1. Valuation Assignment 3
The Midland Case
Gulcin Askin
Michelle Donovan
Kivanc Ozuolmez
Peter Tempelman

2. Question I
How are Mortensen’s estimates of Midland’s cost of capital
used?

3. Answer I
• The Mortensen’s estimates are used for;
• Asset appraisals for capital budgeting and financial
accounting
• performance assessments
• M&A proposals
• Stock repurchase decisions
At division or business unit level as well as Corporate
level
Cost of capital is an essential component in WACC
calculations.

4. Question II
Calculate Midland’s overall corporate WACC. Is Midland’s
choice of EMRP appropriate? If not, what recommendations
would you make and why?

5. Answer 2 - rD
• Mortensen computed the cost of dept for each division
by adding a premium, or spread, over U.S. Treasury
securities of a similar maturity.
• To find rD, we do not use CAPM but we use the interest
rate that we currently pay on the new loans.
• Consolidated Spread to Treasury is given on Table 1 as
1.62%
rD = 30 year yields to U.S Treasury bonds + Overall
Consolidated Spread to Treasury
rD = 4.98% + 1.62%
rD = 6.60%

6. Answer 2 - Tax
Tax rate is calculated based on the Exhibit 1 as average
over 2004, 2005 and 2006
The tax rate =
Midlands Income Taxes / Midland's Income Before Taxes
And the Average across 2004, 2005, 2006
The tax rate = 39%

7. Answer 2 - EMRP
• However, based on the Exhibit 6, the traditional data showed
aprox 6.0% EMRP, and the surveys showed lower EMRP (2.5% -
4.7%), a research over the industry with help from outsiders,
who has broader industry knowledge, would result a better and
up-to-date EMRP for Midland.
• Researches in consultation with its professional advisors,
bankers and investors, as well as Wall Street analysts covering
the industry agreed on the current estimate of 5.0%.
• As the analysts on the industry, bankers and investors have
broader information from different companies and corporates,
we conclude that the approach of outside consulting and the
result of 5.0% estimate is appropriate.

8. Answer 2 - rE
Researches in consultation with its professional advisors,
bankers and investors, Midland used 5.0% as its Equity
Market Risk Premium.
The corporate β is publicly available, and as it represents
corporate level β, we’ll use 1.25 as it is for Overall
Corporate WACC calculation.
rE = rf + β(EMRP)
rE = 4.98% + 1.25 (5%) = 11.23%

9. Answer 2 - Wacc
rE 11.23%
rD 6.60%
tax rate 39%
D/E 59.3%
E 100units
D 59.3units
V 159.3units
E/V 0.62774639
D/V 0.37225361
Corporate
Wacc 8.548%

10. Question III
Should Midland use a single corporate hurdle rate for
evaluating investment opportunities in all of its divisions?
Why or why not?

11. Answer 3
• Midland, as a large enterprise, has diverse business units with different risks.
In Exhibit 5, the Equity Beta represents the risk factor of those divisions.
• As the risk profiles are different per division, the hurdle rates for those
divisions should also be different, and calculated based on the β of the
division.
• Midland should not use single corporate hurdle rate as this will mislead
evaluation of the investments, and will result on Midland invest on risky
projects and will become risky a corporate by time.
• On the other hand, if Midland invests on corporate level, using corporate level
Wacc would be OK.
• Which rate should be used when…
• when buying computer for all staff, use corporate level Wacc
• when investing a drilling project in Alaska, use Exploration & Production’s division hurdle
rate.

12. Question IV
Compute a separate cost of capital for the E&P and
Marketing & Refining divisions. What causes them to differ
from one another?

13. Answer 4 – E&P
rE = rf + β(EMRP)
rE = 4.98% + 1.15 (5%) = 10.73%
rD = rf + E&P Spread to Treasury
rD = 4.98% + 1.60% = 6.58%
rE 10.73%
rD 6.58%
tax rate 39%
D/E 39.8%
E 100units
D 39.8units
V 139.8units
E/V 0.715308
D/V 0.284692
Wacc for E&P 8.818%

14. Answer 4 – R&M
rE = rf + β(EMRP)
rE = 4.98% + 1.20 (5%) = 10.98%
rD = rf + R&M Spread to Treasury
rD = 4.98% + 1.80% = 6.78%
rE 10.98%
rD 6.78%
tax rate 39%
D/E 20.3%
E 100units
D 20.3units
V 120.3units
E/V 0.831255
D/V 0.168745
Wacc for E&P 9.825%

15. Answer 4
• The business units operate on different industries
therefore;
- they have different risk profiles and βs
- they have different credit ratings
• As a result, the E&P and R&M have different Waccs
(8.818% and 9.825% respectively)

16. Question V
How would you compute a cost of capital for the
Petrochemical division?

17. Answer 5
• To calculate cost of capital for Petrochemical, we would
search for couple of companies which focus only on
Petrochemical industry. And use their fact sheet and get
an average on their β and D/E ratio.
• In our team, none of us work in energy / oil /
petrochemical industry and therefore our limited
research didn’t return any sample companies we could
use.
• For that reason; by using the data available on Exhibit 5,
we decided to use arithmetic averages on D/E ratio and
β to calculate cost of capital for Petrochemical division.

18. Answer 5
β=?
Corporate β = Average(E&P β, R&M β, Petrochemical β)
1.25 = Average(1.15, 1.20, Petrochemical β)
Petrochemical β = 1.40
rE = rf + β(EMRP)
rE = 4.98% + 1.40 (5%) = 11.98%
rD = rf +Petrochemical Spread to Treasury
rD = 4.98% + 1.35% = 6.33%

19. Answer 5
Corporate D/E = Average ( E&P D/E, R&M D/E,
Petrochemical D/E)
59.3% = Average(39.8%, 20.3%, Petrochemical D/E)
Petrochemical D/E = 117.8%
rE 11.98%
rD 6.33%
tax rate 39%
D/E 117.8%
E 100 units
D 117.8 units
V 217.8 units
E/V 0.459137
D/V 0.540863
Wacc for Petrochemical 7.589%