Midland Energy Resources

OVERVIEW

Midland Energy Resources is a global energy company. The company operates in three areas: Exploration & Production (E&P), Refining & Marketing (R&M), and Petrochemicals. As part of the annual budgeting process, a report has been prepared to estimate the cost of capital for the company as a whole and each of its three divisions separately.

This report will be split into three parts. To start off, the report will discuss the anticipated uses of the cost of capital estimates and explain how learning the uses of the estimates will affect the calculation. Next, the report will provide the cost estimates and outline the calculation process in detail. Finally, a sensitivity analysis will be included to illustrate how the cost of capital varies with different assumptions.

PART I: Anticipated Uses of Cost of Capital Estimates

The estimates of cost of capital are used as "de facto" standards in many analyses throughout the company, including asset appraisal for capital budgeting and financial accounting, performance assessment, M&A proposals, and stock repurchase decisions.

As discussed above, one major use of the cost of capital estimate is to assess projects performance and investment opportunities within each division. This use highlights the importance of conducting cost of capital estimation at both corporate and divisional level. Midland is a large corporation with operations in three completely different areas. Due to the nature of operations, the three divisions have very different risk exposures and capital structures.

For instance, the E&P division has been demonstrated above-benchmark profitability over the previous five years. The strong profitability has partially contributed to the division’s relatively sound credit rating in comparison to other divisions. However, the E&P division has is particularly susceptible to political risk, as a significant fraction of E&P's productive assets and proven reserves are located in politically volatile countries such as Middle East, Central Asia. The political risk affects expected cash flow and collateral value E&P, and will add to the risk premium for the division. On the contrary, the R&M division runs on small and decreasing margin (as shown in Exhibit 3), which increases the risk for the R&M division.

As the result of different risk exposures and capital structures, the three divisions have different risk profiles, which in turn lead to different minimum required rate of return (aka., hurdle rate). It is critical to use divisional hurdle rate to evaluate investment opportunities for that specific division. Or, the company may miss good investment opportunities by overestimating hurdle rate or take on too risky investment by underestimating hurdle rate. However, as the same