Case a Bulter Company

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Beta Asset = β / [1+(D/E) * (1-tax rate)] = 1.25/ [1+59.3% * (1 - 39.73%)] = 0.92

Then, we inserted the newly calculated D/E ratio into the formula to respond to the change of capital structure in 2007. This levering process is showed as follow.

New Equity Beta = Beta Asset * [1+ (New D/E Ratio) * (1-tax rate)]

= 0.92 * [1+ 73% *(1 - 39.73%)] = 1.32

Therefore, re could be calculated as well using the new equity beta and other factors that we already derived from assumptions and other given information.

re = 4.66% + 1.32 * 5.0% = 11.26%

Based on the new debt ratio 42.2%, we can simply fetch the new equity-to-asset ratio by only calculated the difference between 100% and debt ratio. The answer we perceived is thus 57.8%. Consequently, we all the factors been introduced in former process, we can now calculate the WACC of the company after making proper assumptions and adjusting proper capital changes in the future.

WACC = 11.26% * 57.8% + 6.28% * (1- 39.73%) * 42.2% = 8.1%

Actually, based on the historical data that was given in the case, 5% EMRP is not that reasonable since it appears to be slightly lower than the historical average, which amounts to around 6%. Since the economy is fluctuating and getting uncertain, it is reasonable for investors to asked for higher return to compensate for the accumulating risks that they suffer, thus the EMRP should not being even lower than the number in the former years. Moreover, since the company gave more weight to the data that was given by the professional advisors, some faults could be brought out since the number derived can only represent the personal opinions of the advisor, and is far less objective than applying historical data. Therefore, concerning the recent economy and historical data, we would consider the EMRP likely to fall between 6% - 6.5%.

Q3

Q4

In order to find WACC for different divisions, we need o first calculate the cost of debt and the cost of equity. From the information in the Midland Company, we know the cost of debt is equal to the risk free rate plus the spread.

Hence, for E&P, =+spread=4.66%+1.60%=6.26%; for Marketing & Refining, =+spread=4.66%+1.80%=6.46%[pic 7][pic 8][pic 9][pic 10]

Our next step is to calculate the cost of equity. And we tend to use CAPM model which is also mentioned in the case scenario. The CAPM formula if as follows:

[pic 11]

We can still use 10-year Treasury bill rate as. To decide the value of, we should find the appropriate value of and EMRP. Mortensen’s team chose EMRP at 5% after a careful review of recent research and in consultation with its professional advisors. We assumed that they have already taken all possible relevant factors into account. If we look at Exhibit 3, we 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. Then 5.10% is a decent value due to its longest duration and low standard error. Therefore, 5%, the company estimated, is a fit value of EMRP. [pic 12][pic 13][pic 14]

Exhibit 5 provides us with the average for Miland Company, E&P and R&M. Then the cost of equity equation we find the following:[pic 15]

E&P: [pic 16]

R&M: =4.66%+=10.66%[pic 17][pic 18]

What to do next is to compute the D/V and E/V ratios. From Exhibit 4, we are given the D/E ratio for E&P (39.8%) and R&M (20.3%).We will try to use a simple template below to calculate D/V and E/V ratios. Let’s take R&M, whose current D/E ratio is 0.203, as an example.

Step 1: Solution for D (assume E=1 for simplicity)

D/E=0.203

D/1=0.203

D=0.203

Step 2: Solution for V

D+E=V

V=0.203+1=1.203

Step 3: Solution for D/V

D/V=0.203/1.203=0.169

Step 4: Solution for E/V

E/V=1/1.203=0.831

We get E&P’s D/V (0.2847) and E/V (0.7153) in the same way. From above, we know the tax rate calculated from Exhibit 1 is 39.73%.

Consequently, WACC (for R&M) =[pic 19]

=0.1066(0.831) + 0.0646(0.169)(1-0.3973)=9.52%

WACC (for E&P)=[pic 20]

=0.1041(0.7153) + 0.0626(0.2847)(1-0.3973)=8.52%

The calculations above displayed the current weighted average cost of capital incurred through Midland’s current capital structure. However, Midland preferred to optimize its capital structure with targeted D/V ratios that are displayed in Table 1. Accordingly, the associated WACC will also change.

With capital structure changing that they have shown in Table 1, D/V as well as E/V both changed. The potential values are as follows:

D/V(E&P) =0.46 E/V(E&P) =0.54

D/V(R&M) =0.31 E/V(R&M) =0.69

A change in capital structure will also have influences on the WACC rate. For instance, the cost of equity will also change because the calculation for β has some associations with the debt-to-equity ratio. For Midland, we should make their β unlevered firstly and then calculate the leverage β. To calculate the unlevered β，we used the formula below:

[pic 21]

For E&P,[pic 22]

For R&M, =1.07[pic 23]

Next, we need to leverage the unlevered β with the targeted D/E ratio in Table 1.

[pic 24]

For E&P,=1.40[pic 25]

For R&M,