Midland Energy Resources, Inc: Cost of Capital

Executive Summary: In order to estimate cost of capital, data was utilized from Midland’s financial statements, Standard & Poor’s ratings, Treasury bonds, and comparables. Cost of capital for Midland’s consolidated company and the three divisions, Exploration & Production (E & P), Refining and Marketing (R & M), and Petrochemicals were calculated to be 8.61%, 8.57%, 9.62% and 6.06%, respectively. A marginal tax rate of 35% and a market risk premium of 5.1% were applied to all divisions. Comparables of were used for E & P, R & M, and company. for Petrochemicals was calculated based on weights of debt and equity and on of the other divisions and company. The difference in WACCs suggests that it is beneficial to separate divisions for investment decisions, especially related to the Petrochemicals division. The cost of capital is highly dependent upon the weight of debt and equity. Higher debt yields lower cost of capital which is more desirable than higher equity as the cost of capital increases with equity. Return on equity and debt had little to no effect on the cost of capital, but the return on equity is highly dependent upon the beta of both assets and equity (assets is dependent upon equity, therefore it follows that assets affects the return on equity). In conclusion, the WACC has been determined for consolidated and divisional areas of Midland to be utilized in the capital budgeting