Midland Energy Resources - Cost of Capital

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Financial Management Assignment

Midland Energy Resources, Inc.: Cost of Capital

Submitted by:

Yash Raj Singh (G16121

Midland Energy Resources, Inc.: Cost of Capital

Summary

Midland Energy Resources, Inc. is a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. On a consolidated basis Midland had operating revenue of $248.5 billion and operating income of $42.2 billion in 2006. Janet Mortensen, the senior vice president of project finance for Midland Energy Resources, is preparing the cost of capital estimates for the Midland and each of its three divisions as part of an annual budgeting process.

Company-wide Versus Divisional Hurdle Rates

Using a single cost of capital or hurdle rate for every division, within a consolidated company, which operates across different industries assumes that every division within the company is similar. The single hurdle rate does not take into consideration the different debt structures within divisions and the different nature of assets that may exist in each division. For example, Midland’s E&P division has assets of oil reserves and higher demand for capital expenditures for development (Exhibit 3). Also, Midland’s target debt ratio for each division varies which would change the cost of capital across divisions.

Across divisions, there may also be higher business risks as a result of the specific industry that the division operates in. Midland’s R&M division is its largest, yet it operates on smaller margins that are steadily decreasing (Exhibit 3). This makes division profits less certain and more risky, but being a more mature sector may offset some of this risk. Additionally, the R&M division has less need for increased capital and operates in a more mature and competitive market. This could influence the amount and cost of debt financing.

Problems Identified

• The appropriate risk free rate is not clear.

We have used the rate for 10year Treasury bond for calculating the risk free rate because 1 year is a very short period so investing in such a short period comes with risks. And 30year is a very long period and we don’t know whether the company would even exist for so long.

• EMRP for 2006 has been mentioned but the company has even used greater values of EMRP in the past. We are using the same value of EMRP considering the average values over the period 1978 to 2006.
• Beta estimation
• Single hurdle rate or different for different verticals

We have calculated different hurdle rates because calculating separate hurdle rates for each division will allow Midland to more accurately reflect the specific risks and benefits of projects as they pertain to their different industries.