Midland Energy Resources,inc. Case Study

MIDLAND ENERGY RESOURCES,INC. :

COST OF CAPITAL

EXECUTIVE SUMMARY:

Midland Energy Resources, Inc., is a global energy company that has been in business for over 120 years and employed more than 80,000 individuals.  The company operates three different divisions including:  oil and gas exploration (E&P), refining and marketing (R&M), and petrochemicals.  Midland has reported operating revenue of $248 billion and operating income of $42.2 billion.  Midland’s financial strategy was founded on four pillars:  fund overseas investment, invest in value creating projects across all divisions, optimize it’s capital structure and repurchase undervalued shares.  The Senior Vice President of Project Finance, Janet Mortensen, has been tasked to calculate the weighed average cost of capital (WACC) for the company as a whole, as well as each of its three divisions as part of the annual budgeting process.  

MIDLAND’S OPERATING DIVISIONS:

Exploration & Production

Oil exploration and production (E&P) is Midlands most profitable division, with it’s net margin among the highest in the industry over the last five years.  In 2006, Midland extracted an estimated 2.10 million barrels of oil per day, which was a 6.3% increase from the year before.  Midland expected continued global population and economic growth to drive demand for its products.  With oil prices at historic highs in 2007, Midland anticipated continued investment in acquisitions of properties, development of its undeveloped reserves and expanding production.

Refining & Marketing

Midland had ownership interests in 40 refineries around the world with distillation capacity of 5 million barrels a day.  Midlands advanced technology and vertical integration resulted in Midland leading the industry.  The refining and marketing division was the company largest measured by revenue.  Being that these products were highly commoditized, margins had declined, which was consistent with the long-term trend in the industry over the last 20 years.  Regardless, Midland projected capital spending in refining and marketing would remain stable without significant growth.  This was in part due to declining margins and fierce regulations that created barriers to expand and create new refineries.  

Petrochemicals

Petrochemicals was Midlands smallest division, but had significant potential for growth in the near future.  Capital spending is expected to grow as facilities will be replaced by newer and more efficient capacity.  Midland owned or had equity in 25 manufacturing facilities and five research facilities in eight countries around the world.

OBJECTIVE:  

To propose an appropriate cost of capital analysis to Midland Energy Resources, Inc and it’s three divisions.

ANALYSIS:

Janet Mortensen estimates the cost of capital as a way of evaluating investment opportunities at the corporate and divisional levels of the organization.  Mortensen estimates the cost of capital for the purpose of capital budgeting, financial accounting, M&A proposals, stock repurchase decisions and performance assessments.  Mortensen uses a separate cost of capital calculation for each division because each represent a distinct business with various functions and levels of risk, have different capital structures and different discount rates.  The Oil & Gas Exploration and Production (E&P) division has a different debt structure and target debt ratios because it has oil reserve assets and a high demand for capital expenditure for development.  Refining and marketing (R&M) division is a higher risk because of decreasing margins that lead to uncertainty of future profits.  Petrochemicals ma