1. Midland Energy Resources, Inc.
Capital Budgeting Within a Multi-Divisional Firm
Presenters in order:
Ng Wenying
Nguyen Huong Duong (Tony)
Sim Siang Huat (Ronald)
Oon Zhi Xiang (Wayne)
Ong Sheng Yuan (Gabriel)

2. WHO ARE WE
Janet Mortensen (SVP of Project Finance) of Midland Energy Resources, Inc.,
Advisor to CFO
WHAT IS THE OBJECTIVE OF THIS CASE
Recommend WACC for Corporate & Divisions
Approach
Step 1: Understand operational characteristics
Step 2: Understand how WACC is used
Step 3: Compute Corporate WACC
Step 4: Assess appropriateness of single hurdle rate
Step 5: Compute division’s WACC
- E&P
- R&M
- Petrochemical

3. Step 1: Understand operational characteristics
Midland Energy Resources, Inc.
Year 2006: Op Rev: US$248.5B; Op Income: US$42.2B
Exploration & Production
Rev: US$22.4B | Income: US$12.6B
- Extracting Oil & Natural Gas
- Most profitable business
- Net margin highest amongst industry
- Production has been increasing
- Trends:
• Rising global demand
• Demand for non-traditional
sources also increasing
• Oil price at historical high
prompting more investment 
Higher capital spending
Refining & Marketing
Rev: US$203B | Income: US$4.0B
- Owns 40 refineries & distills oil
- Business with largest Revenue
- Revenue decreasing slightly
- Margins are low
- But still a Market leader due to tech
advancement & vertical integration
- Trends:
- Stiffer competition 
Declining margins
- Difficult to obtain approvals
 little investment
opportunities (low capital
spending)
- In longer term, global
shortage in refining capacity
Petrochemical
Rev: US$23.2B | Income: US$2.1B
- Produces chemical products
- Smallest division
- Trends:
- Facilities are old  Requires
capital spending on
replacement
- Most investment will be
outside US in the form of JV

4. Step 2: Understand how WACC is used
It is used in Asset appraisal, Capital budgeting, Performance assessment, M&A and Stock
repurchasing decision making.

5. Step 3: Compute Corporate WACC
1 2

6. Step 3: Compute Corporate WACC
Weighted cost of debt
1
2 Weighted cost of equity
= weighted cost of debt + weighted cost of equity
= 1.59% + 6.306% = 7.896 %
WACC

7. Step 4: Assess appropriateness of Single hurdle rate
Evaluating Investment Opportunities
1. Single Corporate Hurdle
Rate
Which is the
road most used
by firms?
2. Multiple Risk-adjusted
discount rates
3. Specific Discount rates
for individual projects

8. Step 4: Assess appropriateness of Single hurdle rate
Allocating Capital Among a Firm’s Divisions: Hurdle rates versus budgets

9. Step 4: Assess appropriateness of Single hurdle rate
Capital Budgeting Practices in Singapore
- Singapore Management Review (2011)
• Survey questionnaires, 211 CEOs, 266 firms listed in SGX.
• Exclude companies not registered in Singapore
• Exclude companies registered in Singapore, head offices
overseas.
• To improve response rate, 2 mailings were done at different
timings.

10. Step 4: Assess appropriateness of Single hurdle rate
Capital Budgeting Practices in Singapore
- Singapore Management Review (2011)
54 Survey Responses
• 4 Construction firms (7.4%)
• 4 Hotels (7.4%)
• 16 Manufacturing (29.6%)
• 3 Property (5.6%)
• 3 Retail/ wholesale (5.5%)
• 1 Finance (1.9%)
• 23 firms in other or multiple lines of business (42.6%)

11. Step 4: Assess appropriateness of Single hurdle rate
Capital Budgeting Practices in Singapore
- Singapore Management Review (2011)
Extract:

12. Step 4: Assess appropriateness of Single hurdle rate
The Engineering Economist Volume 48 No.4
- “Divisional Cost of Capital: A Study of its Use by Major US Firms” by Stanley Block

13. Step 4: Assess appropriateness of Single hurdle rate
Business Horizons 2001
“The Trouble with Divisional Hurdle Rates” by Thode, Stephen F.
“All operating risk factors may be unique to each division so that
the conglomerate firm may be viewed as a portfolio of
individual divisions. Each division contributes to the overall
business risk of the firm in the same way that individual
securities contribute to the systematic risk of a portfolio of
securities.”

14. Step 4: Assess appropriateness of Single hurdle rate
Recommendation for Midland
Financing decisions for resources
allocation among divisions
 Single corporate hurdle rate.
Specific
Discount
rates for
Individual
Projects
Multiple Risk-adjusted
Discount
Rates
Single
Corporate
Hurdle Rate
Large projects, new products
Central Investment
Committee or Board of
directors.
Investment decisions
1) Multiple risk-adjusted discount rates
2) Specific discount rates for individual
projects

15. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
Compute separate cost of capital
WACC =Rd(D/V)(1-t) + Re(E/V)
Exploration &
Production
Marketing & Refining
Spread to Treasury 1.6% 1.8%
Debt / Value (Table 1) 46% 31%
Equity / Value 54% 69%
10 year yield for
Treasury Bonds
4.66% 4.66%
Tax rate calculated
from Step 2
40% 40%
Equity Beta (exhibit 5) 1.15 1.2
EMRP 5% 5%

16. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
1 For Exploration & Production
Cost of debt, Rd(D/V)(1-t)
= (Spread + Yield for Treasury Bonds) *(D/V) *(1-t)
= (1.6%+4.66%) * 46% * (1-40%)
=1.73%
Cost of equity, Re(E/V) = {Rf+β(EMRP)} * (E/V)
= (4.66% + 1.15 * 5%) * 54%
= 5.62%
Cost for E&P = 1.73% + 5.62% = 7.35%

17. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
For Refining & Marketing
Cost of debt, Rd(D/V)(1-t)
= (Spread + Yield for Treasury Bonds) *(D/V) *(1-t)
= (1.8%+4.66%) * 31% * (1-40%)
= 1.20%
Cost of equity, Re(E/V) = {Rf+β(EMRP)} * (E/V)
= (4.66% + 1.2 * 5%) * 69%
= 7.36%
Cost for R&M = 1.20% + 7.36% = 8.56%
2

18. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
Why are cost of capital for Exploration & Production and Refining & Marketing
Divisions different?
• Debt/Value:
Exploration & Production has higher debt/value ratio (46% compared to 31% for
Refining & Marketing). Possibly, because Exploration & Production has higher
margin than Refining & Marketing. Hence, financial communities are more willing
to lend money.
• Rd:
Spread over treasury is higher for Refining & Marketing than Exploration &
Production. Reason is because Refining & Marketing has a lower credit rating (BBB)
compared to Exploration & Production (A+)

19. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
WACCPetrochemicals = rd(D/V)(1-t) + re (E/V)
where rd = cost of debt
re = cost of equity
D = Market value of debt
E = Market value of equity
V = Total assets of the company or division = D + E
t = tax rate

20. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
Cost of debt, rd
= risk- free rate, rf + spread to Treasury for the
Petrochemicals Division
Since we are provided the 1 Year, 10 Year and 30 Year
yields to maturity for US Treasury bonds, which one would
be the most appropriate risk-free rate?
rd

21. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
rf
In determining the most appropriate risk-free rate to be used for the
Petrochemicals Division, we will need to consider the useful life of the assets
replaced during the asset replacement process.
• The Petrochemicals Division is primarily involved in
manufacturing and research activities, where the assets involved
have an medium-term useful life (Average 10 years)
• They are also involved in capital spending projects such as replacement of
facilities which generate cash flows over a long period
• Therefore, the 10-year rate shall be used.

22. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
rd
Cost of debt, rd
= risk- free rate, rf + spread to Treasury for the Petrochemicals
= 4.66% (10-Year Treasury bond) + 1.35%
= 6.01%

23. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
re
Cost of equity, re
= risk- free rate, rf (10-Year Treasury bond) + β(EMRP)
Where
β= equity beta for the Petrochemicals Division
EMRP = equity market risk premium
The key to calculating the cost of equity, re is to evaluate the equity beta of the
Petrochemicals Division.

24. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
In order to evaluate the equity beta of the Petrochemicals Division, we need to:
• Obtain the unlevered beta of Midland Energy and the other 2 divisions, the E&P
Division and the R&M division.
• The unlevered beta of Midland Energy Resources is the weighted average of the
unlevered beta of the three divisions
Unlevered βMidland
= w1(Unlevered βE&P) + w2(Unlevered βR&M) + w3(Unlevered βPetrochemicals)
where w1= E&P earnings/ Total earnings
w2= R&M earnings/ Total earnings
w3= Petrochemicals earnings / Total earnings
β

25. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
We need to use unlevered beta for the following reasons:
• All the Divisions have never been publicly traded before, thus we need the
unlevered beta of these divisions to estimate the equity beta of the
Petrochemicals Division
• This will mean using the pure play method, which involves determining the
average unlevered beta of many similar companies in the same industry to
use as a reference. This has been done in the case study for the E&Pindustry
and the R&Mindustry.
β

26. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
• Furthermore, as we are calculating the cost of equity, re, using unlevered
beta allows us to remove the impact of debt on the beta.
• Lastly, once we obtain the unlevered beta of the Petrochemicals Division,
we will re-lever the beta to add back the financial risk as we have been
provided with the debt-equity ratio of the Petrochemicals Division in the
case study.
β

27. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
• Obtain unlevered beta of Midland Energy, E & P Division and R & M
Division using Hamada’s Equation.
• Calculate the weightage of the divisions, using total earnings of each
division as a ratio of Midland Energy’s total earnings.
• Once the unlevered beta of the Petrochemicals Division has been
obtained, re-lever it using the debt equity ratio of the Petrochemicals
Division
β

28. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
β Equity βPetrochemicals = 0.6 *[1 + (1-0.4)* 0.667] = 0.840
Cost of equity, re , for the Petrochemicals Division
= rf + β(EMRP)
= 4.66% + 0.840 (5%)
= 8.86%
re

29. Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical
WACCPetrochemicals
= rd(D/V)(1-t) + re (E/V)
= 6.01% (0.4)(1-0.4) + 8.86% (0.6)
= 6.76%