Midland Energy Resource Case Study
Midland Energy Resources is a fairly successful global energy company which had been incorporated more than 120 years previously and in 2007 had more than 80,000 employees. It has three main operations, oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. E&P is the most profitable segment of Midland and its net margin over the previous five years was among the highest in the industry. Its largest division is R&M with the Petrochemical division being the smallest. The capital spending in R&M would remain stable and in petrochemicals was expected to grow. The four primary goals of Midland’s financial strategy are to fund substantial overseas growth, invest in value-creating projects, optimize its capital structure, and repurchase undervalued shares. Janet Mortensen, the senior vice president of project finance for Midland Energy Resources, has been involved in estimating the cost of capital of the company. She calculated the weighted average cost of capital (WACC) for the company as a whole, as well as each of its three divisions. The estimates are used for asset appraisals for capital budgeting and financial accounting, performance assessments; merger and acquisition proposals and stock repurchase decisions. Financial Analysis
Cost of Capital: By definition, cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk1. For companies which use a combination of debt and equity to finance their businesses, their overall cost of capital is derived from a weighted average of all capital sources, also known as the weighted average cost of capital (WACC). What we use “Cost of Capital” to evaluate? Cost of capital is an important component of business valuation work. Midland uses the cost of capital to evaluate value of the company and most prospective investments. For example, the fundamental value of the enterprise was estimated using DCF analysis with cost of capital as discount rate; the cost of capital rate is also used in determining whether the performance of a business or division is value creating. WACC: The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets2. How are Mortensen’s estimates used at Midland? Mortensen’s estimates were used for many things including performance assessments, mergers and acquisition proposals, stock repurchases, asset appraisals, and financial accounting. To estimate cost of debt, Mortensen computed it for each division by adding a premium (or “spread”) over U.S. Treasury securities with an appropriate maturity depending on the division. To estimate cost of equity, Mortensen used CAPM model. She used published beta for corporate and comparable companies’ published betas for the divisions. CAPM: The capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, given non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable, represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset3. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. Midland’s Corporate WACC
Cost of Debt: From Table 2, we will see the yields to maturity for U.S treasury bonds in January 2007. The 10-year risk-free rate seems more appropriate because Midland’s borrowing capacity is based primarily on its energy reserves and long-lived assets. So the short term 1 year rate would be too low. Based on the potential changes in oil reserves and production business, the 30 year maturity might be too long to compare Midland’s...
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