Midland Energy Resources Inc - Case Study

Introduction

The case presents the cost of capital estimate for Midland Energy Resources, Inc. which is a global energy company offering a wide range of products and services, including oil and gas exploration and production (E&P), refining and marketing(R&M) and petrochemicals. Midland’s main target of financial strategy are four areas: (1). Fund obvious overseas growth (2). Invest in value-creating projects in all departments (3). Optimize capital structure (4).  Repurchase undervalue shares in the appropriate time. In order to reach those targets, Mortensen, as a senior vice president of project finance for Midland Energy Resources, needs to calculate the cost of capital for the company as a whole and each of three departments in the annual report.

Calculation & Analysis

Calculating WACC for the whole company

The primary calculations are based on the formula for WACC:

WACC = rd (D/V) (1-t) + re(E/V)

Tax

From the Exhibit 1, we can calculate the average tax rate during 2004-2006: t = (7414 / 17910+12830 / 32723+11747 / 30447) / 3 ≈ 40%

Cost of debt

Mortensen computed the cost of debt for each division by adding a premium, or spread, over U.S. Treasury securities of a similar maturity. Thus, we can calculate the rd from Table 1 and Table 2: rd = 4.98% + 1.62% = 6.60%

Cost of equity

Mortensen used CAPM to estimate the cost of equity of the company, use the formula: re = rf + β (EMRP) = 4.98% + 1.25 × 5% = 11.23%.

According to the Exhibit 5, D/E is 59.3%. We can calculate the D/V= 37.22% and the E/V= 62.78%. Then, WACC = rd (D/V) (1-t) + re (E/V) = 11.23%× 62.78%+6.60%×37.22%× (1 - 40%) = 8.524%

Although, it is slightly lower for the EMRP of 5% used by Mortensen based on the Exhibit 6A and it is slightly higher based on Exhibit 6b, it is still appropriate to use the EMRP of 5% to calculate company’s WACC. Because Midland reviewed recent researches and consult with some professional advisors, including its banks and auditors, as well as Wall Street analysts covering the industry, who have much border information from different channels.

E&P’s WACC

rd = rf + E&P Spread to Treasury = 4.98% + 1.60% = 6.58%

re = rf + β (EMRP) = 4.98% + 1.15 × 5% = 10.73%

D/E = 39.8%  D/V = 28.47%, E/V = 71.53%[pic 1]

WACC = rd (D/V) (1-t) + re (E/V) = 6.58% × 28.47% × (1-40%) + 10.73% × 71.53% = 8.80%

R&M’s WACC

rd = rf + E&P Spread to Treasury = 4.98% + 1.80% = 6.78%

re = rf + β (EMRP) = 4.98% + 1.20 × 5% = 10.98%

D/E = 20.3%  D/V = 16.87%, E/V = 83.13%[pic 2]

WACC = rd (D/V) (1-t) + re (E/V) = 6.78% × 16.87% × (1-40%) + 10.98% × 83.13% = 9.81%

Difference = 9.81% - 8.80% = 1.01% caused by the different risk and β, as well as the D/E.