Midland Energy

Midland Energy Resources, Inc.: Cost of Capital

Posted on December 25, 2012 by harvardcasestudies—No Comments ↓

by Timothy A. Luehrman and Joel L. Heilprin

Case Overview

The senior vice president of project finance for a global oil and gas company must determine the weighted average cost of capital for the company as a whole and each of its divisions as part of the annual capital budgeting process. The case uses comparable companies to estimate asset betas for each operating division, and employs the Capital Asset Pricing Model to determine the cost of equity. Students are required to un-lever and re-lever betas and, choose an appropriate risk-free rate, and compute costs of debt and equity.

Key Concepts in the Case

Cash flow; capital structure; valuation; Risk assessment

Introduction

In late January 2007, Janet Mortensen, senior vice president of project finance for Midland EnergyResources, was preparing her annual cost of capital estimates for Midland and each of its three divisions. Midland was a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. On a consolidated basis, the firm had 2006 operating revenue and operating income of $248.5 billion and $42.2 billion, respectively.

Estimates of the cost of capital were used in many analyses within Midland, including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. Some of these analyses were performed at the division or business unit level, while others were executed at the corporate level. Midland’s corporate treasury staff had begun preparing annual cost of capital estimates for the corporation and each division in the early 1980s. The estimates produced by treasury were often criticized, and Midland’s division presidents and controllers sometimes challenged specific assumptions and inputs.

In 2002, Mortensen, then a...