: 0.9275 New levered beta is thus: Unlevered*/ (1+ (1-T)*D/E)= 1.404 Using EMRP of 5% R(e) = 4.66 + 1.404*5%= 11.68% R(d)= 4.66 +1.60= 6.26% WACC of division: R(d)*(D/V)*(1-t) + R(e)*(E/V)= 8.04% Refining & Marketing Division: Unlevered Beta for E&P division: 1.06 New levered beta is thus: Unlevered*/ (1+ (1-T)*D/E)= 1.359 Using EMRP of 5% R(e) = 4.66 + 1.36*5% = 11.46% R(d)= 4.66 +1.80= 6.46% WACC of division: R(d)*(D/V)*(1-t) + R(e)*(E/V)= 9.11% Following table shows summary of calculations: Table 1: Cost of Capital for E&P and Marketing and Refining divisions Exploration and Production Levered Beta (of portfolio) D/E Tax Rate Unlevered Beta Target Debt/Value Target D/E New Levered Equity Beta (of division) Refining and Marketing 1.15 39.8000% 39.7283% 0.9275 46% 85.19% 1.2 20.3000% 39.7283% 1.0692 31.00% 44.93% 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% 8.04% 9.11% WACC of division: rd (D/V)(1-t) + re(E/V) 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. 5. How would you compute a cost of capital for the Petrochemical division? Section 5: Cost of Capital for Petrochemical Division For calculating the cost of capital for Petrochemical division, the weight of each division can be found using the information about the total assets in 2006, described in Exhibit 3. According to this information, the weights are 0.534, 0.358, 0.108 for the E&P division, R&M division and Petrochemical division respectively. The following step is to find the unlevered asset beta for Petrochemical division. Since we found the weights based on the assets, using unlevered beta would be more appropriate. To find the unlevered beta for Petrochemical division, first, we should find unlevered betas for 2 remaining divisions of company. Although the Midland Energy Resources, Inc. does not have exact information about the sensitivity of stocks’ returns, it can define betas by looking at competitors’ betas and analysts’ reports. For this purpose, we first need to multiply the beta of each division by respective weight. Then we add all the products and set it equal to the total beta of the company. Finally, we find the unknown beta for Petrochemical division from the equation we formulated. To understand the information given above let’s see calculations: a) Calculations of weights: Divisions: Assets (2006): E&P 140,100 R&M 93,829 Petrochemical 28,450 Total Assets: 140,000+93,829+28,450=262,279 Weight of E&P: 140,000/262,279=0.533782≈0.534 Weight of R&M: 93,829/262,279=0.357744≈0.358 Wight of Petrochemical: 28,450/262,279=0.108472≈0.108 b) Calculations of beta (Petrochemicals): The company has already calculated the levered betas for total and for each division by finding arithmetic mean. (For E&P: 1.15; for: R&M: 1.2; for Midland: 1.25)To find unlevered ones we have following formula: Levered Beta = Unlevered beta* (1+ (1-T)*D/E) D/E stands for debt to equity ratio Unlevered beta= Levered beta/ (1+ (1-T)*D/E) Unlevered beta for E&P division: 1.15/ (1+(1-0.3972)*0.398≈0.9274 Unlevered beta for R&M division: 1.2/ (1+(1-0.3972)*0.203≈1.0692 Unlevered beta for company: 1.25/ (1+(1-0.3972)*0.593≈0.921 Note: Tax rate = 39.72% was calculated as the average of tax rates from 2004, 2005, 2006 from exhibit 1 Now we have equation: 0.921 = 0.5340*0.9275+0.3576*1.0692+.1084* unlevered Beta of Petrochemicals So, from this equation we can find that unlevered beta for Petrochemicals is approximately 0.4 Using the formula above: Levered beta= 0.4* (1+(1-0.3972)*0.6667)≈0.561 Relevering is based on the target capital structure of 60 equity which corresponds to a D/E ratio of 66.67%. c) Then we have following information to calculate WACC for Petrochemical division: Cost of Equity R(e): R(f)+Beta (EMRP) where R(f) is 4.66% and EMPR = 5% R(f)-risk-free rate or treasury rate EMRP-Equity market risk premium Cost of equity is thus: R(e)=4.66% (10-year treasury bond)+0.561*5%≈7.46% Cost of debt R(d): 10 year treasury rate + spread to treasury (from table 1) Cost of debt is thus: R(d)=4.66% +1.35%=6.01% WACC for Petrochemicals division: R(d)*(1-T)*(D/V)+ R(e)*(E/V) where D/V=0.4 and E/V=1D/V=0.6 (from table 1) WACC for Petrochemicals is thus: 6.01*(1-0.3972)*0.4+7.46*0.6≈5.93 The resulting WACC of 5.93% for the Petrochemical division represents the discount rate that can be used to value specific projects of average risk within the division. Recommendations: 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 Rating Target Debt / Value Exploration and Production Refining and Marketing Petrochemicals 8.04% A+ 46.00% 9.11% 5.93% BBB AA- 31% 40% Midland Energy (Consolidated) 8.134% A+ 42.20%