Case Study: Midland Energy Resources, Inc.: Cost of Capital

Case Study

Midland Energy Resources, Inc.: Cost of Capital

Practical Work Number: 15670

Case Summary

Midland Energy Resources is an international company with a wide range of operations and products. It has three main business divisions: oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. The firm has proven to be quite lucrative in the past few years. In 2006, consolidated operating revenue and operating income are $248.5 billion and $42.2 billion.

The goal of the case study is the same as the goal of Janet Mortensen, senior vice president of project finance for the firm, which is to find the appropriate cost of capital estimates for the corporation and each division.

The estimates of cost of capital is widely used in analyses within the firm, including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions.

Three Business Divisions

Exploration and Production (E&P)

E&P is the most profitable business of Midland with a net margin that is among the highest in the industry for the past 5 years. Midland anticipated continued heavy investment in acquisitions of promising properties, in development of its proved undeveloped reserves, and in expanding production, due to the growing demand of its products in the foreseeable future and the historical-highest oil price in 2007.

Refining and Marketing (R&M)

R&M’s business is the firm’s largest if measured by revenue, and Midland is a market leader in this business. However, the division faces stiff competition which leads to a relatively small and shrinking margin. The projected investment in R&M would remain stable.

Petrochemicals

Petrochemicals is Midland’s smallest division but nevertheless an important one. Capital spending in petrochemicals is expected to increase in the near future as certain old facilities would be replaced by newer and more efficient capacity.

Estimating Cost of Capital

My calculation of cost of capital is based on the well-known formula for WACC.

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Cost of Debt

To start my estimation, I begin with finding the cost of debt of the firm and each division. I use the following formula to calculate the cost of debt.

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Relevant data is given as follows.

Table 1 Estimates based on target

SOURCE: Case, Table 1