What is Mortensen’s assignment?
• Calculate a corporate WACC
• Calculate the WACC of each division
1
What is the WACC used for?
• When a measure for the long-term
opportunity cost of funds (i.e., a discount rate)
is needed, such as
–
–
–
–
Capital budgeting
Asset appraisals for financial accounting exercises
Determining stock repurchases
Evaluating M&A proposals
• Will also likely be used for performance
assessments at the corporate and division level
2
Calculating the corporate WACC
• Ideally we want to use long-term target
capital structure ratios, using market
values.
• We want target ratios because we want the
capital structure that will correspond to the
future cash flows.
3
E
D
WACC  ke  k d 1  t 
V
V
rf  4.98%
k d  4.98%  1.62%  6.60%
t  35%
D
V
 42.2%
 57.8%
V
D  73.01%
E
ke  ?
E
4
• The current corporate beta of 1.25 reflects
the current capital structure. We can’t use it
in the WACC formula using target capital
structure.
• Need to unlever current beta to take out the
financial risk attributed to the current
capital structure
5
 unlevered 
 levered
1  1  t  D
E
1.25

1  1  0.350.593
 0.90223
We then relever to reflect the target capital structure

 levered   unlevered 1  1  t  D E

 0.902231  1  0.350.7301
 1.3304
6
Solving for the cost of equity
k e  r f    MRP
 4.98  1.3304  5
 11.632
Solving for WACC
E
D
WACC  ke  kd 1  t 
V
V
 11.6320.578  6.60.4220.65
 8.5337%
7
Should the company use single hurdle
rate to evaluate investment
opportunities for its divisions?
• The discount rate must reflect the riskiness of
the cash flows being discounted. This is
because if we want to maximize value, the
discount rate must reflect the opportunity cost
of the funds. This is appropriate regardless of
how corporations actually raise funds
(internally, externally, debt, equity), etc.
• Divisions (or projects) with different risks
must have different discount rates.
8
Divisional WACCs
• Calculate unlevered betas for Exploration &
Production and Refining & Marketing
Exploration & Production:
Equity
Net
Market Value
Debt
Equity
D/E
Beta
Unlevered
beta
Jackson Energy, Inc.
57,931
6,480
11.2%
0.89
0.83
Wide Palin Petroleum
46,089
39,375
85.4%
1.21
0.78
Corsicana Energy Corp.
42,263
6,442
15.2%
1.11
1.01
Worthington Petroleum
27,591
13,098
47.5%
1.39
1.06
39.8%
1.15
0.92
Average
Refining & Marketing:
Bexar Energy, Inc.
60,356
6,200
10.3%
1.70
1.59
Kirk Corp.
15,567
3,017
19.4%
0.94
0.83
White Point Energy
9,204
1,925
Petrarch Fuel Services
2,460
(296)
20.9%
1.78
1.57
-12.0%
0.24
0.26
Arkana Petroleum Corp.
18,363
5,931
32.3%
1.25
1.03
Beaumont Energy, Inc.
32,662
6,743
20.6%
1.04
0.92
Dameron Fuel Services
48,796
24,525
50.3%
1.42
1.07
20.3%
1.20
1.17 <<<< ----- average excluding Petrarch Fuel Services
Average
9
Solve for Petrochemical unlevered beta using the
E&P, R&M, and corporate unlevered beta. Here I use
Net Income as the weights.
 unleveredCORP  wE & P  unleveredE& P  wR & M  unleveredR& M  wP  unleveredP
12,556
4,047
2,097
0.90223 
0.92 
1.17 
 unleveredP
18,701
18,701
18,701
 unleveredP  0.2795
10
Finally, we solve for the divisional WACCs
Assumptions:
30-Year T -Bond
Equity Market Risk Premium
T ax Rate
4.98%
5.00%
35.0%
Target Consolidated
Target
D/E
73.0%
Target
D/V
42.2%
Target
E/V
57.8%
Asset
Beta
0.90
Equity
Beta
1.33
Cost of
Equity
11.63%
Treasury
Spread
1.62%
Cost of
Debt
6.60%
WACC
8.53%
Exploration & Production
Refining & Marketing
Petrochemicals
85.2%
44.9%
66.7%
46.0%
31.0%
40.0%
54.0%
69.0%
60.0%
0.92
1.17
0.28
1.43
1.51
0.40
12.13%
12.53%
6.98%
1.60%
1.80%
1.35%
6.58%
6.78%
6.33%
8.52%
10.01%
5.84%
11