Midland Energy Resources Inc - Case Study

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Petrochemical’s cost of capital

In order to calculate the cost capital for the petrochemical division, we should find out the relevant β and D/E ratio. For this case, we can use Exhibit 5’s available data with arithmetic averages to compute the cost of capital for petrochemical division.

Corporate β = (E&P β + R&M β + petrochemical β) / 3 = (1.15 + 1.20+ petrochemical β) / 3 = 1.25 Petrochemical β = 1.40[pic 3]

rd = rf + E&P Spread to Treasury = 4.98% + 1.35% = 6.33%

re = rf + β (EMRP) = 4.98% + 1.40 × 5% = 11.98%

Corporate D/E = (E&PD/E + R&MD/E + petrochemical D/E) / 3 = (39.8% + 20.3% + petrochemical D/E) / 3 = 59.3%

Petrochemical D/E = 117.8% D/V =54.09 %, E/V =45.91 %[pic 4]

WACC = rd (D/V) (1-t) + re (E/V) = 6.33% × 54.09% × (1-40%) + 11.98% × 45.91% = 7.55%

Conclusion

In order to estimate of Midland’s cost of capital, Mortensen’s analysis include asset appraisals for both capital budgeting and financial accounting, performance assessment, M&A proposals and stock repurchase decisions. Some analysis were at division or business unit level, while others were executed at the corporate level. If the projects have the same average risk, these anticipated uses should not affect the calculation and vice versa.

Lastly, it is not appropriate for Mortensen to use a corporate single hurdle rate to evaluate investment opportunities in each division, because each division has different level of risk that is obviously in the Exhibit 5. As the risk is different per division, the hurdle rates for them should also be different and calculate based on its own situation. If Midland use the single corporate hurdle rate in all three divisions, it will get the wrong evaluation of investment and make wrong decisions for the company, even leading to the whole company into risk.