MIDLAND ENERGY RESOURCES

From: Janet Mortenson, Senior VP of Project Finance

Re: Annual Assessment of Cost of Capital
Executive Summary
After a successful fiscal year, Midland’s financial strategy has been directed toward; i)
investing in projects creating value across divisions, ii) funding overseas growth, iii) optimizing
capital structure, and iv) repurchasing undervalued shares. To meet such objectives, it is crucial
to understand the risk or opportunity cost associated with every investment project, which can be
estimated by discounting future project cash flows by the weighted average cost of capital rate.
Here at Midland, we use the cost of capital estimates for various purposes. Since each
division is based in different countries and carry different economic and political risks, using the
same cost of capital estimates across all divisions would indicate that all divisions have the same
systematic risk, which is unlikely. That being said, we have calculated individual cost of capital
for the entire firm and each division, based on target debt to value ratios and the systematic risk
each division faces, as well as the debt-to-equity composition representing the financial risk each
division bears. Doing so will present a more accurate representation of Midland’s cost of capital
at each business unit level, while also ensuring the viability of our financial strategy.

Key Issues and Decisions

The key issue at hand is whether one single firm-wide estimate of cost of capital would
be sufficient in determining the rate of return Midland earns on different investment projects and
the return lenders and shareholders expect in return for providing capital across the three
different business divisions This is not practical due to the fact that each of the divisions carry
different characteristics. Instead, we are pushing for three separate divisional WACC estimates.
Some factors to consider include, economic stability, comparable industry cost of capital, and the
size of the division. Using one single cost of capital estimate would fail to consider each
division’s unique capital structure and nature of assets. Thus, the creation of divisional WACC
estimates will more reliably present the risk and rewards associated with each division. If
proceeding with divisional rates, one of the most important issues and decisions is determining
which comparable companies to use when comparing the risk of a division relative to the market.

Quantitative Analysis
The following assumptions are consistent across all calculations for WACC:
1. The corporate tax rate is assumed to be 38.58% (same rate that Midland faced in 2006).
2. The 10-year maturity security is used as the risk-free rate of 4.66% for calculating the
cost of debt, since Midland’s borrowing capacity is inherent in its energy reserves and in
long-lived productive assets. The 10-year rate is most applicable as only 1-year is far too
short and 30-years may be too long under-valuing the risk-free rate.
3. The market risk premium to be used is 6% for 2007 based on historical data and
expectation of a growth among the company’s divisions. This represents the premium of
taking on the inherent risk of the market beyond the risk-free rate. In the prior year a
market risk premium of 5% was used, however higher rates have been used in the past.
4. The target Debt-to-Equity ratio from Table 1 will be used for calculations of corporate
and divisional levered beta. This is because we want to calculate the risk going forward
and the target ratios best represent the expected future capital structure.

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 In calculation of the corporate and divisional WACCs, the cost of debt is calculated by
adding the spread of treasury for each division (Table 1), over the 10-year maturity U.S. Treasury
security risk-free rate (Table 2). To find the cost of equity, the corporate and divisional beta’s
should be first determined. The equity beta is calculated by relevering the unlevered beta (see
Exhibit 5) with the target D/E ratio for each division. While Midland’s equity beta is provided,
E&P and R&M divisions are supported by comparables. Out of the four comparable companies
for E&P division, only Wide Palin Petroleum had a considerably close D/V ratio of 46% and
profit margin of 48%, all other companies had drastically different capital structures and lower
profit margins, and were thus excluded (see Exhibit 2a and Exhibit 4). The equity beta for R&M
is determined by taking the average of the equity betas from the top 3 companies within a list of
publicly-traded companies deemed comparable to the R&M division. Rather than taking the
average of all the companies’ equity betas, we selected a top 3 based on the most similar
debt-to-equity composition and/or profit margin (see Exhibit 3a). With the calculated re-levered
equity beta for each division and the given 10-year maturity risk-free rate, we are able to find the
cost of equity of each division using the CAPM model. The calculated cost of equity and cost of
debt values contributes to the WACC formula and calculation for each division, where: Midland
has an equity beta of 1.36 and a WACC of 9.03%; the E&P division has an equity beta of 1.21
and a WACC of 8.20%; the R&M division has an equity beta of 1.26 and a WACC of 9.67%. As
both the corporate and divisional beta are above 1, which indicates that the corporation and all its
divisions are more volatile than the market. In comparison, the R&M division has the highest
WACC across the corporation.

Qualitative Analysis
With comparisons from our analysis, Petrochemicals generates the lowest WACC and
R&M has the highest. This implies the fast growth in the petrochemicals division and lack of
growth in R&M, as lower WACC indicates the division has a relatively higher revenue which
reduces its needs of debt and borrowings, meaning a lower cost of debt. Thus, it is suggested that
Midland takes advantage of the low cost of debt of petrochemicals to help boost the growth in
R&M. In summary, it is suggested that a single corporate-wide WACC should not be imposed
across all divisions. Each division is composed of a different debt and equity structure and
contains its unique set of economic and political risks since the divisions are based in different
countries. Therefore, using a single WACC would misestimate the firm’s projections and mislead
on evaluations and decision-makings on investments, which can hurt the corporate’s performance
and profit. For Midland Energy to achieve its financial goals, it is crucial for Midland to
construct investment strategies that considers the cost of capital of each division and must
continuously re-evaluate the strategies against the ever-changing plans and circumstances.

Reasoned Recommendation
Based on the analysis performed, I recommend moving forward with a WACC for each
division. This best reflects the risk each division faces based on their debt structure, profit
margins, divisional growth among other factors. Midland Energy would require a rate of return
of 9.03% (see Exhibit 1). Whereas, the E&P division would have a required rate of return of
8.20% (see Exhibit 2) and R&M 9.67% (see Exhibit 3), while PetroChem would be lower than
all three. If we applied a firm-wide rate to a project in E&P we would over-value the required
rate of return, vice-versa for R&M. This could lead to decisions to take or avoid projects within
divisions because a WACC that does not reflect the division.

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 Key areas of risk and uncertainty need to be acknowledged when making a final decision.
First, all rates were projected using the target Debt-Value ratios discussed with division heads. If
the projected proportion of debt by a division changes this changes the inherent risk of the
division. More debt can decrease the risk. Furthermore, the division's risk relative to the market
cannot be measured precisely like the firm since they are not traded on an open-market. To
mitigate this risk we evaluated comparable companies based on their capital structure and profit
margins to select the most accurate comparables.
It is important to understand that using divisional rates can create disagreement between
divisions. One division may question “Why is our division riskier than that division” or “Why
are more projects being taken under a different division”. However, I would like to emphasize
that these rates are strictly based on the structure of debt the division undertakes, the risk of the
comparable companies compared to the market, and the spread of the debt.

Conclusion & Discussion

i) What would WACC be for PertroChem:
To calculate the WACC for the Petrochemicals division, we need to determine its equity
beta. However, there are no comparable companies, we would calculate its beta based on the
weighted average of the three divisions, where w1, w2, w3 are the weight of each divisional
asset out of Midland’s total asset. From Exhibit 3, Petrochemicals’ assets are only 10.84% of the
total assets in 2006, which suggests that the beta for petrochemicals would be relatively lower
than the other two divisions. Petrochemicals has a similar debt value and spread to treasury with
Midland and other divisions based on Table 1, therefore, as it has a lower beta than Midland and
the other two divisions, the WACC for Petrochemicals would also be lower than in relation.

ii) Manager of the Petrochem reaction to Single firm-wide WACC:

Considering that the Petrochemicals division is Midland’s smallest, yet most promising
and undervalued division, it not only maintains a completely unique capital structure among the
rest of the divisions, but also entails a substantially lower amount of risk associated with its
operations. That being said, as the manager of the Petrochemicals division, I would disagree with
implementing a firm-wide WACC as it would essentially be overstated. This would, in turn,
overstate the discounted cash inflows from investment projects, while also overstating the risk
associated with the division, increasing the rate of return lenders will demand for providing
capital. Overall, this would be bad for our financial strategy as an overstated divisional WACC
will diminish the opportunity for Midland to take advantage of their low cost of capital to
increase/sustain anticipated growth in the Petrochemicals division, interfering with their ability
to compensate for the steady decline in growth observed in the Refining & Marketing division.
iii) Unlevered Beta Equation Used:
You will see I used the equation to unlever beta, the risk of the firm or division relative to
β𝐿
the market, using the formula; β𝑈 = (1+𝐷/𝐸) . You may know that there is another formula that
β𝐿
is also acceptable for unlevering a beta; β𝑈 = [1+(1−𝑇𝑐)𝐷/𝐸]
. The second equation is more
commonly used when setting a fixed amount of debt in perpetuity. This would mean that the
amount of debt would be fixed and the Debt-Value ratio would fluctuate each year. That is
ultimately why the first equation was used since we are assuming a fixed Debt-Value ratio going
forward based on discussions with each division.

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 Appendix

Exhibit 1: Firm-Wide WACC Calculation

Exhibit 2: E&P WACC Calculation

Exhibit 2a: Comparable Company to E&P

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Exhibit 3: R&M WACC Calculation

Exhibit 3a: Comparable Companies to R&M Division

Exhibit 4: Divisional Profit Margins