Background: You have just taken a job at Midland Energy, Inc. Midland is a global energy company with operations in oil and gas exploration and production, refining and marketing, and petrochemicals. Your supervisor has asked you to compute the weighted-average cost of capital (WACC) for Midland that will be incorporated into other analyses throughout the upcoming year. These include routine capital budgeting metrics such as NPV, asset appraisals for financial accounting exercises, and analyses for stock repurchases and merger and acquisition proposals. Then, you are to use the WACC to evaluate two current issues: a new energy investment and an acquisition. The WACC is intended to represent the longterm opportunity cost of funds for Midland, one of its divisions, or an acquisition target. It is the discount rate, or a benchmark for the discount rate, in a discounted cash flow (DCF) analysis. Data: Midland has announced a long-term debt-to-value ratio target of 42.2% D/V, but in fact the company is not yet at that target. Its current ratio is 37%. Midland pays taxes at a rate of about 40%. Table 1: Debt Data Business Segment Credit Rating Debt/Value (target) Spread to treasury (pp) Consolidated A+ 42.2% 1.62 Exploration and Production A+ 46.0% 1.60 Refining and Marketing BBB 31.0% 1.80 Petrochemicals AA- 40.4% 1.35 The companys debt was rated A+ by Standard & Poors. The current yields to maturity for U.S. Treasury bonds are: 1-Year: 4.61% 10-Year: 3.61% 30-Year: 3.65% Midland used an equity market risk premium of 5.0%, but higher EMRPs6.0% to 6.5% have been used by Midland at various times in the past. Midlands beta was 1.25. Betas for Midlands divisions were not observable, since they do not have traded shares of stock. To estimate betas for the divisions, Midland relies on published betas for publicly traded companies comparable to each divisions business. For refining and marketing, they use 1.2 and for exploration and production, 1.15.

PART I

1. Define opportunity cost of capital and what Midland uses it for?

2. What is the formula for the WACC? Explain each term in the equation and how you would determine what they are?

3. Calculate Midlands cost of debt. Show your work.

4. Calculate Midlands cost of equity. Use the following capital asset pricing model: k_e = r_f + b_Midland (EMRP)

5. Calculate the WACC for the whole company and its production division. Do these differ and why?