Midland Energy Resources

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(d) Equity market risk premium

Although the past data can be used as the reference for the estimated EMRP value for the future, the estimation is with error and is not very relevant to the current economic situation. So, we should combine the historical data and the forecasted data to reach a more reasonable estimation value.

From Table A in Exhibit 6, among all of the average excess returns in the past, the one from 1798 to 2006 is with the smallest standard error and the longest time period. So, we should use this value, which is 5.1% as our first reference number.

Table B gives us three different ranges estimated by researchers. By calculation, we can know that the average number is around 3.6%, which would be the second reference number.

Considering the current estimate of 5% is the result after consultation with professional advisors and Wall Street analysts, we think this number as the third reference.

Combining the three reference numbers above, we decide to use 5% as the estimate for EMRP.

In summary, the cost of equity should be calculated as 0.0498+0.05*1.326=0.1161. The cost of capital of Midland is calculated as 0.066*0.422*(1-0.4)+0.1161*(1-0.422)=8.38%.

3. Hurdle rates

Midland should not use a single corporate hurdle rate for evaluating investment opportunities in all its divisions. Generally, hurdle rate is the minimum required return on a project, which should be larger than the cost of capital.

[pic 1]

rd=rf + Spread re = rf +βe*(EMRP)

According to the WACC equation, capital structure, rating and risk are the main factors that will affect cost of capital, thus affecting hurdle rate in this case.

(1) Capital structure: Each of Midland’s divisions had its own target debt ratio. Targets were set based on considerations involving each division’s annual operating cash flow and the collateral value of its identifiable assets. For example, E&P has assets of oil reserves and higher demand for capital expenditures for development, which increases its D/V ratio to a higher level than other two divisions, thus differing its WACC and hurdle rate.[pic 3][pic 2]

(2)Risk: Three divisions operated in different functions and have different specific risks (political risk, exchange rate risk, etc.), which will have an impact on the various cost of capital. For example, E&P’s productive assets and proven reserves are located in politically volatile countries. All else equal, such properties support less borrowing than might be expected or need higher borrowing rate for certain amount of collateral. Besides, its long-term expected cash flow and collateral value are affected by political risk as well. As for Petrochemical division, because of its overseas investments, it is exposed to exchange rate risk and interest rate risk, which varies Petrochemical’s cost of capital from other divisions.

(3) Rating: Three divisions have different ratings, indicating that they have different risks in their specific industry as well as the spreads to compensate the high risks, so that they will have different (=risk-free rate + spread). Take R&M as the example. R&M operates on small margins that are steadily decreasing, which shows higher risk in R&M division. In that case, R&M has a higher spread to treasury to compensate its higher risk, driving its cost of debt(rd) higher than other two divisions differing in hurdle rate.[pic 5][pic 4]

Single hurdle rate assumes that divisions in the company are financed, operated in a similar way. However, in the Midland case, three divisions have different functions and structures. Using a single hurdle rate would ignore the different risks of different divisions, make mislead evaluation of the investments, cause wrong allocation of funds, thus may increasing the risks of the investments.

Due to the mentioned reason, Midland should create divisional hurdle rates based on division cost of capital (WACC). Also, Midland should adjust WACC depending on the risk and financing methods of each investment project.

4. E&P and R&M divisions cost of capital

To compute the separate cost of capital for the E&P and M&R divisions, we use WACC equation:

[pic 6]

- Cost of debt:

It is computed as the risk-free rate plus the spread of different divisions. Since the E&P and R&M divisions are both exposed to political risks, which is hard to predict in the long term, we use 10-year treasury bond rate as the risk-free risk. [pic 7]

- Cost of equity:

First is to calculate the asset beta for each one of the comparable companies following the equation: [pic 8]

Then take an average of individual asset betas to have the industrial division average asset beta, which for E&P is 0.93 and for R&M is 1.05.

Second, by inputting the division asset beta, D/E ratio, and tax rate of different divisions in the asset beta equation, we can have the cost of equity for industrial E&P is 1.41 and for industrial R&M is 1.33.[pic 9]

[pic 10]

Third, to compute Midland’s cost of equity for E&P and R&M, we follow the cost of equity equation: re = rf +β(EMRP)[pic 11]

- WACC

Given the rd, D/V, re, tax rate, we can compute the WACC following the equation:

[pic 13][pic 12]

The reason why E&P and R&M have different WACCs is that they have different leverage, namely different allocations/weights of debt and equity. In that case, even with the similar cost of debt(rd) and cost of equity(re), due to different allocations/weights of debt and equity, these two divisions have different WACCs. [pic 14][pic 15]

5、Cost of Capital for the Petrochemical Division

To get the cost of capital for the petrochemical, we use the formula for WACC. It is important to calculate the cost of capital and cost of equity respectively. As we can know, the cost of debt equals U.S. Treasury securities for 10 years (4.66%) plus a premium (spread to Treasury for Petrochemicals =1.35%), which is 6.01%.

We

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