Case study: Midland Energy Resources, Inc.

Company Background: Midland Energy Resources, Inc. (Midland) has a history of more than 120 years. There are three main business segments within the company: Exploration & Production, Refining & Marketing and Petrochemicals.

Objectives: In this report, I am going to estimate and calculate the cost of capital for Midland and each of its three divisions.

Assumptions: 1. CAPM Model is used in calculating re. Since we chose CAPM model to calculate re, then the assumptions of the CAPM Model have to be followed correspondingly. (Some important assumptions of the CAPM Model: 1) Investors are rational and risk-averse 2) Investors are price takers 3) There is no transaction or taxation costs 4) Investors may lend and borrow unlimited amounts using the risk free rate 5) Investors have the same information at the same time, etc. 2. rd and re remain constant for Midland and each of its three divisions For simplicity, I assume rd and re remain constant. 3. Tax rate remains constant. 4. D/V remains constant. 5. remains constant 6. US Treasury bonds are risk-free and the rates are constant for each maturity. Although US Treasury bonds might not be free of risk in reality, I assume they are free of risk in this report for simplicity, which is in fact a commonly used assumption. I also assume that the T-bond rates remain constant for each different maturity.

7. Costs of capital to be calculated are effective in project evaluation in 2007 only. They cannot be used in evaluation after 2007. This is to help guarantee projects are accurately elevated based on the most current data provided.

8. There are other assumptions which will be mentioned later in the Calculation and Analysis part.

Calculation and Analysis: To calculate the cost of capital for Midland and each of its three business segments, the formula for weighted average cost of capital (WACC) will be used as shown below: [pic] D=market value of debt E=market value of equity V=D+E=the value of the company or the division rd=cost of debt re=cost of equity t=tax rate

1. rd According to the case, rd for each division is calculated by adding a premium/spread over US Treasury securities of a similar maturity: rd =rf+ Spread to Treasury (Additional assumption: spread to treasury for each division and the company remain constant)

Besides, the two tables below are given in the case: | |Consolidated |Exploration & Production |Refining & Marketing |Petrochemicals |Spread to Treasury |1.62% |1.60% |1.80% |1.35% | | | | |

YTM for US treasury bonds (January 2007) |Maturity |Rate |

|1-Year |10-Year |30-Year

|4.54% |4.66% |4.98%

| | |

rd for 1) Exploration & Production and 2) Refining & Marketing: I use the risk free rate of 30-Year US Treasury bonds as the rf of 1) Exploration & Production and 2) Refining & Marketing. This rate is equal to 4.98%. This is because the two divisions usually carry out long-term projects, and I assume that 30-Year T- bond rate is a good estimate.

Therefore, rd for Exploration & Production =rf+ Spread to Treasury=4.98%+1.6%=6.58%

rd for Refining & Marketing = rf+ Spread to Treasury=4.98%+1.80%=6.78%

rd for Petrochemicals: I use the risk free rate of 1-Year US Treasury bonds as the rf of Petrochemicals. This rate is equal to 4.54%. This is because this division usually carry out projects with a shorter duration, and I assume that 1-Year T- bond rate is a good estimate.

Therefore, rd for Petrochemicals = rf+ Spread to Treasury=4.54%+1.35%=5.89%

rd for Midland: I use the risk free rate of 30-Year US Treasury bonds as the rf of Midland. This is because Midland s Refining and Marketing s business was the company s largest and Refining and Marketing usually carries out long-term projects.

Therefore, rd for Midland = rf+ Spread to Treasury=4.98%+1.62%=6.6%

2. re Capital Asset Pricing Model (CAPM) is used to calculate re: [pic] Rf=risk-free rate of return, =a measure of systematic risk EMRP=Equity market risk premium (According to the definition shown on the case report: it is the amount by which the return on a broadly diversified portfolio or risky assets is expected to exceed the risk-free return over a specific holding period)

for Midland is given, which was 1.25. Based on my assumption at the very beginning, is assumed to remain constant, then for Midland is 1.25)

However, for Midland s three divisions are not given, and I m going to estimate them by using published for publicly traded companies as stated in the case. By using Exhibit 5 and the formula below, I m going to show the adjusted . Asset = Equity / [1 + (1-T)*(D/E)] Tax rate is 39.73% as shown below, and its calculation will be shown in the report) |Exploration & Production |Jackson Energy |Wide Plain Petroleum |Corsicana Energy |Worthington Petroleum |Average | | | | | |39.73% |39.73% |Tax rate t |39.73% |39.73% |39.73% |39.73% |39.8% | | |10.30% |19.40% |D/E |Equity Beta |0.89 |1.21 |1.11 |1.39 |0.93 | | |1.7 |0.94 | |1.6 |0.84 | | | |0.83 |0.8 |1.02 |1.08 | | | |Asset Beta | | |

|11.20% |85.40% |15.20%

|47.50% |1.15 |

|Refining and Marketing |Bexar Energy |Kirk

|White Point Energy |Petrarch Fuel Services |Arkana Petroleum |Beaumont Energy |Dameron Fuel Services |Average |

|39.73% |39.73% |39.73% |39.73% |39.73% |59.3%

|20.90% |-12.00% |32.30% |20.60% |50.30% |1.25

|1.78 |0.24 |1.25 |1.04 |1.42 |1.05

|1.58 |0.26 |1.05 |0.93 |1.09 |

| | | | |

summary: (I assume that D/E remain constant for Midland and its three divisions) Equity for Midland = 1.25 Equity for Exploration & Production=0.93*[1+(1-39.73%)*85.19%]=1.41 Equity for Refining and Marketing =1.05*[1+(1-39.73%)*44.93%]=1.33 (85.19% and 44.93% are calculated based on Table 1)

In order to get for Petrochemicals, I m going to use the following expression: for Midland =w1* for Exploration & Production+w2* for Refining & Marketing+w3* for Petrochemicals (w1, w2, w3=weights that three divisions have in the company respectively; the weights are based on Total Assets of a specific division to the Total Asset of Midland)

The logic behind the expression is similar to the calculation of of a portfolio. When we want to calculate a portfolio , we use the weighted average of its different assets.

In our case: The shadowed parts are figures of Total Assets, while the bolded parts are the weights of the division s assets divided by the Total Assets of Midland. (My assumption: The arithmetic average is an effective method for this calculation. (Average weights are good estimates for project evaluation in 2007.)

|2004

|2005

|2006 |US$125,042 | | |US$91,629 |US$28,000 |US$244,671

|Average |US$140,100 | |US$93,829 |US$28,450 |US$262,379 |0.51 |0.37 |0.12 | | | |

| | |

|Exploration & Production |US$76,866 |(1) | |

|Refining & Marketing (2) |US$60,688 |Petrochemicals (3) |Midland (4) |W1=(1)/(4) |W2=(2)/(4) |W3=(3)/(4) |US$19,943 |US$157,497 |0.49 |0.39 |0.13

| | | |

|0.51 |0.37 |0.11

|0.53 |0.36 |0.11

Therefore, W1=0.51, W2=0.37, W3=0.12

Now, I can use the formula below to generate the for Petrochemicals for Midland =w1* for Exploration & Production+w2* for Refining & Marketing+w3* for Petrochemicals ( 1.25= w1*1.41+ w2*1.33+ w3* for Petrochemicals 1.25=0.51*1.41+0.37*1.33+0.12* for Petrochemicals ( for Petrochemicals=0.32

EMRP As shown in the case, there are two ways to calculate Midland s EMRP: 1) Historical date on stock returns and bond yields 2) Survey results Below are my thoughts about the two ways: a. If a survey is regarded as a good one, then it has to satisfy some very important considerations: not biased, not misleading, has sufficient sample size, etc. As far as I am concerned, the survey results in the case cannot reflect objective facts because the sample size (the number of survey

subjects) is not big enough no matter which researcher s result we are looking at. Therefore, their survey results are subjective. b. Historical data can reveal objectively what has happened in the past. I am more convinced by the figure collected for a period from 1798 to 2006 (EMRP=5.1%) because its corresponding Standard Error (1.2%) is the smallest among all the periods. As the sample size becomes larger and larger, the result generated will get closer and closer to the real parameter we are looking for.

EMRP obtained from historical dates from 1798 to 2006(5.1%) is similar to what Midland adopted (5 %). Considering that Midland adopted its 5% estimate after reviewing recent research and consulting with professionals, I think Midland s current estimate of 5% should be more reasonable. Therefore, EMRP=5% and I assume that remains constant.

re I will use the expression below to calculate re: [pic] re for Midland=4.98%+5%*1.25=11.32% re for Exploration & Production=4.98%+5%*1.41=12.03% re for Refining & Marketing=4.98%+5%*1.33=11.63% re for Petrochemicals=4.54%+5%*0.32 =6.14%

3. WACC I will use the expression below to calculate WACC: [pic]

1) Marginal tax rate =( tax2004/IBT2004+ tax2005/IBT2005 +tax2006/IBT2006) * (2006-2004+1)-1 = 39.73% (IBT=Income before tax)

2) D/V

D/V figures for Midland, Exploration & Production, Refining & Marketing and Petrochemicals are provided in Table 1. They are 42.2%, 46.0%, 31.0% and 40.0% respectively. (At the beginning of the report, I assumed that D/V remain constant for Midland, Exploration & Production, Refining & Marketing and Petrochemicals)

3) WACC cost of capital we want to get 1-t=1-39.73%=60.27% WACC for Exploration & Production =6.58%*0.46*60.27%+12.03%*(1-0.46) =8.32% WACC for Refining & Marketing =6.78%*0.31*60.27%+11.63%*(1-0.31) =9.29% WACC for Petrochemicals =5.89%*0.4*60.27%+6.14%*(1-0.4) =5.10% WACC for Midland= =6.6%*0.422*60.27%+11.32%*(1-0.422) =8.22%

Midland Energy Resources, Inc. was a global energy company with operations in oil and gas exploration, refining and marketing and petrochemicals. A profitable organization, in 2006 the company registered an operating revenue of $248.5 billion and an operating income of $42.2 billion. Midland had been in existence for more than 120 years and employed more than 80,000 individuals within the company. Midland enjoyed great success within all three divisions, including the industry s most profitable operation in exploration and production.

Midland s Operation Structure Scenarios Exploration & Production Midland Energy Resources has been incorporated more than 120 years. Oil exploration and Production (E&P) is Midland s most profitable business, and its net margin was among the highest in the industry over the previous five years before 2007. With the high price of oil in 2007 and fierce competition from other places of the world such as the Middle East, Central Asia, Russia and West Africa, Midland s capital investment in E&P was expected to be more than $8 billion in 2007 and 2008. Refining and Marketing Midland had ownership interests in 40 refineries around the world. Global revenue from 2006 was $203 billion, the largest of the company. Although the margins had been declining over the previous 20 years, Midland s capital spending in refining and marketing would remain stable according to the project. Midland is still a market leader in the business owing to its advanced technology and vertical integration. Petrochemicals Petrochemicals were Midland s smallest but most promising division. Midland owned equity interests in 25 manufacturing facilities and five research centers in eight countries around the globe. Capital spending in petrochemicals was expected to grow in the short-term project.

Financial Strategy In 2007, the organization restructured its financial strategy with an emphasis in four different areas: funding significant overseas growth, investing in value-creating projects across all divisions, optimizing its capital structure and the repurchasing of undervalued shares. Overseas Growth Overseas investments were the main engine of growth for most large U.S producers. Midland usually invested in foreign projects as a foreign business or a local business partner. Midland and its foreign partners shared the equity interest, with the foreign partner generally receiving at least 50% plus a preferred return. Value-Creating Investment

Midland used discounting cash flow methodologies to evaluate the most prospective investment. This method typically involved debt-free cash flow and a hurdle rate equal to or derived from the WACC for the project or division. Optimal capital structure Midland optimized its capital structure in large part by exploiting the borrowing capacity in energy reserves and in long-lived productive assets such as refining facilities. Each division had its own target debt ratio and these targets were set on considerations involving each division s annual cash flow and the collateral value of its identifiable assets. Stock Repurchases In the past, Midland repurchased its own shares on occasion and revealed that whenever an attractive opportunity became available, it would take advantage. When the stock price fell below the stock s intrinsic value, Midland would always consider repurchasing its share.

Weighted Average Cost of Capital In this report, Midland Energy explains the importance of the weighted average cost of capital (WACC), a computation of the minimum return that the company must earn on existing assets to satisfy its creditors, owners and other providers of capital. Midland obtains money from a number of sources including common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities executive stock options, etc. These securities represent sources of finance and are projected to generate different returns for the organization. The WACC is calculated by taking into account the relative weights of each component of the capital structure. Midland Energy can use this computation to see if the projects available to them are worthwhile investments. A calculation of Midland s cost of capital, in which each category of capital is proportionately weighted. All capital sources including common stock, preferred stock, bonds and any other long-term debt are included in a WACC calculation. All else equal, the WACC of Midland increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

Components of the WACC Cost of Debt Midland uses this computation to measure the effective rate that it pays on its current debt or simply, the cost of borrowing. This calculation provides the company with an idea of the overall rate being paid by the company to use debt financing. It also gives investors of Midland Energy an indication of how risky a company can be. Generally, riskier companies generally have a higher cost of debt. In order to obtain the cost of debt, Midland multiplies the before-tax rate by one and subtracts the marginal tax rate.

Cost of Equity A much more complex computation, the cost of equity refers to the return Midland provides to its equity investors such as shareholders to obtain their capital. A company needs to acquire capital from individuals or other partners to operate and grow. Individuals and organizations who were willing to provide Midland with their funds, obviously, want to be rewarded for their investments. Organizations obtain initial capital from two kinds of sources, lenders and equity investors. Lenders are rewarded through interest, while investors seek dividends or appreciation in value proportional to their investment. Referred to the cost of capital, Midland must pay for the funds it obtained from lenders and investors. In theory, as Midland s risk increases, its cost of capital increases. Capital providers expect reward for offering their funds to Midland. Providers are usually rational, preferring safety over peril.

Weighted Average The weights in the formula are, respectively, the proportion of total value represented by equity and the proportion on total value represented by debt. Each quantity to be averaged has to be assigned a weight. These weightings determine the relative importance of each quantity on the average.

Tax Rates The tax rate describes the burden ratio at which Midland Energy was taxed. Taxes can be one of the largest cash outflows that an organization experiences. Corporations endure taxable incomes, marginal tax rates and average tax rates. Typically, marginal tax rates are relevant for financial decision making.

Risk-Free Rate The risk-free rate represents the interest an investor would expect from a completely, risk-free investment over a certain period of time. The risk-free rate is the minimum return an investor expects for any capital investment. The investor will not accept additional risk unless the potential rate of return is greater than the risk-free rate. Unfortunately, even the most harmless investments carry some sort of risk.

Beta Beta represents the number that describes the relation of its returns with that of the financial market as a whole. For example, an asset that has a Beta of zero indicates that the asset s returns generally follow the market s returns. Both figures tend to be above their respective averages together, or on the contrary, tend to be below their respective averages.

Equity Market Risk Premium The equity market risk premium refers to the excess return that an individual stock or overall stock market provides over a risk-free rate. This return compensates investors for taking on the higher risk of the equity market. Higher risk investments are reimbursed with a higher premium, enticing riskier investments.

Midland Energy Resources Weighted Average Cost of Capital Calculation

Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate

V= E+D= $134,114+$79,508= $213,622 Weight of debt= D/E= $79,508/$213,622= 62.78% Weight of equity= E/V= $134,114/$213,622= 37.22%

Re= Where: Es: The expected return for a security Rf: The expected risk-free return in that market (government bond yield) s: The sensitivity to market risk for the security RM: The historical return of the stock market/ equity market

(RM-Rf): The risk premium of market assets over risk free assets.

Re= 4.66%+ 1.25*5%=10.91% Rd=1.62%+ 4.66%= 6.28% Tax rate= $11,747/ $30,447= 39%

WACC= 62.78%* 6.28%* (1-0.39) + 37.22%* 10.91% =0.024+ 0.041 =6.5%