Midland Energy Resources Inc.

KEY
WAC
C
rd
re
rf
Sprea
d
EMRP

Cost of Capital
Cost of Debt
Cost of Equity
Risk Free Rate
Spread to Treasury
Market Risk
Premium
Debt
Equity
Value
Taxes
Economic Value
Added
Net Operating
Profit After Taxes
Market Value
Operating Income
Long Term Debt

Midland Energy Partners

Andrew Picone
Will
McDermott
Taylor Appel
Liam Joy

Purpose of the Case

The purpose of the Midland Energy Resources
D
case is to determine the Weighted Average Cost
E
of Capital (WACC) for the company as a whole,
as well as each of the companys divisions. This
V
is done as a part of the annual capital budgeting
T
process the company must go through. To find
EVA
the WACC for the company and its divisions, we
needed to first calculate the cost of debt and the
NOPA
cost of equity. In calculating the cost of debt, we
needed to determine the appropriate risk free
T
rate whereas for calculating the cost of equity, we
MV
needed to determine whether to use the Dividend
OI
Discount Model or the Capital Asset Pricing
LTD
Model (CAPM). In addition, we needed to
determine an appropriate Equity Market Risk Premium (EMRP), as well as appropriate
betas to use; some of which required taking out the debt (un-levering) and then adding
back the debt (re-levering). Following these calculations we needed to calculate the
appropriate tax rate for the company. To wrap this up, we needed to analyze the given
market values of debt and equity in order to calculate the enterprise value of the
company and use them to find the ratios of debt to enterprise value (D/V) as well as
equity to enterprise value (E/V). With all of that information we then had to calculate the
WACC for both the company and its divisions and answer the following questions:
1. How are Mortensens estimates of Midlands cost of capital used? How, if at all,
should these anticipated uses affect the calculations?
2. Calculate Midlands corporate WACC. Is Midlands choice of EMRP appropriate?
If not, what recommendations would you make and why?
3. Should Midland use a single corporate hurdle rate for evaluating investment
opportunities in all of its divisions? Why or why not?
4. Compute a separate cost of capital for the E&P and Marketing & Refining
divisions. What causes them to differ from one another?

5. How would you compute a cost of capital for the petrochemical division?
Background on Midland Energy Resources
Midland is a global energy company with operations in oil and gas exploration and
production (E&P), refining and marketing (R&M), and petrochemicals. The company
was incorporated over 120 years ago and as of 2007 it has more than 80,000
employees. In 2006, the companys operating revenue totaled $248.5 billion, with
operating income totaling $42.2 billion. Starting in the early 1980s, Midlands corporate
treasury staff started preparing annual cost of capital estimates for the company and its
divisions. The estimates included asset appraisals for both capital budgeting and
financial accounting, performance assessments, M&A proposals, and stock repurchase
decisions. These estimates, however, were often criticized, with the assumptions and
inputs questioned by Midlands divisions presidents and controllers. Starting in 2002,
Janet Mortensen, a senior analyst, prepared estimates of Midlands cost of capital in
connection with a large proposed share repurchase. Soon after she was asked to
calculate both corporate and divisional costs of capital that would be incorporated in
planned performance evaluations. She has since been calculating these estimates
every year, but has recently questioned whether the calculations are appropriate for all
applications.

Midlands Divisions
Exploration and Production
Exploration and production is Midlands most profitable division, with after tax earnings
of $12.6 billion. In 2006, the company extracted roughly 2.10 million barrels of oil per
day and roughly 7.28 billion cubic feet of natural gas per day. Midland expected demand
for their products to increase in the future due to global population increase and
economic growth. As a result, they increased production from deep-water drilling, heavy
oil recovery, liquefied natural gas, and arctic technology. Their capital spending in E&P
is expected to exceed $8 billion in 2007 and 2008.
Refining and Marketing
Refining and Marketing is Midlands second most profitable division, with after tax
earnings totaling $4 billion. This division had the largest revenue, however, out of their
three divisions, with global revenue in 2006 totaling $203 billion. Most of Midlands
refinery output was gasoline, sold as fuel for automobiles. Thanks to Midlands
advanced technology and vertical integration, the company has the manufacturing
capacity to produce 120,000 barrels of base-stock lubricants per day. As a result, they
have become a market leader in this business. Due to historical trends of low and
shrinking margins and increased difficulty obtaining approvals for refinery expansions,
Midlands capital spending in this division is projected to remain stable in 2007 and
2008.
Petrochemicals
Petrochemicals, Midlands smallest division, was their least profitable division, with
after-tax earnings totaling $2.1 billion. With ownership/interests in 25 manufacturing

facilities and five research centers around the world, this division produces a myriad of
chemicals, aromatics, and fuel and lubricant additives. Capital spending is expected to
grow in the near-term due to facility upgrades and new facility purchases to increase
capacity efficiency.
In order to make the calculations for Midland Energy Resources current Capital
Structure we needed to find the individual components that make up that computation:
Cost of Debt (rd), Cost of Equity (re), the Equity to Value ratio (E/V), the Debt to Value
ratio (D/V), and finally the tax rate of the firm. Before getting into these individual
calculations however we want to stress the importance of the WACC. For example, say
the company was debating implementing a new project in its Exploration & Production
division and wanted to know if the project would bring value to the firm. In order to make
this decision, it would not make sense to use the Corporate WACC, but instead we must
find the individual WACC for the E&P division. The same would apply for all other
divisions, and so it is essential that we calculate the WACC not just for Corporate, but
also each of our individual divisions in the case that this situation arises.
So, to dissect the WACC formula lets begin with Corporate. In order to calculate the
Cost of Debt of the firm we look at its formula: rd = rf + spread. When analyzing the risk
free rate, we decided to choose 4.98%. As represented in Exhibit 1 this rate
corresponded to a yield to maturity on US Treasury bonds of 30 years. Our underlying
reason for choosing this is merely because it represented the longest duration.
Assuming we chose a project for Midland Energy Corporate, or one of its divisions, the
duration of that project would assumedly be lengthy and thus this rate would be the
safest and most accurate assumption. Moving on now to the other aspect of our
equation we need to find the spread. As displayed in Exhibit 2 we were given unique
spread to treasury for the consolidated business as well as each division. Thus now
putting together our whole formula we come up with a cost of debt equal to the
following:

Corporate
E&P
R&M
Petro

rd=rf+sprea
d
rd=rf+sprea
d
rd=rf+sprea
d
rd=rf+sprea
d

rd=4.98%
+1.62%
rd=4.98%
+1.60%
rd=4.98%
+1.80%
rd=4.98%
+1.35%

rd=6.6%
rd=6.58%
rd=6.78%
rd=6.33%

The next aspect of the WACC formula we need to look at is the Cost of Equity. Again
dissecting this formula requires the risk free rate, which as we just explained above was
4.98%. This number will hold throughout the duration of this project. Moving on to the

next part of this equation is finding the EMRP and the Beta. First lets start with the
Beta. If you look at Exhibit 3 you will find a variety of Market Risk Premiums available
based on historic US stock returns minus Treasury bond yields as well as market risk
premium survey results from Researching Companies. Out of all the options available
we chose 5.10% as our EMRP due to it having the longest period of time as well as a
low standard error. In addition, this EMRP will remain constant throughout all necessary
calculations.
So now looking at Beta. Exhibit 4 displays the Beta for Corporate, E&P and R&M, but
fails to provide us with the Beta for our Petro division. To make the most accurate
decision, we took the average between our other two divisions (1.20 and 1.15) to
calculate a projected beta of 1.18 (rounded) for our Petro division. So now, putting the
Cost of Equity equation together we find the following:

Corporate
E&P
R&M
Petro

re=rf+B(EMRP
)
re=rf+B(EMRP
)
re=rf+B(EMRP
)
re=rf+B(EMRP
)

re=4.98%
+1.25(5.10%)
re=4.98%
+1.20(5.10%)
re=4.98%
+1.15(5.10%)
re=4.98%
+1.18(5.10%)

re=11.36%
re=10.85%
re=11.10%
re=11..00%

Now that we have fully calculated the Cost of Equity and the Cost of Debt for Corporate
as well as each of our divisions the only task that remains to find each individual WACC
calculations is to calculate the tax rate of Midland Energy and then calculate both the
D/V and E/V ratios. Lets look at taxes first. To most accurately calculate the taxes of
Midland Energy we need to find the average Tax Rate over the course of its years.
Looking at Exhibit 5 we are provided with the companys Income Statement for years
2004, 2005, and 2006. Under each statement we are provided with two very important
pieces of information to help calculate each years Tax Rate; Income before taxes &
Taxes. To find each years tax rate we only have to divide the taxes by the income
before taxes. Once we have each individual calculation we can average them out over 3
years to find the tax rate we project for our WACC calculations. See calculations below.

2004
Taxes/Income
Before Taxes
Tax Rate

=
$7,414/$17,91
0
=41.40%

2005
$12,830/$32,7
23

2006
$11,747/$30,4
47

=39.21%

=38.58%

Midlands Tax
Rate

(41.40% + 39.21%
+38.58%)/3

=39.73
%

Now that we have the tax rate of Midland Energy we just need to compute the D/V and
E/V ratios. Taking a look back at Exhibit 4 we are given the D/E ratio for Corporate, E&P,
and R&M; not the Petro division. Similar to how we previously calculated the beta of the
Petro division, we took up a similar tactic, calculating the average D/E ratio between
both our R&M and E&P division, (20.3% and 39.8%) giving us a D/E ratio of 30.05%.
Now that we have the D/E ratio for each firm we can start to calculate both the D/V and
E/V ratios by creating an algebraic assumption. We will provide an example for
Corporate below, explaining each step along the way.

Corporate
*Known: Firm has a current D/E ratio of 0.593
Step 1: Solve for D (assume E=1 for simplicity)
D/E = 0.593
D/1 = 0.593
D = 0.593

Step 2: Solve for V

D+E=V
0.593+1=1.593

Step 3: Solve for D/V

*We now know both D and V under our simplified assumptions
D/V = 0.593/1.593
D/V = 0.3722

Step 4: Solve for E/V

*We also know E and V under our simplified assumptions

E/V = 1/1.593
E/V = 0.6277
Now that we know how to calculate both the D/V and E/V ratios we can follow the same
step by step logic and apply it to each division. Below see D/V and E/V ratios for each
division.

D/V
E/V

Corporate
37.23%
62.77%

E&P
28.47%
71.53%

R&M
16.87%
83.13%

Petro
23.11%
76.89%

Now that we have all of the components we can calculate the WACC of Corporate as
well as our divisions: E&P, R&M, and Petro. We start by looking at our formula and
plugging the appropriate data in. See calculations in table below.

Corpora WACC=re(E/V)
te
+rd(D/V)(1-T)
E&P
WACC=re(E/V)
+rd(D/V)(1-T)
R&M
WACC=re(E/V)
+rd(D/V)(1-T)
Petro
WACC=re(E/V)
+rd(D/V)(1-T)

=.1136(.6277)+.0660(.3723)
(1-.3973)
=.1085(.1687)+.0658(.8313)
(1-.3973)
=.1110(.2847)+.0678(.7153)
(1-.3973)
=.1100(.2311)+.0633(.7689)
(1-.3973)

=8.61
%
=8.89
%
=9.92
%
=9.34
%

The calculations displayed above represent the current weighted average cost of capital
incurred through Midland Energy Corporate and each of divisions based on its current
capital structure. However, as requested from the company, Midland would prefer to
operate under a new capital structure with targeted D/V ratios that are displayed in
Exhibit 2. We will now address their new structure and the associated WACC
calculations that will be incurred due to these changes.

As we mentioned earlier, Midland Energy was exploring the option of a capital structure
change. When debating a change in capital structure, there are a number of factors that
need to be considered, such as:

An increase in debt means a higher risk of bankruptcy

Firms can deduct interest expenses
Debt holders have prior claims on cash flows compared to stockholders

Additional debt can affect the behavior of managers

Net effect on WACC?

In this case, Midland Energy was determining the net effect of an increase in their D/E
ratio on their WACC. Midlands goal was to decrease their Weighted Average Cost of
Capital throughout all divisions and as a corporation. You can see their current and
potential values below:

A change in capital structure has a number of effects on the WACC rate. The cost of
equity for instance, is tied to a companys debt levels. The cost of equity or r e=rf+
(EMRP) changes with different capital structure allocations because part of the
calculation for Beta contains the debt-to-equity ratio. For Midland, we had to first get
their unleveraged beta or their beta without debt, and then calculate the leverage beta
with capital structure changes. To calculate the firms unleveraged beta we used the
formula below:
D
BU = BL/(1+(1-T)*( E )
We used the Betas and debt-to-equity ratios determined earlier for each division and the
firm as a whole, to strip out the debt. Below are the calculations and unleveraged beta
for each division:
.37

Corporate: 1.25/(1+(1-.3973)*( .63 ) = 0.92

..28

E&P: 1.15/(1+(1-.3973)*( .72 ) = 0.93

.17

R&M: 1.2/(1+(1-.3973)*( .83 ) = 1.07

.23

PETRO: 1.18/(1+(1-.3973)*( .77 ) = 1.00

Now we had to leverage the unleveraged beta with the changed capital structure from
the chart above. The formula and calculations for leveraging the unleveraged beta are
below:
.42

Corporate: 0.92*(1+(1-.3973)*( .58 ) = 1.32

.46
E&P: 0.93*(1+(1-.3973)*( .54 ) = 1.40
.31
R&M: 1.07*(1+(1-.3973)*( .69 ) = 1.36
.4

PETRO: 1.00*(1+(1-.3973)*( .6 ) = 1.38

We then plugged the new leverage Betas into the formula for the cost of equity and as
you can see from our chart below, the WACC dropped for each segment.

WACC Comparison
10.50%

9.91%

10.00%
9.50%
WACC with Current Structure
9.00%

8.88%

9.48%
WACC with
Capital Structure Change

8.61%

8.50% 8.46%

9.37%
8.74%

8.38%

8.00%
7.50%
Corporate

E&P

R&M

PETRO

Given the data, we would recommend that Midland Energy make the capital structure
change.
When building the excel file to make these calculations, we made the file dynamic so
that we could play with the capital structure to see how it changed the WACC and make
our own recommendation. After playing with the ratios for a little while, we realized that
the higher the debt-to-equity ratio, the lower the WACC. In the real world, debt is
cheaper than equity up to a certain point. The cost of debt should become higher once
the debt ratio of a firm reaches a certain level. Unfortunately, with the information given
to us by the case, we were not able to add this element. Most companies have a debt

ratio of 25%-50%, so we recommended Midland have a debt level of 50% given the
information from the case. With this 50% debt level or D/E ratio of 1, the resulting
WACC rates are:

Corporate WACC = 8.24%

E&P WACC = 8.26%
R&M WACC = 8.90%
PETRO WACC = 8.48%

To expand further on potential determining factors that would allow Midland to decide
whether or not to implement a project to their company we could address how the
particular project would impact the companys Economic Value Added (EVA). To
calculate this we need NOPAT, the WACC, and Invested Capital. The EVA equation is
displayed below along with the individual equations for each component. We will be
looking at Exhibit 6 to calculate NOPAT, and Exhibit 7/Exhibit 8 to calculate Invested
Capital. Then we will use the above WACC and Tax Rate calculated under Midland
Energys Ideal Corporate Cost of Capital Structure.
To refresh your memory (WACC = 8.24%, Tax Rate = 39.73%)

EVA = NOPAT (WACC) (Invested Capital)

NOPAT = OI (1-T)
Invested Capital = MV Equity + Net Debt
MV Equity = Po x # Shares Outstanding
Net Debt =
Long Term Debt
-Current Portion Long Term Debt
+Cash & Cash Equivalents
+ Restricted Cash
Placing these formulas together in the following table we calculate the EVA for Midland
Capital. Please consider all information provided throughout this case thoroughly before
making the decision to implement a project or not.

NOPAT

OI (1-T)

$42,243(1-.3973

$25,459.86

)
WACC
MV Equity
Net Debt

EVA

Po x # Shares
Outstanding
LTD-Cash

NOPAT-(WACC)
(MV Equity +
Net Debt)

$44.11 x 2951
($20,767+
$81,078)($19,206 +
$3,131)
$25,459.86
(0.0824)
($130,168.61 +
$79,508)

0.0824
$130,168.61
$79,508

$8,184.82

Appendixes
Exhibit 1

Exhibit 2

Maturity

Rate

1 Year

4.54%

10 Year

4.66%

30 Year

4.98%

Exhibit 3

Exhibit 4
Exhibit 5

Exhibit 5

Exhibit 6

Exhibit 7

Exhibit 8