Midland Case: Case Study Valuation Case

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Midland Energy was global large company with three divisions operating in oil and gas. To support the financial decision of repurchasing stock, the corporate and divisional cost of capital need to be calculated.
Solution (a)
The formula for WACC is WACC=r_d (D/V)(1-t)+r_E (E/V). Hence, to calculate Midland’s corporate WACC, we should have r_d, which is the cost of debt, or expect return that is required by a firm’s creditors. And r_E is the cost of equity, usually obtained by the Capital Asset Pricing Model. And then we should know about the firm’s corporate tax rate – t. Finally comes to the debt to value ratio and equity to value ratio.
First let us look at the cost of debt. In this case, the r_d was not acquired directly, but computed by adding a spread over U.S. Treasury securities of a similar maturity. Which means:
r_d = r_f (risk-free rate) + Spread to Treasury
Table 2 shown three different maturities of Treasury rate. Considering Midland Energy Resources had more than 120 years of history in 2007, I believe 30-year Treasury rate is the best choice, compared to 1-year and 10-year Treasury rate. Because Midland primarily undertake long-term investment, for instance, its E&P division continue to expand its production scale, and R&M division construct more refineries.
In the meantime, table 1 demonstrated the firm’s consolidated spread to Treasury was 1.62%.
Therefore, r_d = 4.98% + 1.62% = 6.6%.

The two tables are given by:
Table 1
Business Segment Credit Rating Debt/ Value Spread to Treasury
Consolidated A+ 42.2% 1.62%
E&P A+ 46.0% 1.60%
R&M BBB 31.0% 1.80%
Petrochemicals AA- 40.0% 1.35%

Table 2
Maturity Rate
1-Year 4.54%
10-Year 4.66%
30-Year 4.98%

Unlike cost of debt, cost of equity’s computation is much more complicated. As I said earlier, generally we use the CAPM to estimate r_E. The equation is r_E = r_f+ β_E(EMRP). In order to maintain consistency in calculation, I assume the risk-free interest rate equals to the 30-year U.S. Treasury bond rate, which is 4.98%. Because we usually regard the U.S. Treasury securities are free from default risk, even though S&P’s Rating Services once lowered its long-term sovereign credit rating on the USA to “AA+” from “AAA” in 2001. What’s more, when surveyed, most large companies and authoritative financial experts using the yield of long-term bonds to determine the risk-free interest rate. As for EMRP, I suppose Mindland’s choice of 5% is appropriate. As for the reason I will explain in the following pages. While the last input β_E has been given in Exhibit 5, which is 1.25. Thus equity cost of capital r_E = 4.98% +1.25(5%) = 11.23%
Tax rate plays an important role in WACC. When the firm finance by debt, it will benefit from the interest tax deduction. And that is why we create WACC to include this benefit. Exhibit 1 indicates Midland’s taxes and income before taxes from 2004 to 2006. By calculating the average corporate tax rate across 2004, 2005 and 2006, we can acquire the tax rate t = 39.7%
Last but not least, the relative proportions of equity and debt financing has been indicated in Table 1, in other words: D⁄V =42.2%, thus E⁄V = 1 - D⁄V = 57.8%.
So now the WACC is given by
WACC=r_d (D/V)(1-t)+r_E (E/V) = 6.6% (42.2%) (1-39.7%）+ 11.23% (57.8%) = 8.17%
As for the reason why I consider Midland‘s choice of EMRP is appropriate. One is that historical data may have little relevance for investors’ expectations of the market risk premium today, that means we cannot trust data used in the past. By contrast, the survey result presented in Exhibit 6 is much more credible. Because the researchers and professional advisors tend to have broader information and accurate data of the industry. And their estimation backed by large amount of data from recent years. Based on their survey result Midland adopted 5% as EMRP. Hence I believe 5% of EMRP is appropriate.
Solution (b)
As far as I am concerned, Midland should not use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions. The reasons are as follows.
First, Midland Energy has three divisions, they are exploration and production (E&P), refining and marketing (R&M) and petrochemicals. Each division is mutually independent, and together they constitute the firm’s production line. As its name suggests, each division undertake their own project and make their own investment decision, not to mention the invested cost and risk and payback period are all different. Hence it is unreasonable to share the same corporate hurdle rate in all of its divisions.
Second, if Midland apply a single corporate hurdle rate, consequently, it would mislead evaluation of the investments. Usually risky project needs higher payback, if the firm use a low hurdle rate on a high-risk project, then it is highly possible that the firm would suffer loss.
However, for some corporate level investments, like purchasing office stationery for all divisions, using the same WACC to evaluating is feasible. But overall, Midland should use different hurdle rate in distinct divisions.
Solution (c)
On the basis of calculation of Midland’s corporate WACC, we can use the same way to compute a separate cost of capital for the E&P and R&M.
As is shown in Table 1, E&P division’s spread to Treasury is 1.6%, and that for R&M is 1.8%. Thus we can obtain the E&P’s r_d = 4.98% + 1.6% = 6.58%, R&M’s r_d = 4.98% + 1.8% =6.78%. As for the tax rate, which has been calculated, is 39.7%.
While the tricky part of the question is the equity beta of the two divisions. We already have risk-free rate (4.98%) and Equity Market Risk Premium (5%), but we do not have theβ_E. Recall that comparable firms share the similar unlevered beta, we can calculate the division’s unlevered beta firstly and then obtain the equity beta. The table below is the information that we need extracted from Exhibit 5:
Table 3
D/E Equity Beta
Exploration & Production
Average 39.8% 1.15
Refining & Marketing
Average 20.3% 1.20

Now we can calculate the industry’s unlevered beta, or asset beta (β_A) by the equation:
β_A = β_E/([1+(1-t)*(D/E)])
Thus〖 β〗_A for E&P = 1.15 / [1 + (1 – 39.7%)*39.8%] = 0.93
〖 β〗_A for R&M =1.2 / [1 + (1 – 39.7%) * 20.3%] = 1.07
From Table 1 we can acquire that D/E for E&P = 85.19%, and D/E for R&M = 44.93%. Again by using the equation of asset beta, we would be able to compute the equity beta for the two division of Midland:
Equity beta for E&P = 0.93*[1 + (1 – 39.7%)*85.19%] = 1.41
Equity beta for R&M = 1.07*[1 + (1 -39.7%)*44.93%] = 1.36
Now the equity cost of the two divisions can be calculated as:
Equity cost for E&P = r_f+ β_E(EMRP) = 4.98% +1.41*5% = 12.03%
Equity cost for R&M = 4.98% + 1.36*5% = 11.78%
Finally, WACC for E&P = r_d (D/V)(1-t)+r_E (E/V) = 6.58% * (46%)*(1 – 39.7%) + 12.03% *(1 – 46%) = 8.32%
WACC for R&M = 6.78%*31% *(1 – 39.7%) + 11.78% *(1 – 31%) = 9.40%
There are several reasons behind the discrepancy between the costs of capital of the two divisions. First and foremost, these divisions operate in different industries, although they belong to the same company. And that lead to they are likely have different set of market risks, thus the betas could be distinct.
Another reason is the leverage, or the extent to which they rely on debt as a source of financing. From Exhibit 5, we get to know E&P’s debt-to-equity ratio is 39.8%, and that figure for R&M is 20.3%. That is a huge difference, which means they have total different capital structure. Without a doubt leverage increases the risk premium of the equity, that is to say, the equity cost of capital increases.
Solution (d)
In the same way, I use the WACC to measure the cost of capital for Petrochemicals division. But there is one point that makes Petrochemicals different from the other two divisions of Midland. That is to say Petrochemicals tend to undertake short-term projects or investments. That leads to the reconsideration of choice of maturity of U.S. Treasury rate, in other words, we should use the 1-Year Treasury rate to calculate the cost of debt for Petrochemicals:
r_d for Petrochemicals = 4.54% + 1.35% = 5.89%
The next step is to compute the equity beta for Petrochemicals. In the previous solution, the equity betas for the other two divisions have been calculated, plus the known equity beta for the whole corporate, we would be able to figure it out. I assume W1, W2, and W3 are based on the total assets of a division divided by Midland’s total assets, W1 for E&P, W2 for R&M, and W3 for Petrochemicals. To find these weights, we can calculate the average corporate and divisional asset across 2004, 2005, and 2006:
Midland’s average assets = (157497 + 244671 + 262378)/3 = 221515.33
E&P’s average assets = (76866 + 125042 + 140100)/3 = 114002.67
R&M’s average assets = (60688 + 91629 + 93829)/3 = 82048.67
Petrochemicals’ average assets = (19943 + 28000 + 28450) = 25464.33
W1-3 are given by:
W1 = 114002.67/221515.33 = 0.51, W2= 82048.67/221515.33 =0.37, W3 = 25464.33/221515.33 = 0.12
Thus the equity beta for Petrochemicals =(1.25-0.51*1.41-0.37*1.36)/0.12 = 0.32
As for the risk-free rate, I believe we should still use the same one, as 4.98%.
So the equity cost of Petrochemicals:
4.98% + 0.32*5% = 6.58%
WACC for Petrochemicals:
5.89%* 40% (1-39.7%) + 6.58% (1 – 40%) = 5.37%