Midland Energy Resources is a fully integrated energy company with operations in E&P, Refining & Marketing (R&M) and Petrochemicals. Capital budgeting at Midland is done using discounted cash flow method and weighted average cost of capital (rwacc). Corporate Weighted Average Cost of Capital, rwacc
The primary use of the corporate rwacc is valuation (TV=FCF/(rwacc-g)). While the rwacc may be used for evaluating internal projects, the usage will be incorrect owing to the fact that the risk-return profile, debt structure and credit rating of individual projects/departments may be different. Sometimes companies may want to repurchase stock if they think their stock undervalued and to do this valuation cost of capital is required. But this would be a short term valuation and hence the risk free rate of return to be used should be of short term. The corporate rwacc for Midland is 8.55% (refer Ex-1). The following table enumerates the various assumptions: AssumptionValueRemarks
Market risk premium5.1%
5.1% represents the 200 year average, with the lowest standard error of 1.2%. Moreover this value is between the acceptable range of 4-6%.
Risk free rate of return4.98%
30 year long term treasury rates have been used for two reasons. A) Short term rates will eventually converge to long term rates. B) Energy projects are usually long term lasting for 10-30 years.
Levered β @ target D/E ratioRatio=42.2%
The target ratio defines the target D/E that the company requires to reach for the credit rating to be applicable.
E&P Weighted Average Cost of Capital, rE&P-wacc
Division wise WACC is essential as each business line has different risk-return profile. Since individual divisional stocks are not traded in the market, β for E&P has been calculated by revenue based weighted average of pure-play E&P companies. However it is important to note that none of the companies (used in the exercise) have revenues comparable to that of...