Midland - a Global Energy Company

Midland case report

Midland is a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. Janet Mortensen, senior vice president of project finance for Midland Energy Resources, was preparing her annual cost of capital estimates for Midland and each of its three divisions. In fact, 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. However, sometimes the results were not satisfied by the presidents and controllers, so this report is going to analysis the cost of capital.

First of all, people should understand one thing which is how are Mortensen’s estimates of Midland’s cost of capital used? As we can see from the case the Mortensen’s estimates are used for asset appraisals for capital budgeting and financial accounting, performance assessments, M&A proposals and stock repurchase decisions. At division or business unit level as well as Corporate level. Cost of capital is an essential component in WACC calculations.                      

Next step is to calculate Midland’s corporate WACC. Mortensen computed the cost of debt for each division by adding a premium, or spread, over U.S. Treasury securities of a similar maturity. To find R, we do not use CAPM but we use the interest rate that we currently pay on the new loans. Consolidated Spread to Treasury is given on Table 1 as 1.62%. Then Rd = 4.98% + 1.62% = 6.60%. Tax rate is calculated based on the Exhibit 1 which is 39%. Actually, Midland used 5.0% as its Equity Market Risk Premium. The corporate β is publicly available, and as it represents corporate level β, I will use 1.25 as it is for Overall Corporate WACC calculation. Re = Rf+ β(EMRP) Re = 4.98% + 1.25 (5%) = 11.23%. By using the WACC formula the answer is 8.55%. Now we look back and discuss why better to use market premium. From the Exhibit 6, the traditional data showed nearly 6.0% EMRP, and the surveys showed lower EMRP (2.5% - 4.7%), a research over the industry with help from outsiders, who has broader industry knowledge, would result a better and latest EMRP for Midland.

In addition, as a global company, midland would invest different business for diversification and also to reduce the risk. In Exhibit 5, the Equity Beta represents the risk factor of those divisions. Since the risk preferences are different per division, the hurdle rates for those divisions should also be different, and calculated based on the β of the division. Midland should not use single corporate hurdle rate as this will lead to a wrong decision on a risky investment which make a huge profit lose.