Midland Energy Resources Inc: Cost of Capital

Midland Energy Resources, Inc.: Cost of Capital

Midland Energy Resources is a leading global energy developer with three divisions Exploration & Production, Refining & Marketing, and Petrochemicals. Janet Mortensen, the senior vice president of project finance for Midland Energy Resources must determine the weighted average cost of capital (WACC) for the company as a whole and each of its divisions as part of the annual capital budgeting process. Mortensen’s primary calculations were based on the formula for WACC, in this expression, D is debt and E is equity, Rd is cost of debt and Re is cost of equity, while t is tax. WACC= Rd*(D/(D+E))*(1-T)+Re*(E/(D+E)).

So the Rf =4.98%, equity risk premium=5%, D/(D+E)=0.372, t=0.40, E/(D+E)= 0.628. R(D)=6.60, β =1.25. R(EL)=4.98 + 5*1.25=11.23%. WACC=0.372*6.60*(1-0.40) + 0.628*11.23 = 8.52%.

Because the company will optimize its capital structure by prudently exploiting the borrowing capacity inherent in its energy reserves and in long-lived productive assets such as refining facilities and the company will increase its borrowing capacity. So it will in turn represented an opportunity to shield additional profits from taxes. As to the target WACC, it is = 0.422*6.60*0.60 + 0.578*11.52=8.33%.

As to the separate division, we can calculate the cost of debt as follows, We used the risk free rate of 30 year treasury bond, which is 4.98%, since it is the longest rate with a small-possibility default risk:

Exploration and Production’s cost of debt (rd)= 4.98 + 1.66= 6.58%.

Refining and Marketing’s cost of debt (rd)= 4.98 + 1.80= 6.78%.

Corporate Level cost of debt (rd)= 4.98 + 1.62= 6.60%.

The calculation of cost of equity is much more subjective and complex than the calculation of cost of debt. Many approaches have been suggested to calculate the cost of equity. One such approach is the Capital Asset Pricing Model (CAPM). Rf = 4.98%, in 2006, Midland used 5% as EMRP. Levered Cost of Equity (re) of proxy firms: