Midland Energy Resources, Inc.

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Re=Rf+Beta(Rm-Rf+CRP)

Due to the lack of information, we do not know which overseas country Midland Energy invested in. So we are not able to cannot take this factor into further consideration. Nonetheless, we should take the country risk premium into consideration if we had the information.

WACC

In this case, Mortensen’s primary calculates the WACC based on the following formula.

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The key assumptions are mentioned before:

- For consolidated, D/V = 42.2%, E/V=1-D/V=57.8%.

- We Assume the tax rate is the average rate generated from 2004-2006, therefore we got t=41.40%+39.21%+38.48%)/3=39.73%.

- and are mentioned before, which are 6.28% and 10.91% separately. [pic 5][pic 6]

Therefore, applying all the information into the formula, we got (See table 2):

WACC= 6.28%*42.2%*(1-39.73%)+10.91%*57.8%=7.9%

Use single hurdle rate or not?

After we estimate the WACC of the whole corporate, we can use the formula Hurdle Rate = Cost of capital *(Callable annuity rate/ Risk free rate) to get the Hurdle Rate of the corporate. Since Hurdle rate is very helpful regarding the investment decision, we believe that we shall use different hurdle rate when assessing different investing opportunities for these three divisions.

Hurdle rate is a rate higher than the cost of capital and is utilized in investment timing. If the NPV of one project is positive when employing hurdle rate as discount rate in calculation, the company would not wait but to implement it as soon as possible. Hurdle rate is a determinant when firms are confronted with uncertainty of one investment opportunity. In this case, we could know that it would be better if we can calculate the hurdle rate for each division of the company as this would help them make better investment decision.

In the material, it claims that the three divisions of this company each has different outside environment and is with different business characteristics. The Exploration & Production division has the highest net margin for the last five years in the industry. In addition, the continued global population and economic growth indicates a rise in the demand for products of Exploration & Production department. While Refining and Marketing division is confronted with fierce competition, leading to a relative small and decreasing margin. The revenue of this division is almost ten times of E & P’s, but the after-tax earning of R & M is only one third of E & P’s. As for the Petrochemicals division, it has interests in equities around the world, which, results in a country spread of risk. Given the current situation, Midland is determined to invest heavily in E &P and Petrochemicals, boosting the development of these two promising divisions. It is very likely that they differ in cost of capital and thus have different hurdle rates. A tailored hurdle rate for each division can improve their decision making by capturing the good timing and screening bad projects. So we reckon it is necessary to find the cost of capital for each division in order to find the appropriate hurdle rate for them.

Cost of Capital of E&P and R&M

In order to calculate cost of capital for E&P and R&M, we apply the same formula as we calculate the corporate WACC:

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where rd is the division th adjusted by adding spread from U.S. Treasury bond; D/V is the division weight of debt; t is the tax rate; re is the division cost of equity and E/V is the division weight of equity. For tax rate, we use the calculated t=39.37%. For D/V we use the data from the Mortensen’s estimates for D/V value for 2007. E/V can be simply derived from 1-D/V. Thus we have t=39.39%, D/V for E&P and R&M are 46% and 31% respectively, and E/V for these two divisions are 54% and 69%.

To estimate rd, we are using the data from Mortensen’s preliminary estimates of spread to Treasury for 2007. Spread to Treasury for E&P division and R&M division are 1.62% and 1.8% respectively. Since we are using the 10-year U.S treasury bond 4.66%, the cost of debt for E&P is 4.66%+1.6%= 6.26% and cost of debt for R&M is 4.66%+1.8%=6.46%.

To estimate cost of equity, as we know the cost of equity re = rf+Beta(EMRP), we cannot simply apply the same corporate cost of equity because we can apply the same corporate beta. The reason behind this is that a specific division is not represented by a public traded company, so we cannot apply the same beta directly. Thus, when we estimate the division beta we need to use a method so called pure-play-method, which is a process that to estimate division beta based on the equity beta of public firms that are engaged in similar business with similar risks to those of the division under consideration, so that theses companies are comparable to the division. A firm’s beta not only indicates its business risks but also its financial structure. The higher the company’s reliance on debt, the higher its equity beta is. Thus, when we use pure-play-method to estimate the division beta we need to adjust the beta from the comparable companies for the companies’ leverage and then re-lever it based on the division’s financial structure.

According to the provided comparable companies equity beta and D/E for E&P, we did not take the simple average of the equity beta, instead, we calculate each firm’s unlevered beta using this formula:

Unlevered Beta=Equity Beta[1/(1+(1-t)D/E)],

where D/E is the debt to equity ratio of each comparable company, and then take the average from it. Thus, we have the average unlevered beta for comparable companies for E&P equals 0.93. (See table 3 ) And then we adjust it based on the financial structure of E&P using the following formula:

Relevered Beta=Unlevered Beta*[1+(1-t)*D/E)],

where D/E is the debt to equity ratio of E&P, which equals 89.19%. Plugging all the number to the above formula we get, relevered beta of E&P equals 0.93*[1+(1-t)* 89.19%.)]=1.41. Applying the same method, relevered beta of R&M is equal to 1.33. We then can use these two betas to calculate the cost of equity of the two divisions. According