Midland Energy

Midland Energy  

For John Watson

Cost of Capital

23-Apirl-17

This paper focuses on talking about the Cost of Capital for Midland Energy. There are three separate divisions in Midland Energy. Each divisions has their own functions and conduct different discount rate to evaluate its projects. So, it is very difficult for Midland as if use one handler rate for many diverse purpose. The WACC calculation is based on DCF model. Cost of debt is using “bond yield plus risk premium” approach. I use CPAM to calculate cost of equity, for beta variable I choose industry data as related information.

Midland Energy Resources, Inc is a international energy company. It has broad range of products and services, such as refining, oil & gas exploration, and petrochemicals. Janet Mortensen is Senior Vice president of project finance. She is asked to justify weighted average cost of capital for the company and its three major divisions. Tax rate is 39.72% (average from Exhibit 1)in this case.

Mortensen’s method has been used for Midland cost of capital analysis for since 2002. For overseas investment, the cost of capital analyse based on converted foreign cash flows. For value adding project, discounted cash flow of project is used to calculate cost of capital. For approaching optimal capital structure, Midland conducts borrowing cost based on its inherent cost, and Debt ratio is one of major measurement. Lastly for M&A proposals, management uses DCF techniques to determine value of the company.

Midland may not able to use single corporate hurdle rate, because its three major division require different risk profiles based on their nature of business. Same hurdle rate may take unexpected risk for one division, or miss a high return low risk project for another division. For example, M&A division may need adjust its WACC and including higher risk premium, due to financial leverage. Exploration and Production division may require lower WACC compare with M&A, because of certain long-lived assets and stable cash flows.

To get Cost of Capital for Midland’s Corporate, I made some assumptions:

• Corporate tax rate is 39.72% (From Exhibit 1, average 2004-2006)
• Cost of debt based on 10 year U.S Treasury Bond 4.66% plus 1.62% (Table 1 spread) for long term purpose, because of Midland business is energy corporation, its borrowing collateral mainly based on energy resource and long-lived asset. 30 year bond is just too long for a business future perspective

Cost of Equity

From Exhibit 5, we get Levered Beta is 1.25% and D/E is 59.3%. According to equation between Levered Beat and Unlevered Beta, Unlevered Beta is 0.92. From Table 1, we know Equity/Value is 57.8% (1-42.2%), so D/E is 73% in this case. New equity beta is 0.92*(1+(1-0.3972))*0.73=1.33. So Cost of Equity is 4.66%+1.33*(5%)=11.31%

WACC for Midland is ((1-39.72%)*6.28%*42.2%)+(11.31%*57.8%)=8.13%

There are two reasons Midland Corporation cannot use single company hurdle rate. One reason is divisions have different risk profiles, the other reason is Midland’s target D/R is varies across divisions that would change cost of capital for division level.