Midland Energy Resources Case Study Solution
Midland’s Corporate WACC
The current corporate WACC of the company is 8.31% which is based on the underestimated equity market risk premium of 5% and the overestimated beta average of 1.25, which Morten uses for evaluation of all projects. The cost of debt of 6.28% is based on the spread of 1.62% and the 10-year risk free rate of 4.6%. For the calculation of cost of equity of 12%, the one year risk free return of 4.54% have been used. (Exhibit 2)
The midland’s choice of valuing the WACC using the market risk premium of 5% is not appropriate since it is below the actual market risk premium of 6% and will understate the cost of equity and overstate the projected cash flows therefore incorrect decisions will be made by the company. It will be recommended that the market risk premium of 6% should be used to reflect the true cost of equity and enable the company to make right investment decisions. After using the market risk premium of 6%, the corporate WACC was estimated at 6%. (Exhibit 3)
Use of Single Discount Rate for all Divisions
Since the divisions are based in different countries and have different economic and political risks, using the same hurdle rate across different divisions would indicate that all divisions have the same systematic risk which is unlikely. Also, 77.7% of the company’s investments and divisions are in non US countries, therefore, using US denominated discount rate will give incorrect and unrealistic results.
Therefore, different discount rates should be calculated for different divisions based on the systematic risk each division faces, the debt to equity composition that is the financial risk each division faces and using the discount rates which reflect the currency in which the division is based.
The WACC for Each Division
Exploration and Production Division:In order to calculate the cost of equity for this division, the average equity beta of 1.15 is used which is calculated by taking the average of its main competitor’s equity beta.The actual equity market risk premium of 6% has been used, also, since no data regarding the market value of debt and equity of E&P division was given, the average of the market value of equity and debt of the competitors was used which amounted $43468 and $16349 respectively. Since, this division was assigned the credit rating of A+, spread of 1.6% and the 10 year risk free rate of 4.66% was used. On the basis of mentioned information, the division’s WACC was estimated at 9.44%. (Exhibit 4)
Marketing and Refining Division: By averaging the equity beta of the division’s competitors, the division’s own beta equity was estimated at 1.2, this is greater than the average beta of E&P division indicating that the higher systematic risks are faced by M&R division. The market risk premium of 6% was used, the market value of equity and debt amounted $26773 and $6864 and was calculated by taking the average of competitors’ market value of debt and equity. Since, this division was assigned credit rating of BBB, credit spread of 1.8% was used and 10 year bond risk free rate of return was used. The cost of equity was estimated at 11.83% leading to achievement of 10.22% WACC. (Exhibit 5)
WACC for Petrochemical Division
The WACC of the petrochemical industry has been calculated by using the equity market risk premium of 6% and using the current equity beta of 1.4 (Finance Yahoo, 2019)of one of the leading petrochemical company of the US(Ibis World, 2019). To calculate the cost of debt, the 10 year risk free rate of 4.66% and credit spread of 6.01% is used, which is based on the credit rating of AA-. The debt to equity composition is assumed to be 40;60 and the cost of equity of 12% is used. Based on the mentioned data, the WACC of the division was estimated at 8.7%.(Exhibit 6)
Exhibits
Exhibit 1 A: Financial Statements
| Operating Results: | 2004 | 2005 | 2006 | |
| Operating Revenues | 201,425 | 249,246 | 248,518 | |
| Plus: Other Income | 1,239 | 2,817 | 3,524 | |
| Total Revenue & Other Income | 202,664 | 252,062 | 252,042 | |
| Less: Crude Oil & Product Purchases | 94,672 | 125,949 | 124,131 | |
| Less: Production & Manufacturing | 15,793 | 18,237 | 20,079 | |
| Less: Selling, General & Administrative | 9,417 | 9,793 | 9,706 | |
| Less: Depreciation & Depletion | 6,642 | 6,972 | 7,763 | |
| Less: Exploration Expense | 747 | 656 | 803 | |
| Less: Sales Based Taxes | 18,539 | 20,905 | 20,659 | |
| Less: Other Taxes & Duties | 27,849 | 28,257 | 26,658 | |
| Operating Income | 29,005 | 41,294 | 42,243 | |
| Less: Interest Expense | 10,568 | 8,028 | 11,081 | |
| Less: Other Non-Operating Expenses | 528 | 543 | 715 | |
| Income Before Taxes | 17,910 | 32,723 | 30,447 | |
| Less: Taxes | 7,414 | 12,830 | 11,747 | 38.58% |
| Net Income | 10,496 | 19,893 | 18,701 |
Exhibit 1 B: Financial Statements
| Assets: | 2005 | 2006 |
| Cash & Cash equivalents | 16,707 | 19,206 |
| Restricted Cash | 3,131 | 3,131 |
| Notes Receivable | 18,689 | 19,681 |
| Inventory | 6,338 | 7,286 |
| Prepaid Expenses | 2,218 | 2,226 |
| Total Current Assets | 47,083 | 51,528 |
| Investments & Advances | 30,140 | 34,205 |
| Net Property, Plant & Equipment | 156,630 | 167,350 |
| Other Assets | 10,818 | 9,294 |
| Total Assets | 244,671 | 262,378 |
| Liabilities & Owners’ Equity: | ||
| Accounts Payable & Accrued Liabilities | 24,562 | 26,576 |
| Current Portion of Long Term Debt | 26,534 | 20,767 |
| Taxes Payable | 5,723 | 5,462 |
| Total Current Liabilities | 56,819 | 52,805 |
| Long Term Debt | 82,414 | 81,078 |
| Post Retirement Benefit Obligations | 6,950 | 9,473 |
| Accrued Liabilities | 4,375 | 4,839 |
| Deferred Taxes | 14,197 | 14,179 |
| Other Long Term Liabilities | 2,423 | 2,725 |
| Total Shareholders’ Equity | 77,493 | 97,280 |
| Total Liabilities & Owners’ Equity | 244,671 | 262,378 |
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