Midland Energy Resources Case Study

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Because the consolidated credit rating is A+, we assume debt is zero. Asset is[pic 19][pic 20]

[pic 21]

[pic 22]

[pic 23]

So, the target WACC is:

[pic 24]

2.3 EMRP choices

The EMRP assumption Midland used is based on consultation of professional advisors. Even though historical data supported higher estimates of the EMRP and survey results suggested lower figures, we think that the professional advisors such as bankers, auditors and Wall Street analysts covering the industry has more information and better knowledge of the company. Therefore, their estimation is appropriate.

We also conduct a scenario analysis for the WACC calculation. When the EMRP changes from 3.0% to 7.5%, both the actual and target WACC increase.

Actual

Target

EMRP

Cost of Equity

WACC

Cost of Equity

WACC

3.00%

8.41%

6.74%

8.64%

6.65%

3.50%

9.04%

7.13%

9.31%

7.03%

4.00%

9.66%

7.52%

9.97%

7.41%

4.50%

10.29%

7.91%

10.64%

7.80%

5.00%

10.91%

8.30%

11.30%

8.18%

5.50%

11.54%

8.70%

11.96%

8.57%

6.00%

12.16%

9.09%

12.63%

8.95%

6.50%

12.79%

9.48%

13.29%

9.33%

7.00%

13.41%

9.87%

13.96%

9.72%

7.50%

14.04%

10.27%

14.62%

10.10%

3. Hurdle Rate

3.1 Hurdle rate definition

Hurdle rate is used to as a higher discount rate than the cost of capital to compute NPV, but then applies the regular NPV rule: Invest whenever the NPV calculated using this higher discount rate is positive. This higher discount rate is known as hurdle rate because if the project can jump the hurdle, then it should be undertaken. (Berk J B, DeMarzo P M. Corporate finance[M]. Pearson Education, 2007, pp.849) Hurdle rate depends on different level of riskiness of individual project and type of funding. Hurdle rate is calculated by formula below

Hurdle Rate= Cost of Capital ×[pic 25]

Based on the formula, we can see that the latter part is the same for different divisions. So, we can compare the difference hurdle rate simply based on difference in cost of capital.[pic 26]

3.2 Factors cause different cost of capital

Firstly, divisions have different targets in credit rating. Secondly, Debt/ Value ratio varies in different divisions and so do Spread to Treasury. Such factors can lead to different individual risk which caused differentβ. Last but not least, according to features of each divisions, in coming years, they lay emphasis on different directions and thus have own goals, which are stated in table below.

[pic 27]

Based on different target D/E and credit rating which leads to different cost of debt, we calculate cost of capital for divisions.

3.3 Comments on Midland’s using hurdle rate

For Midland, it is more reasonable to create different hurdle rate based on separate WACC. And the minimum hurdle rate should be divisional cost of capital. What is more, it would be better if hurdle rate is adjusted depending on level of risk, financing and available investment opportunities accordingly.

4. WACC for E&P and R&M

In order to calculate the cost of capital for the E&P and market & refining decisions, we need to figure out the cost of debt and the cost of equity for the two divisions respectively.

4.1 The cost of debt of each division

We calculate the cost of debt of divisions in the same way. The spread to treasury is determined by the credit rating of each division, which is 1.60% for E&P, and 1.80% for Refining & Marketing. So

E&P = 4.66% + 1.60% = 6.26%[pic 28]

Refining & Marketing = 4.66% + 1.80% = 6.46%[pic 29]

4.2 The cost of equity of each division

The