Midland's Cost of Capital

Abstract

Midland Energy Resources has its operations divided amongst three separate divisions. The divisions have different functions and need separate discount rate to evaluate its projects. The cost of capital is very critical in Midland as it used for many diverse purposes. Therefore it is important to calculate an accurate cost of capital. The Weighted Average Cost of Capital is used to discount Midland’s cash flows. Cost of debt is comparatively easier to calculate using a ‘bond yield plus risk premium’ approach. The cost of equity is calculated using the Capital Asset Pricing Model (CAPM). In CAPM the calculation of beta requires significant judgment. Industry data is used to calculate the beta but such data is not available for one of the divisions where an alternative method is applied. There is also some controversy in using the market risk premium: the historical risk premium for US stocks significantly differs from the risk premium used in the industry. By making certain assumptions about these variables four separate costs of capital are estimated for Midland and its three divisions.

Excel Sheet

Return on Debt,

T-Bills Return,

Yield Spread, Beta,

Return on Equity,

WACC for Midland, Exploration and Production, Refining and Marketing and Petrochemicals.

Questions Covered

What should be the cost of capital for Midland operational divisions?

How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations?

Is Midland’s choice of an expected market risk premium for equity appropriate? If not, do you have alternatives you might suggest?

Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations. Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why?

Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its...