Midland Energy Resources: Cost of Capital

Midland Energy Resources, Inc.: Cost of Capital

Executive Summary:

Midland Energy Resources Inc. is a global energy company with operations in three primary divisions- Oil & Gas exploration (E&P), Refining and marketing (R&M) and petrochemicals. The company is currently profitable, with potential for further expansion in the years to come. The operating revenues and operating incomes in 2006 were $248.5 billion and $42.2 billion respectively. Miss Janet Mortenson is the company’s senior vice president of project finance and the current case at hand is an in-depth analysis of the costs of capital, both at a corporate and divisional level.

Apart from asset appraisals (both for capital budgeting and financial accounting), the cost of capital estimates were used for performance assessments, M&A proposals and stock repurchase decisions. However, more importantly, the cost of capital estimates would play a substantial role in Midland’s 2007 financial and investment policies ranging from evaluating prospective investments and divisional performance to taking stock repurchase decisions, making the cost of capital estimates crucial with high ramifications.

Master Key:

①- Table 1

②- Table 2

❶- Exhibit 1

❸- Exhibit 3

❺- Exhibit 5

❻- Exhibit 6

₡- Per calculations

Midland’s overall corporate cost of capital:

1. Assumptions made in the calculation of the cost of capital:

1. Calculation of Tax Rate: Due to the lack of any information regarding tax rate changes, it has been calculated as an average of the previous three years as shown below:

Table 1: Calculation of Tax Rate

1. Calculation of cost of debt: From the information given in table 1 and table 2, we are able to determine the cost of debt. However, the choice of the maturity period of debt is crucial to our decision. Midland’s borrowing capacity is correlated to its energy reserves and long-lived productive assets. Hence, the choice of a one year maturity seems too short. Further, through the information provided, we can see that changes are expected in the oil reserves and production business. Thus these changes lend to the volatility of the business in a 30-year time frame and we aren’t in a position to model the same into our workings. Thus, by elimination, a 10-year maturity period has been selected.

Therefore, the cost of debt is:

Table 2: Cost of Debt calculation

1. Calculation of Cost of Equity:

Introduction to the concept of un-levering and re-levering the Betas: Levered Betas incorporate two risk factors that bear on systematic risk: business/ operating risk and financial/ capital structure risk. Removing this effect of financial leverage (i.e. un-levering the beta) leaves the effect of business risk only. If the leverage of the data differs significantly from the leverage of the guideline public companies used for analysis, it is typically desirable to remove the effect of leverage before using them as a proxy to estimate divisional beta. The steps involved are: