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Ivan Xolalpa

on 24 March 2015

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Q&A
Question I
Question II
Question III
Should Midland use a single corporate hurdle rate for evaluating investment
opportunities in all of its divisions?
Why or why not?
Question IV
Question V
Midland Energy Resources
Cost of Capital
How are Mortensen’s estimates of Midland's cost of capital used?


How, if at all, should these anticipated uses affect the calculations?
Calculate Midland’s corporate WACC.
Be prepared to defend your specific assumptions and the various inputs to the calculations.
WACC
Cost of debt
r = 30 year yields for US Treasury bonds + Overall Consolidated Spread to Treasury

r = 4.98% + 1.62%




Is Midland's choice of EMRP appropriate? If not, what recommendations would you make and why?
Cost of Equity
Risk free rate: 4.98%
Beta: 1.25
EMRP: 5%
r = 4.98% + 1.25(5%)

e
r = 11.23%
r = 6.60%
D/(E+D) = 42.2%
E/(E+D) = 57.8%
Tax = 0.39

WACC= (0.578)(0.1123)+(0.422)(0.066)(1-0.39)
WACC= 0.081899
WACC= 8.19%
= 11.23%
r = 6.60%
e
d
d
d
d
Compute a separate cost of capital for the E&P and Marketing & Refining divisions.
Cost of debt

RD(E&P) = 30 year yields for US Treasury bonds + E&P Spread to Treasury


Exploration and Production (E&P)
RD(E&P) = 4.98% + 1.60%

RD(E&P) = 6.58%
Refining and Marketing (R&M)
RD(R&M) = 4.98% + 1.80%

RD(R&M) = 6.78%

RD(R&M) = 30 year yields for US Treasury bonds + R&M Spread to Treasury
Cost of Equity
Exploration and Production (E&P)

RE(E&P) = 4.98% + 1.15(5%)

RE(E&P) = 10.73%

Refining and Marketing (R&M)
RE(R&M) = 4.98% + 1.2(5%)

RE(R&M) = 10.98%

WACC
Exploration and Production (E&P)
WACC= (0.54)(0.1073)+(0.46)(0.0658)(1-0.39)
WACC= 0.0764
WACC= 7.64%

Refining and Marketing (R&M)
WACC= (0.69)(0.1098)+(0.31)(0.0678)(1-0.39)
WACC= 0.0886
WACC= 8.86%



What causes them to differ from one another?
Equity Betas
The Beta represents a measure of systematic risk for each division’s equity in comparison to the market. The R&M division’s relatively higher beta in comparison to E&Ps beta of 1.15 means R&M equity has relatively higher volatility.
Credit ratings
Capital Structure
E&Ps higher debt/value ratio relative to the R&M division (46% compared to 31%) results in a greater weighting of cost of debt in the WACC.
WACC
How would you compute a cost of capital for the Petrochemical division?
Petrochemical Beta
Midland beta = w1 x E&P beta + w2 x R&M beta + w3 x Petrochemical beta

Where: Midland beta = 1.25, E&P beta = 1.15, R&M beta = 1.20
Petrochemical beta
Total Assets = 140,100 + 93,829 + 28,450 = 262,379
w1 = 140,100/262,379 = 53.40%
w2 = 93,829/262,379 = 35.76%
w3 = 28,450/262,379 = 10.84%
Midland beta = w1 x E&P beta + w2 x R&M beta + w3 x Petrochemical beta

1.25 = 53.40% x 1.15 + 35.76% x 1.2 + 10.84% x Petrochemical beta
Petrochemical beta = 1.91
Risk-free treasury bond
The Treasury bond we found to be most appropriate was the 10-year 4.66% Treasury bond.

- Medium term activities
- Recent capital expenditure
Risk free rate = 4.66%, Petrochemical beta= 1.91 and (EMRP) = 5%
Cost of equity = 4.66% + 1.91 x 5% = 14.21%
Cost of debt = 4.66% + 1.35% = 6.01%
WACC= (0.60)(0.1421)+(0.40)(0.0622)(1-0.39) = 9.99%
- Capital budgeting

- Financial accounting

- Performance assessments

- M&A Proposals

- Stock Repurchase decisions
Operating as Senior Vice President of Project Finance in 2007, Mortensen's cost of capital estimates have become widely used within many analyses throughout the company. Mortensen now questions the appropriateness of their application within business units and Midland's analyses and is considering a user manual for her current year estimates.
Our team will now present the user manual for the 2007 estimates
Our Role
Ivan Xolalpa - James Humpherson - Andrew Tantri - Sam Tsagaris - Joel Alexander
Financial Objectives

- Overseas growth

- Value creating projects

- Optimization of capital structure

- Stock valuation
Hurdle Rate
What is a corporate hurdle rate?
Target rate of return required by a firm before it will invest in a project
Should consider:

1) Riskiness of cash flows

2) How it is funded

3) Industry conditions

Quantifying the hurdle rate
The cost of capital is a good way to determine the minimum hurdle rate


1) Considers Funding Risk

-D & E ratio



2) Considers Market Risk

-Beta used in Re
Why?
Is a single hurdle rate appropriate for Midland?
Exploration & Production
A+ credit rating @ 46% leverage
Assets > Revenue
Strong pipeline of work coupled with a booming industry set to continue for at least the next 5 years

Refining & Marketing
BBB credit rating @ 31% leverage
Assets < Revenue
Declining profit margins in industry expected to remain flat in the future

Petrochemicals
AA- credit rating @ 40% leverage
Assets ≈ Revenue
Growth business – significant global capital expenditure planned near-term

Will a single hurdle rate be an appropriate investment decision tool for each of these divisions ?

What should Midland do then?


Hurdle rate for each of Midlands businesses based on divisional cost of capital

Divisional cost of capital will be the minimum hurdle rate

Minimum hurdle should be increased when the project carries greater risk or when Midland has greater investment opportunities

Our user manual proposes the following:

Why not use the project specific cost of capital ?


1) Project cost of capital

Equity Beta? Unlikely to find a comparable firm to a single project

2) Does not consider addition of project to the broader division investment mix

Issues
WACC must equal the average risk of all company projects

Adjustments to WACC required if the project risk greater or less than the average company risk

E&P: exchange risk and political risk
Risk free rate = 4.66%, Spread to treasury = 1.35%
D/(E+D) = 0.4 E/(E+D)= 0.6 Tax Rate = 39%
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