Midland Energy Resources, Inc.: Cost of Capital

Midland Energy Resources, Inc.: Cost of Capital

Practical Work Number: 17530

1. Introduction

• Executive Summary

Midland Energy Resources, Inc. is a global energy company based in the U.S. that operates in the oil and gas industry with over 120 years of history and 80,000 employees by 2007. It compromises of 3 main business segments: exploration and production (E&P), refining and marketing (R&M), and petrochemicals. Midland Energy’s business and operations have generated strong cash flows and net income over the period of 2004-2006. By Dec 31 2006, Midland Energy has operating revenue of $248.5 billion and net income of $18.7billion.

• Rationale for cost of capital analysis

Cost of capital is the opportunity cost of all capital invested in a business, and it takes account both equity and debt holders into consideration. Main financial strategies of Midland Energy are to fund overseas growths, invest in value-creating projects across all divisions, optimize its capital structure and repurchase undervalued shares. In order to accomplish these 4 main goals, cost of capital analysis is of paramount importance to the firm. It can be used to assess and convert foreign cash flows, evaluate share repurchase opportunity, asset write-ups and impairments for financial accounting purpose, and calculate capital budgeting metrics such as net present value(NPV) and IRR(internal rate of return).

This report will provide an estimation of the cost of capital for Midland Energy Resources on a consolidated basis as well as on a divisional basis. It will first delve into assumptions in order to assist this analysis, then it will estimate all parameters that are involved in calculating weighted average cost of capital. Then, this report will examine the limitations and sensitivity analysis of results.  

1. Assumptions

• A 40% tax rate is assumed as the average tax rate of Midland Energy from 2004 to 2006 is 39.73%, based on taxes divided by income before taxes. In addition, as the case didn’t mention expected tax policy would change in the near future, the 40% tax rate seems plausible.

Table 1:

• The cost of debt is calculated using the credit rating approach where a spread over U.S. treasury bond is added to the risk-free rate given the credit rating of the company provided by rating agencies such as Moody’s and S&P. This method is preferred as the alternative yield to maturity method can’t be deployed as information on debt portfolio of Midland Energy such as bond interest rate and maturity is not available.[pic 1]

Furthermore, based on table 2 below, 10-year rate on U.S treasury bond will be utilised to calculate the cost of debt . It is preferred over 1-year rate as 1-year rate doesn’t capture the long-term financing needs for Midland Energy. For example, exploration and production (E&P) business involves field discovery, evaluation, development, production and abandonment, and it generally lasts from 5 to 25 years. Furthermore, the weight of long-term debt in total liabilities is 49.1% based on Midland’s consolidated balance sheet in 2006, it further reflects 1-year rate is not ideal. 10-year rate is also preferred over 30-year rate. Given that Midland management team needs to evaluate its business and expected cash flows on an ongoing basis subject to geopolitical and economic conditions, 30-year rate seems not plausible. [pic 2]

Table 2:

• Estimate  using Hamada formula in the pure play approach based on the assumption that Midland Energy will have a constant debt level in 2007 and company’s debt doesn’t have market risk, i.e. .  Pure play method allows us to estimate beta for a Midland Energy using comparable publicly traded companies’ beta and adjust it for financial leverage difference. Unlevered beta is referred to as the asset beta as it reflects the business risk of the assets., and it is shared between creditors and shareholders. We would also take account into the tax shield effect for debt. [pic 3][pic 4]

Therefore, the equation  now becomes  as we assumed .[pic 5][pic 6][pic 7]

• Equity market risk premium (EMRP) is selected at 5%. Based on Table 3A and Table 3B provided in the case study, we have examined that the average of EMRP in different time periods from 1798-2006 in Table 3A is 6.0%, and the standard error is 2.2%.  However, Based on Table 3B utilising different survey results conducted by different researchers, the EMRP tends to be lower, generally in 3.5% range. Furthermore, the 5% EMRP for Midland Energy is advised by bankers and auditors who have expertise in the industry. Hence, 5% seems a reasonable estimate.

Table 3A:

Table 3B: