Midland WACC

Midland Energy Resources Inc. 1. Midland’s consolidated WACC WACC = (Debt/Capital)×k d×(1-t) + (Equity/Capital)×k e

Debt and Equity are measured at their market valu es. Capital = Debt + Equity 1.1. Capital structure ratios Actual (Debt/Capital)actual = 37,2%  (Debt/Equity)actual = 59,3% (Equity/Capital)actual = 62,8%

Target (Debt/Capital)target = 42,2%  (Debt/Equity)l = 73,0% (Equity/Capital)target = 57,8% 1.2. Cost of debt k d = US 30-Year T-Bond yield + spread s pread = 4,98% + 1,62% = 6,60% 1.3. Tax rate Tax rate = 40% 1.4. Cost of Equity k e = risk-free rate + β(EMRP)

risk-free rate = 30-year T-bond yield = 4,98% EMRP = 5,00% Equity Beta –  Actual  Actual capital structure βlevered = 1,25 Equity Beta – Target – Target capital structure Adjust Midland’s beta to reflect the target capital structure: a. un-lever the current beta  “asset beta” = βunlevered = βlevered/[1+(1-t)×(D/E)actual]  b. re-lever the “asset beta” to reflect the target capital structure  βlevered = βunlevered × [1+(1-t)×(D/E)target] = 1,33 k e = risk-free rate + β(EMRP) = 4,98% + 1,33×5,00% = 11,61% WACC = 0,422×6,60%×(1-0,40) + 0,578×11,61% = 8,38% 2. Midland’s Divisional WACC a. Estimate an asset beta for each division based on data for comparable companies (Exhibit 5) – un-lever the equity beta of each comparable company using data on each company’s capital structure; – average the resulting asset betas  estimate the systematic risk of each of Midland’s  business divisions; – compute the asset beta of the petrochemical division considering that Midland’s asset beta must be a weighted average of the divisional asset betas (after-tax earnings can be used as weights).

 b. Calculate the WACC for each of Midland’s divisions according to the procedure described for Midland as a whole in paragraph 1. 3. Leverage and WACC  Take one of Midland’s divisions and compute its WACC using varying degrees of leverage. Compare the effect of the change in leverage on the cost of equity and on the WACC. 