Midland Energy Resources

Midland Energy Resources is a global energy company with operations in oil and gas exploration and production(E&P) providing a broad array of products and services to customers worldwide including refining and marketing (R&M) and petrochemicals. Janet Mortensen, the senior vice president of project finance for Midland Energy Resources must determine the weighted average cost of capital (WACC) for the company as a whole and each of its divisions as part of the annual capital budgeting process. Various considerations have to be evaluated as risk factors when calculating the cost-of capital.

Midland, as a large and diverse company, should not use a single hurdle rate for evaluating investment opportunities. Its different business segments have very different operating characteristics, as such, have very different margins and risk profiles. In Exhibit 5, the Equity Beta represents the risk factors of those segments. With risk profiles that are different for each of the business segments, the hurdle rates for those segments should also be different and primarily calculated based on the Beta of the specific business segment. Thus, Midland should calculate the cost of capital for each department and use it for assessments rather than a corporate level hurdle rate. Incase, a corporate level single hurdle rate is used, the investments in the high-risk departments may seem favorable and investments in low risk departments may seem unfavorable; thus forcing the management into making incorrect decisions. This also increases overall risks at the company level and for the shareholders.

Exhibit 5 notes that at the corporate level, Midland Energy demonstrates an Equity Beta of 1.25. This beta of 1.25 can be used for the corporate WACC generally speaking. If a particular analysis requires a division's specific WACC to be calculated this can be done using comparables. We could obtain as many comparables for each division as possible. We could then take the average of these and then test the consistency of the result with reality by ensuring that the asset weighted average of these divisional betas ties to the total of 1.25. We can then adjust the disaggregated betas until they fit both the company beta and the range of comparable betas. This would ensure a reasonable estimate of each division's beta while ensuring it still foots with the firm's observable aggregate beta. In addition, if we intend to use different hurdle rates for each division, we should also consider different betas for them, otherwise the analysis becomes problematic. We should note though, that whatever method we use will present challenges regardless. By disaggregating betas, we are challenged in finding companies that have similar characteristics (risk, cash flow, growth, etc) as each division; maybe we can only find companies that are only slightly similar and if that is the case, we would have to control for the differences in the variables (i.e.: