Midland Energy Resources, Inc.: Cost of Capital (Brief Case) - Case Solution

This case solution includes an Excel file with calculations.

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The Company – Midland Energy Resources, Inc.

Midland Energy Resources, Inc. is a global energy company operating in the Oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals with a consolidated revenue of $248.5 bn and an operating income of $42.2 bn in 2006.

Uses of estimates of the cost of capital and the effects of the uses on the calculations

Midland Energy Resources, Inc. uses the Cost of Capital estimates for various purposes, including asset appraisals, performance assessments, M&A proposals, and stock repurchase decisions.

The anticipated uses affect the calculations in the following ways:

• The cost of capital needs to be adjusted based on the risk level of the project
• The cost of capital may be calculated on the firm level or individual division/BU level, depending on the project
• It should be adjusted based on the capital structure and the target debt ratio

Midland Energy Resources, Inc.’s Corporate WACC

The WACC is calculated using the following formula:

rd(D/V)(1-t)+ re((E/V)

Where,
rd=Cost of debt=6.6% D/V= Target debt ratio=42.2%
T=tax rate=40% re= Cost of equity= 11.23%
E/V=Target equity ratio=57.8%

WACC = 6.6%(42.2%)*(0.6)+11.23%(57.8%)
WACC = 8.16%

Assumptions

• Capital structure weights: We have used the target debt ratio for the company provided in Table 1 as the basis for calculating capital structure weights.
• Risk-free rate: We have used the 30-year Treasury bond rate to arrive at the risk-free rate, assuming that oil reserves generally have a life ranging between 15-30 years.
• Cost of debt: We have used the spread over the treasury bill of 1.62% above the 30-year rate.
• EMRP: We have used the EMRP of 5% that Midland Energy Resources, Inc. has used in its latest calculations based on various inputs from analysts and consultants.
• Beta: We have used the Beta provided in the case (1.25)
• Cost of equity: We have used CAPM to arrive at the tax-free rate

Please refer to Exhibit 1 for detailed calculations.

Use of a single hurdle rate for all divisions

Midland Energy Resources, Inc. should not use a single hurdle rate for all of its divisions since each of its divisions is different in size, margins, investment terms, capital structure, and risk.

Using a single hurdle rate would assume that all the divisions are similar, which is not the case. We will, in the following sections, calculate the WACC rates of its divisions.

Calculation of WACC for E &P and R&M