Midland Energy Resources

Case study: Midland Energy Resources, Inc.

Company Background:

Midland Energy Resources, Inc. (Midland) has a history of more than 120 years. There are three main business segments within the company: Exploration & Production, Refining & Marketing and Petrochemicals.

Objectives:

In this report, I am going to estimate and calculate the cost of capital for Midland and each of its three divisions.

Assumptions:

1. CAPM Model is used in calculating re.

Since we chose CAPM model to calculate re, then the assumptions of the CAPM Model have to be followed correspondingly.

(Some important assumptions of the CAPM Model: 1) Investors are rational and risk-averse 2) Investors are price takers 3) There is no transaction or taxation costs 4) Investors may lend and borrow unlimited amounts using the risk free rate 5) Investors have the same information at the same time, etc.

2. rd and re remain constant for Midland and each of its three divisions

For simplicity, I assume rd and re remain constant.

3. Tax rate remains constant.

4. D/V remains constant.

5. β remains constant

6. US Treasury bonds are risk-free and the rates are constant for each maturity.

Although US Treasury bonds might not be free of risk in reality, I assume they are free of risk in this report for simplicity, which is in fact a commonly used assumption. I also assume that the T-bond rates remain constant for each different maturity.

7. Costs of capital to be calculated are effective in project evaluation in 2007 only. They cannot be used in evaluation after 2007.

This is to help guarantee projects are accurately elevated based on the most current data provided.

8. There are other assumptions which will be mentioned later in the Calculation and Analysis part.

Calculation and Analysis:

To calculate the cost of capital for Midland and each of its three business segments, the formula for weighted average cost of capital (WACC) will be used as shown below:

D=market value of debt

E=market value of equity

V=D+E=the value of the company or the division

rd=cost of debt

re=cost of equity

t=tax rate

1. rd

According to the case, rd for each division is calculated by adding a premium/spread over US Treasury securities of a similar maturity:

rd =rf+ Spread to Treasury

(Additional assumption: spread to treasury for each division and the company remain constant)

Besides, the two tables below are given in the case:

Spread to Treasury

Consolidated 1.62%

Exploration & Production 1.60%

Refining & Marketing 1.80%

Petrochemicals 1.35%

YTM for US treasury bonds (January 2007)

Maturity Rate

1-Year 4.54%

10-Year 4.66%

30-Year 4.98%

rd for 1) Exploration & Production and 2) Refining & Marketing:

I use the risk free rate of 30-Year US Treasury bonds as the rf of 1) Exploration & Production and 2) Refining & Marketing. This rate is equal to 4.98%. This is because the two divisions usually carry out long-term projects, and I assume that 30-Year T- bond rate is a good estimate.

Therefore, rd for Exploration & Production

=rf+ Spread to Treasury=4.98%+1.6%=6.58%

rd for Refining & Marketing

= rf+ Spread to Treasury=4.98%+1.80%=6.78%

rd for Petrochemicals:

I use the risk free rate of 1-Year US Treasury bonds as the rf of Petrochemicals. This rate is equal to 4.54%. This is because this division usually carry out projects with a shorter duration, and I assume that 1-Year T- bond rate is a good estimate.

Therefore, rd for Petrochemicals

= rf+ Spread to Treasury=4.54%+1.35%=5.89%

rd for Midland:

I use the risk free rate of 30-Year US Treasury bonds as the rf of Midland. This is because Midland's Refining and Marketing's business was the company's largest and Refining and Marketing usually carries out long-term projects.

Therefore, rd for Midland

= rf+ Spread to Treasury=4.98%+1.62%=6.6%

2. re

Capital Asset Pricing Model (CAPM) is used to calculate re:

Rf=risk-free rate of return,

β=a measure of systematic risk

EMRP=Equity market risk premium (According to the definition shown on the case report: it is the amount by which the return on a broadly diversified portfolio or risky assets is expected to exceed the risk-free return over a specific holding period)

β

βfor Midland is given, which was 1.25. Based on my assumption at the very beginning,β is assumed to remain constant, thenβfor Midland is 1.25)

However, βfor Midland's three divisions are not given, and I'm going to estimate them by using published βfor publicly traded companies as stated in the case. By using Exhibit 5 and the formula below, I'm going to show the adjusted β.

Asset β = Equity β/ [1 + (1-T)*(D/E)]

Tax