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Midland Energy Resources, INC

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Maria Kafarakis

on 15 April 2013

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Transcript of Midland Energy Resources, INC

Midland Energy Resources, Inc Cost of Capital Primary uses for the cost of capital include:
Asset appraisal, performance assessment, M&A proposals, and stock repurchase decisions.
These uses can potentially have a great affect on the appropriate cost of capital that should be used in the calculation.
Midland Energy is divided into three divisions: Exploration and Production, Refining and Marketing, and Petrochemicals. All of these divisions have different capital structures and operate in different respective industries. Midland Energy is vertically integrated and to use the same cost of capital for each division would not accurately discount cash flows for suggested projects. WACC In order to calculate Midland’s WACC, several assumptions must be made. First, the appropriate risk-free rate to use for Midland is unclear. Mortensen provides the rates for 1-year, 10-year, and 30-year U.S. Treasury bonds. Given the long-term investment nature of the industry, I thought it appropriate to use a 10-year Treasury bond for the risk free rate when calculating re for the Midland and each of its respective divisions. Another assumption that is made is in regards to the equity market risk premium (EMRP). Mortensen uses 5.0% EMRP when calculating the WACC for Midland. This is approximately the EMRP for U.S. Equities from 1798-2006, which is 5.1%. WACCcorporate Tax = 40%, ßmid = 1.25, and D/V = 42.2%.
re = rf + ß(EMRP)
re = .0466 + 1.25(.05) = 10.91%
rd = 4.66% + 1.62% = 6.28%
WACCmidland = (1-.4)(.0628)(.422) + (.1091)(.578) = 7.90% Cost of Capital
E&P and Marketing and Refining The average beta for the E&P division is 1.15, and D/V of 46.0% as stated in Table 1 of the case. In addition, we will continue to use 5.0% for EMRP
WACC Inputs for E&P:D/V = 46.0%Beta = 1.15Tax = 40%Rd = 6.26%Spread = 1.60%Rf = 4.66%EMRP = 5.0%
Re = rf + ß(EMRP) = .0466 + 1.15(.05) = 10.41%
WACCE&P = (1-.4)(.46)(.0626) + (.54)(.1041) = .0172776+ .056214 = 7.35%

Inputs for Refining:D/V = 31.0%Beta = 1.20 Tax = 40%Spread = 1.80%Rd = 6.46%Rf = 4.66%EMRP = 5.0%
Re = .0466 + 1.20(.05) = 10.66%
WACCRefining = (1-.4)(.31)(.0646) + (.69)(.1066) = 8.56%
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