Discussion notes

Midland Energy Resources Inc- Cost of capital

Factors affecting the cost of capital

Capital structure policy

Dividend policy
Investment policy

Uncontrollable factors affecting the cost of capital

Level of interest rates
Level of tax rates

Question 1: How are Mortensens estimates of Midlands cost of capital used? How, if at all,
should these anticipated uses affect the calculations?

Strategies

Uses of cost of capital

Asset appraisals for capital budgeting and financial accounting Help in

achieving the strategy using the cost of capital to invest in value creating
projects For example, you are doing an investment in short term project.
You may use short term rates for debt/risk free rate and risk premium. To that
extent, the calculations will vary. Calculations also vary based on the risk of
the project. If the project is risky, you may choose a higher COC
Performance assessments- cost of capital depends on the DCF which is
related to the performance of the company. Rates vary depending the length
of the going concern assumption and other factors use of debt free cash
flows discounted at cost of equity. Beta is dependent upon the stock prices.
Capital structure. Divisional EVA. Evaluation of EVA
M&A proposals-
Stock repurchase plans

Question 2: Reasons for choosing ERMP

5.1% Chosen due to longest period and lowest standard error. This is used at the
corporate level and across various divisions. 5% is not selected since there is no
basis behind the same and it cannot be chosen due to analyst estimates.

Question 3: Should Midland use a single corporate hurdle rate for evaluating investment
opportunities in all of its divisions? Why or why not?
Why to use different hurdle rates

Beta is different for different divisions, risk profile is different for different
divisions
They have different credit ratings
Hurdle rate is different for different divisions
Should not use a single hurdle rate as it will mislead the evaluation of
investments and will result in Midland investing in risky projects which is risky
in the perspective of the corporate nature
They have different target debt/equity ratio and different weights, different
target capital structure
CF/revenues and different collateral value of identiable assets

4. Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What
causes them to differ from one another?

The various business units operate on different industries

They have different risk profiles and different beta
They have different credit ratings

Therefore it is appropriate to calculate cost of capital for each if its divisions

5. How would you compute a cost of capital for the Petrochemical division?

No data given form the beta and the D/E related to the petrochemical
companies
Using the data available on exhibit 5, we decided to use arithmetic averages
on D/E ratio and beta to calculate the cost of capital for the petrochemical
division.

Corporate Beta= Average (E&P beta, R&M Beta, petrochemical Beta)

Corporate Beta= Average (E&P D/E, R&M D/E, petrochemical D/E)
Effect of change in the capital structure

An increase in the debt means higher risk of bankruptcy

Firms can deduct interest expense
Debtholders have prior claims on cash flows as compared to stockholders
Additional dent can affect the behavior of managers
Net impact on WACC-
Details of the divisions of Midland
Exploration and production:
Questions for the case discussion posted in D2L

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. Be prepared to defend your specific assumptions

about the various inputs to the calculations. 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?