Midland Energy Resources Analysis
Date: 1/25/2007
To: Janet Mortensen
CC: Prof. Joseph Rizzi
From: Corey Ptaszynski
RE: Cost of Capital Estimates
Ms. Janet Mortensen,
I have completed my analysis in determining cost of capital estimates using the Weighted Average Cost of Capital. This analysis can help Midland make future capital budgeting decisions, specifically in Exploration and Production and in Refining and Marketing. These estimates of WACC can also be used for performance assessments of the company, merger and acquisition proposals, and stock repurchase decisions. These estimates can be used at both the corporate and business unit level.
However, please keep in mind that these are estimates. If they are inaccurate, Midland could face some unfortunate consequences. For example, if this estimate is too high, NPV on new investments will be lower than “true” NPV. We could underestimate investments and miss out on investment opportunities. On the other hand, if this estimate is too low, NPV will look more attractive. Midland could invest in an opportunity that has been overestimated. Just to clarify, these are worst case scenarios, I feel confident with my estimates.
First, I calculated Midland’s firm-wide WACC. The following assumptions were used in the calculation:
1. The cost of debt was calculated as the 30 year rate on Treasury Bonds plus the spread to Treasury for the consolidated company. This equals 4.98%+ 1.62% so 6.60%. The 30 year rate is used because Midland’s borrowing capacity is based on long-lived assets.
2. The tax rate is calculated based on the average tax rate from 2004 to 2006.
3. Equity Market Risk Premium of 5% was used instead of Midland’s EMRP of 6%. This was due to recent research and consultation from professional advisors and Wall Street analysts. These are the so called “experts” in the field and have more access to information from other companies.
4. Equity Beta of 1.25 used, this was public data used for the corporate level.
5. Equity cost of capital was calculated using the following formula, 4.98% + (5% x 1.25) = 11.24%.
By using the WACC formula provided, corporate WACC equaled 8.54%.
There are several points I would like to make about the corporate WACC. Midland should not use this rate for evaluating investment opportunities in all of its divisions. Midland is a large company with diverse business units. All of these units have different
