Weighted Average Cost of Capital and Midland Energy

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Executive Summary: Midland Energy Resources, Inc. is a global energy company with a broad array of products and services. The company operates within three different operations including oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. Midland has proven to be a very profitable company, with reported operating revenue of $248.5 billion and operating income of $42.2 billion. The company has been in business for over 120 years and employed more than 80,000 individuals. Janet Mortensen, the senior vice president of project finance for Midland Energy Resources, has been asked to calculate the weighted average cost of capital (WACC) for the company as a whole, as well as each of its three divisions as part of an annual budgeting process. Midland’s Three Divisions: Exploration & Production Oil exploration and production (E&P) is Midland’s most profitable business, and its net margin over the previous five years was among the highest in the industry. With oil prices at historic highs in early 2007, Midland anticipated heavy investment in acquisitions of promising properties, in development of its proved undeveloped reserves, and in expanding production. They also needed to account for competition from areas such as the Middle East, Central Asia, Russia, and West Africa. Refining and Marketing Midland had ownership interests in forty refineries around the world with distillation capacity of five million barrels a day. Measured by revenue, this side of the business was Midland’s largest. The relatively small margin was consistent with a long-term trend in the industry. Margins had declined steadily over the previous twenty years. Petrochemicals Petrochemicals is Midland’s smallest but most promising and undervalued division. Midland owned twenty-five manufacturing facilities and five research centers in eight countries around the world. Capital spending in petrochemicals was expected to grow in the near term.

[Midland Energy Case Analysis] Managerial Finance

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In order to find the cost of capital for Midland Energy Resources and each of the three divisions within the company, we will need to use the formula for weighted average cost of capital (WACC) which is: ( )( rd= Cost of debt re= Cost of equity D= Market value of debt E= Market value of equity V= D+E= Value of the company (or division) T= Tax rate First, we can calculate “rd” for each division as it is outlined in the case by adding a premium/spread over US Treasury securities of a similar maturity. In other words: ( The two tables in the case are as follows: Table 1 Business Segment Consolidated E&P R&M Petrochemicals Credit Rating A+ A+ BBB AATable 2 Maturity 1-Year 10-Year 30-Year Rate 4.54% 4.66% 4.98% Debt/Value 42.2% 46.0% 31.0% 40.0% Spread to Treasury 1.62% 1.60% 1.80% 1.35% ) ) ( )

*For my calculation, I used the 30-year maturity for E&P, R&M, and Midland as a whole as they take on longer term projects. I used the 1-year for petrochemicals as they tend to take on short term projects.

[Midland Energy Case Analysis] Managerial Finance

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Calculations are as follows: rd for Exploration & Production:

rd for Refining & Marketing:

rd for Petrochemicals:

rd for Midland:

Second, we need to calculate “re” for the three divisions as well as Midland as a whole. To find “re”, we will use the CAPM model outlined in the case: ( )

In order to solve this equation, we need to find beta for the three divisions. The case already outlines Midland’s overall beta at 1.25. However, the case does not state the beta for the three divisions. We can calculate this using beta for publicly traded companied outlined in the case. Using the following formula, as well as exhibit 5 in the case, we can calculate beta for the three divisions:

*

(

) ( )+

[Midland Energy Case Analysis] Managerial Finance

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Exhibit 5(from case)
Exploration & Production: Jackson Energy, Inc. Wide Plain Petroleum Corsicana...
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