MIDLAND ENERGY RESOURCES INC., COST OF CAPITAL Case Solution

Question 2 (10 Points)

Estimate the WACC for 2007 for Midland on a consolidated basis (i.e. for the entire firm). Be careful to describe and justify your assumptions as well as any adjustments that you have made.

            There are certain assumptions which have been made in order to calculate the WACC for the Midland Company as a whole. These are:

  • The corporate tax rate has been calculated to be 40% by taking average of the tax rate for the years 2004 to 2006.
  • The cost of debt for the company has been calculated as the 10 year treasury rate for US bonds plus the spread on the treasury. The cost of debt is 6.28%.
  • 10 year rate has been used because the borrowing capacity of the company is based upon the energy reserves and the long lived assets for the company.
  • The market risk premium suggested by company analysts is 5%. However, recent projections for MRP are 6.4% and the average of the historical MRPs is also 6%.
  • The current levered beta of 1.25 for Midland has been de-levered and then re-levered on the basis of the 73% target debt to equity ratio. The levered beta is calculated to be 1.33. The target debt to value ratio is 42%. Finally, using the formula for the weighted average cost of capital and all the above assumptions the WACC for Midland is calculated to be 8.90%. The calculations are shown below:
MIDLAND’s WACC
Average Tax Rate 40%
Risk Free Rate 4.66%
Spread to Treasury 1.62%
Before tax cost of debt 6.28%
Levered Beta 1.25
Debt/Equity 59%
Unlevered Beta 0.922
Target equity capital structure 58%
Target debt capital structure 42%
New debt/equity ratio 73.0%
New equity beta 1.33
Market risk premium (given) 5%
Cost of Equity 11%
WACC 8.90%

Questions 3 (15 Points)

Estimate a separate WACC for the E&P division as well as for the Marketing & Refining division for 2007. Be careful to describe and justify your assumptions as well as any adjustments that you have made. Please include a table outlining your calculations in your write-up.

            Most of the assumptions which have been made to calculate the WACC for the entire firm have also been used here similarly. For instance, the tax rate is assumed to be 40%. The market risk premium is taken to be 6% and the risk free rate of 10 year treasury of 4.66% has also been used in the same way to calculate the cost of equity of both the divisions.

            First of all, the average equity beta for both the divisions has been taken from exhibit 5 which are 1.15 and 1.20 respectively. Then using the target debt to equity ratio for both the divisions the new levered beta for both the divisions has been calculated. The target debts to capital ratio for both the divisions are 46% and 31% respectively. The new levered equity betas for both the divisions are 1.54 and 1.94 respectively. The cost of debt has been again calculated by adding the spread over the treasury to the risk free rate for each of these two divisions………………….

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