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midland energy resources
Janet Mortensen, senior vice president of project finance at Midland Energy Resources, is in the process of preparing her annual cost of capital estimates for Midland and each of its three divisions (oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals). These estimates are used in many analyses within Midland, including capital budgeting decisions, financial accounting, performance appraisals, M&A proposals, and stock repurchase decisions. There has been some disagreement in the past about specific inputs and assumptions used to arrive at the cost of capital estimate, so Mortensen needs to devote extra care in preparing the cost of capital estimates and justifying her assumptions.

These questions relate to the Midland Energy Resources, Inc: Cost of Capital case. See spreadsheet named: Midland Energy Resources Exhibits.xls.

1. For what purposes does Mortensen estimate Midland’s cost of capital? What would be the potential consequences of a too high estimate compared to the firm’s “true” cost of capital? What about a too low estimate?

2. Calculate Midland’s firm-wide WACC. Make sure you explain clearly your method and your choice of inputs. In particular, is Midland’s choice of market risk premium appropriate, and if not, what recommendations would you make and why?

3. Should Midland use a single corporate hurdle rate (i.e. a firm-wide WACC) for evaluating investment opportunities in all of its divisions? Why or why not?

4. Compute a separate estimate of the WACC for the E&P and R&M divisions. Again, make sure you explain how you arrive at your estimates. What are the main reasons the estimates differ from one another?

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