Midland Energy Resources, Inc.: Cost of Capital

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ESE
 540
 
Case
 Study
 1:
 Midland
 Energy
 Resources,
 Inc.:
 Cost
 of
 Capital
 
Team
 S
 

 
As
 a
 profitable
 company
 that
 has
 been
 incorporated
 more
 than
 120
 years
 and
 with
 
more
 than
 80,000
 employees,
 Midland
 Energy
 Resources
 provides
 a
 wide
 range
 of
 
operation
 and
 services,
 which
 can
 be
 concluded
 with
 three
 major
 divisions:
 
Exploration
 &
 Production,
 Refining
 and
 Marketing
 and
 Petrochemicals.
 Janet
 
Mortensen,
 the
 senior
 vice
 president
 of
 project
 finance
 for
 the
 company,
 has
 been
 
asked
 to
 calculate
 the
 WACC
 of
 the
 company,
 including
 the
 company’s
 three
 
divisions
 as
 part
 of
 the
 annual
 assessment
 of
 Midland’s
 financial
 condition.
 Given
 the
 
exhibits
 of
 all
 relevant
 financial
 information,
 accurate
 calculations
 can
 be
 done
 by
 
choosing
 appropriate
 data.
 
 

 
As
 mentioned
 in
 the
 document,
 Midland
 Energy
 Resources
 had
 been
 incorporated
 
more
 than
 120
 years
 previously.
 In
 order
 to
 do
 the
 calculation
 of
 cost
 of
 debt
 and
 
cost
 of
 equity
 for
 such
 a
 historical
 company,
 1-­‐year
 or
 even
 10-­‐year
 risk-­‐free
 rate
 
values
 are
 not
 accurate
 enough.
 The
 risk-­‐free
 rate
 with
 the
 longest
 period
 should
 be
 
suitable
 for
 this
 situation.
 Thus
 the
 value
 4.98%
 (30-­‐year)
 should
 be
 used.
 
 

 
Due
 to
 the
 document,
 the
 cost
 of
 debt
 for
 each
 division
 can
 be
 calculated
 by
 adding
 a
 
premium,
 or
 spread,
 over
 U.S.
 Treasury
 securities
 of
 a
 similar
 maturity:
 

 
rd
 (Midland):
 4.98%
 +1.62%
 =
 6.60%
 
rd
 (Exploration
 &
 Production):
 4.98%
 +1.60%
 =
 6.58%
 
rd
 (Refining
 &
 Marketing):
 4.98%
 +1.80%
 =
 6.78%
 
rd
 (Petrochemicals):
 4.98%
 +1.35%
 =
 6.33
 %
 

 
Considering
 about
 the
 credit
 rating:
 The
 higher
 the
 credit
 rate
 is,
 the
 lower
 the
 
spread
 to
 treasury
 is.
 As
 the
 credit
 ratings
 of
 the
 three
 divisions
 are
 different,
 the
 
spread
 to
 treasury
 value
 would
 be
 different.
 Thus
 the
 costs
 of
 debt
 are
 different.
 
 

 

1
 


 
Considering
 about
 the
 nature
 of
 the
 divisions’
 operations:
 The
 spread
 to
 treasury
 
depends
 on
 the
 factors
 such
 as
 division’s
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