Midland Case Study

1. Objective:

Estimate the cost of capital for Midland Energy Resources’ operating divisions

2. Assumptions:

(1) Though the cost of capital should be calculated according to each project, we assume that cash flow within each operating divisions (E&P, R&M and Petrochemicals) are homogenous, thus we can calculate one single WACC for each division.

(2) Overseas investments are the main engine of growth for Midland and account for 77.7% of its earnings, however, since most of these investment are similar to project financing and Midland collected a management fee or royalty, we can assume that those overseas projects are not subjected to country risk and Beta along can be a good estimate for its risk level.

(3) One of Midland’s financial strategies in 2007 is to optimize capital structure and each of Midland’s divisions had its own target debt ratio, thus we can assume that Mortensen’s preliminary estimates can be used in calculating the capital structure in each division.

(3) Tax rate remains constant over years.

3. Calculation:

3.1 Calculate the cost of debt

(1) Risk-free rate

Since Midland is an energy company that invests in long-term projects, we choose Treasury securities of a similar maturity to the projects, presumably T-bonds with maturity of 30-Year (4.98%)

(2) Calculate cost of debt for each division by adding a premium over US T-bonds with maturity of 30-Year. The premium depends on the Credit Rating

　 | E&P | R&M | Petrochemicals |

risk-free rate | 4.98% | 4.98% | 4.98% |

Premium | 1.60% | 1.80% | 1.35% |

r(d) | 6.58% | 6.78% | 6.33% |

3.2 Calculate the cost of equity

(1) Estimate Beta

We use the comparable company information for calculating divisional Beta. Since there is lack of information for Petrochemical Division, we use the information of Company Beta, E&P equity Beta and R&M equity Beta to calculate it.

| E&P | R&M | Petrochemicals | Consolidated |...