Midland Energy Resources

1. Cost of capital

Estimates of the cost of capital are used in many analyses, including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. The cost of capital is usually estimated using the formula of WACC (weighted average cost of capital), which requires at least the values of financial leverage, cost of equity and cost of debt. Sometimes, in some ways of using WACC, we should also take account of tax rate. While the level of financial leverage can be easily got, we need to use CAPM (capital asset pricing model) to estimate the cost of equity and the spread over U.S. treasury securities of similar maturity to estimate the cost of debt.

As to capital budgeting, WACC would be used to compare with the IRR (Internal rate of return) and discount the cash flows to find NPV (Net present value) of projects, which can help Midland evaluate and identify more accurately whether the potential projects could bring value to company. So, for this use, we should calculate WACC with tax shield if the financing of the project includes debt. Furthermore, when we make use of treasury security rate, we should choose the one that of similar maturity as the horizon of the project. The beta now can be estimated by the average of published betas for publicly traded companies with single business the same as the project’s and similar leverage ratio. Moreover, we can use the discount rate that is consistent with the current level of S&P 500 index as the market rate when we calculate the market risk premium to better the current expectations and downsize the standard error.

For its use in financial accounting, we mainly use cost of capital for tax purpose and financial reports. So, the calculation of capital should be based on the actual interest rate paid on debt after tax deduction and the accounting return on equity. When estimating risk-free rate, we should use a relatively long-term treasury bond yield, such as 10 year U.S. treasury bond yield. As to the beta and market risk premium, we should use the historical values to make estimations. For example, we use the average of the past 5-year monthly beta values of the entire company. As to the estimation of cost of debt, besides the three factors mentioned in the case, we should also consider the business nature and the financial leverage ratio to adjust the estimation of the spread.

The third financial purpose is to assess the financial performance of the company or its divisions. To achieve this, it is very significant to calculate the residual wealth so called EVA (Economic value added) by deducting the cost of capital from the NOPAT (Net operating profit after tax). When we do this part, the estimation of each parameter should be similar as when we do financial accounting. However, we should further consider the increase of risk with the increase of leverage, the macro economy and the business cycle. If there is more risk due to any one of the three, we should increase the estimated beta and spread accordingly.

M&A is one of the important financial proposals for Midland and thus, the estimation of NPV of the whole target firm is a necessary part to assess the M&A proposal. The calculation of NPV is based on discounting all the future cash flows of the target firm by WACC. The way of using WACC in M&A should be similar to the one in capital budgeting, which means we can think of the target company as an investment project. The calculations are also similar except that we should also pay more attention to the influence of risk to the estimation of beta and spread.

Lastly, Midland has been always seeking the opportunity on repurchasing the undervalued stocks. In order to find the perfect timing, WACC should be continuously calculated in use of discounting the cash flows and then find the ultimate intrinsic value of company shares. The estimations of each value should be the similar to the value we use when assess the company performance. In order to find the true value of company stocks, we should further consider both the potential market and economic risk and the company’s growth potential.

2. Midland’s WACC

Midland optimized its capital structure in large part by prudently exploiting the borrowing capacity inherent in its energy reserves and in long-lived productive assets such as refining facilities. This year, both the oil prices and Midland’s stock price were at historical highs, and we can see from the B/S for 2006, net PP&E is 167,350, representing a 6.84% increase from last year. So, there is enough evidence for us to believe that Midland is going to capture the opportunity by increasing debt to shield additional profits from taxes.

 (a) Cost of debt

Using the yields to maturity of 30-Year U.S. Treasury bonds and the corresponding spread to the consolidated business with the rating of A+, we get the cost of debt equals to 6.60%.

(b) Beta for Equity

Mortensen used betas published in commercially available databases.

From table 1, we can know that the estimated D/V ratio for 2007 is 42.2%, however, the D/V ratio now is only 37.22% (calculated from the D/E ratio given in Exhibit 5). With a higher leverage ratio, the company stock's price movements tend to be more volatile relative to the overall market's movements, and thus a higher beta value.

The tax rate is decided as the average of the past three years’ tax rates. From Exhibit 1, we can get the tax rates for each of the years. By calculation, we can get 1/3* (0.3858+0.392079+0.413959)=0.4.

By deleveraging the current beta value for Midland, we can get the unlevered beta value of 0.922 (=1.25/(1+(1-0.4)*0.593)). Then, we leverage this beta with the estimated D/E ratio for 2007 and get 1.326 (=0.922*(1+(1-0.4)*0.73)), which is the beta we will use.

(c) Risk free rate

We use the long-term U.S. Treasury to proxy the risk free rate according to two reasons. Firstly, the company is relative mature and has been operated stably for more than 120 years. The borrowing capacity is inherent in its energy reserves and in long-lived productive assets such as refining facilities. Secondly, their product experienced a long business turnover. Thirdly, considering the future uncertainties of the company’s business, we think it is better to be more conservative. So, the 30-year U.S Treasury bond is selected, which equals 4.98%.