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HW #5: For Thursday, Oct 15th

READING AHEAD. If you wish to read ahead to familiarize yourself with material to be covered in
class on Tuesday and Thursday, Oct 13th and 15th, read Chapter 7 Depreciation and Income
Taxes in the textbook.
TEAM ASSIGNMENT:
Your team has been hired as consultants by Janet Mortensen, senior vice president of Midland
Energy Resources, Inc., to advise her on cost of capital matters. Read the Midland Energy
Resources, Inc.: Cost of Capital case which is accessible at:
https://cb.hbsp.harvard.edu/cbmp/pl/41905559/41905613/9c076ab97b6ee7865e0c906832a2fbc3.
This case illustrates how the Capital Asset Pricing Model (CAPM) may be used to estimate the
Weighted Average Cost of Capital (WACC) in a corporate setting. Then, working with your team,
answer each of the following questions using data provided in the case:
i.

From Table 2, what risk-free rate (rf) would you recommend that Midland use in its cost
of debt (rd) and cost of equity (re) calculations? Why?

ii.

For the consolidated company, what is Midlands cost of debt (rd)? What is the cost of
debt for each of the 3 operating divisions? Discuss why these 4 values differ in terms of
their respective credit ratings and the nature of their business operations.

iii.

From Exhibit 1, what tax rate (t) would you recommend that Midland use in its WACC
calculations? Why?

iv.

Your client has instructed you to use an equity market risk premium (EMRP) of 5%.
Does this value seem reasonable? Explain. (NOTE: Use the 5% value in your
calculations, regardless of your opinion, because this is your clients instruction.)

v.

Using the CAPM method and data from Exhibit 5, what is your estimate of Midlands
consolidated cost of equity (re) at this time?

vi.

What is Midlands consolidated weighted after-tax cost of capital (WACC) at this time?

vii.

Based on data from Exhibit 5, what is the un-levered asset beta for the consolidated
company?

viii.

What would be the consolidated companys cost of equity under its future target capital
structure as shown in Table 1? What is the corresponding after-tax WACC for the
consolidated company under its future capital structure? How might this change in
WACC affect the companys investment choices in the future?

ix.

Graph the consolidated companys cost of equity and WACC as a function of its debt
fraction (D/V) over a range from no debt to 100% debt. Discuss the sensitivities of both
variables to changes in the debt fraction. Also discuss practical considerations and
constraints to the extremes of this range of debt fractions.

x.

Using the data in Exhibit 5, calculate the asset betas for each of the comparable
companies, then calculate the average asset beta for the Exploration & Production group
and the average asset beta for Refining & Marketing group. Use these average asset
betas to estimate the equity beta, cost of equity and WACC for Midlands Exploration &
Production division and Refining & Marketing division under their respective capital
structures as provided in Table 1. If used, how would these WACC values affect the
future investment choices in each division?
(Continued)

xi.

Should Midland use a single consolidated corporate hurdle rate (i.e., minimum attractive
rate of return) for evaluating investment opportunities in all of its divisions, or should it
use differing hurdle rates reflecting the respective WACC values of each division?
Why?

All teams are to submit a typed analysis of this case addressing each of the above questions and
including your recommendations to your client, Janet Mortensen. This analysis is to be in essay
format (not Question & Answer format) with a professional appearance. Avoid excessive rehashing of the case. Show all work, neatly and concisely, on 8.5 x 11 inch paper. Your teams
written report must be a stand-alone document and must show all work to support your analysis and
conclusions. Graders must be able to see clearly how answers were derived. If needed to support
your analysis, copies of pertinent Excel spreadsheet elements (if any) should be incorporated into the
body of your written report. Credit will not be given for unsupported answers. If your analysis was
done in multiple files, compile them into a single comprehensive document. Each team must submit
its report in PDF format via the Canvas website prior to the beginning of class. Late submittals will
not be accepted. NOTE: Each team must upload only one PDF document. Any one team member
may submit the file, but submit only one file per team. If a previously uploaded file is found to
contain errors, a corrected version may be resubmitted online prior to the deadline.
All work is to be that of your team only, consistent with the University Honor Councils Guide to
Academic Integrity. All contributing members of your team must sign the required Academic
Integrity cover page for this case posted in Canvas Files. The signed cover page must be scanned
and inserted at the front of your teams report prior to submitting the report on Canvas. Reports
without this cover page will not be accepted.
The following teams should also prepare a verbal presentation of their analysis of this case:
Bhasin/Golden/Jakubowicz/Montamat/Toole
Cui/C.Gao/H.Lee/H.Tang/Zou
Presentations should not exceed 10 minutes in length and must involve at all team members. Use
Powerpoint slides to supplement your presentation. Assume your audience is Janet Mortensen and
the Board of Directors of Midland Energy Resources, Inc, and you are consultants retained by them.
Powerpoint files are to be emailed directly to Dr. Cassel (tcassel@seas.upenn.edu) no later than 9
a.m. on the date of the class. No changes may be made to your Powerpoint files after this deadline.
Be sure to follow the Effective Presentations guidelines as discussed in class (and posted in the
Classroom Slides folder in Canvas Files). Presentations will be graded on their professionalism,
effectiveness and accuracy.

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