Midland Energy Resources, Inc.

is a global energy company, comprised of three different

operations -- oil and gas exploration and production (E&P), refining and marketing (R&M), and
petrochemicals. E&P is Midland’s most profitable business, and Midland anticipated heavy
investment in acquisitions of promising properties, in development of its proved undeveloped
reserves, and in expanding production. Measured by revenue, R&M was Midland’s largest
business. The relatively small margin was consistent with a long-term trend in the industry.
Petrochemicals is Midland’s smallest but most promising and undervalued division. Capital
spending in petrochemicals was expected to grow in the near term.
The primary goals of Midland’s financial strategy are to fund substantial overseas growth, invest
in value-creating projects, achieve an optimal capital structure, and repurchase undervalued
shares. To accomplish these goals, Midland must calculate an appropriate cost of capital that will
allow reasonable valuations of their strategies. In funding overseas growth, Midland must use its
cost of capital to analyze, evaluate, and convert foreign cash flows. In evaluating value-adding
projects, the cost of capital must be used to discount project cash flows. To optimize its capital
structure, the company must continuously evaluate its ideal borrowing based on its inherent cost.
Midland Cost of Capital Assumptions: To evaluate cost of capital for Midland Energy
Resources and each of the three divisions within the company, we will need to consider few
assumptions:
a) Cost of Debt: We have used the cost of debt as 30 year rate for U.S. Treasury Bonds in Table
2 plus the spread to Treasury for the consolidated company calculated as presented in Exhibit B
for Midland Energy, E&P division and R&M as these divisions pursue long run projects with
borrowing capacity dependent on long-lived assets and energy reserves. Petrochemical division
has short term focus projects with efficiency as goal. Thus, we have used 10-year treasury bonds
for our calculations.
b) Market Return: Although EMRP of 5% has been provided, neither the derivation, nor
empirical evidence is shared. We will use EMRP of 5.1% for period 1798-2006 from Exhibit A
as it gives us a long run average with lowest standard deviation minimizing any bias created by
point data.
c) Beta estimation: Levered equity Beta is estimated as an average for similar companies for
Exploration & Production and Refining & Marketing division. Whereas, the beta for debt was
assumed to be zero for Exploration & production division because it had A+ credit rating and the
debt beta for refining and marketing was estimated using the CAPM model. In the case of
Refining & Marketing, the Petrarch Fuel Services does not relate well to Midland due to its size
and operations. It seems to have unusual leverage and beta and low revenue and thus can be
ignored while calculating average beta values.
d) Comparable Firms and Weighted Scheme: We have calculated unlevered Beta using mean of
similar companies. We have ignored irrelevant firms with contrasting Beta like Petrarch for
R&M calculations as seen in Exhibit C
e) Estimation of enterprise value: The exact amount of excess cash, cash equivalents and other
short-term investments that the company has (theoretically) is not known from the given data.
Thus, we estimated the enterprise value using two different methods as shown in Exhibit C-
Method 1: Enterprise value= (Share price x total outstanding shares) + (Total debt) - (Total cash
and cash equivalents)
Method 2: We subtracted all the capital expenditures from the cash and cash equivalents to arrive
at the excess cash value (the logic being that every quarter we would require atleast sufficient
cash to cover our capital expenditures) required for calculating enterprise value (Enterprise value
= Total debt + Total Equity - excess Cash)
Cost of Capital: We understand that each of the 3 divisions of Midland Energy requires different
capital on an annual basis with Exploration & Production division demanding the highest capital
as seen in Exhibit 3. Thus, we analyzed each division using different Beta values. Since we do
not have relevant data to estimate the beta for petrochemical division, it has been calculated
using weighted average method. Weights have been assigned to each division on the basis of
total assets for the year 2006 as seen in Exhibit D.

Business Unit Unlevered Credit Cost of Cost of Debt Risk free return
Beta Rating Capital

Midland 0.91 A+ 9.621/9.111 6.6 4.98%

E&P 0.84 A+ 9.264 6.59 4.98%

R&M 1.15 BBB 10.845 5.9 4.98%

Petrochemicals -0.256/.466 AA- 3.35/7.03 6.01 4.66%

The cost of capital (as shown above) varies for the three divisions because the business operates
in different industries having different betas, risk exposure and credit ratings. All of these
components will affect a company’s cost of capital differently for eg: R&M has highest cost of
capital owing to greater leverage.
Conclusion: As seen from the Exhibit E, the cost of capital varies for different divisions of
Midland energy and for Midland to achieve its financial objectives it must take into
consideration cost of capital for each project. The cost of capital for each division of the
company is dependent on factors like capital structure employed, capital expenditure needs, risk
factor and cash flow for each division. Midland Energy can take advantage of the diversification
by leveraging low cost debt of Petrochemical division with increasing growth to compensate for
saturated division like Refining and Marketing with low growth opportunities.
It is clearly evident from Exhibit E that the three divisions of Midland Corporation based on the
underlying risk associated with each one of them. So, if a single hurdle rate is used across all
divisions then there is a likelihood of making a faulty judgment in investing strategy and
eventually investing in a risky division. Consider a scenario, if a decision is made to invest in
BBB rated refining and marketing division based on a single hurdle rate then it would be a risky
investment when compared to AA- rated petrochemicals or A+ rated exploration and production
division. This would affect the future cash flows and profitability of the company and in the
long run the value of the company will go down.