Midland Energy Resources

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Recently, I was asked to provide detailed estimates of Midland’s corporate WACC, as well as estimated calculations of the cost of capital of each of the company’s divisions: Exploration & Production, Refining & Marketing, and Petrochemical. The first calculation performed was the company’s corporate WACC, which based on detailed computations, was 8.54%. This was accomplished by using the rate of 30-year U.S. Treasury bonds in 2007, which was 4.98%, as the risk free rate, because it was assumed that using long-term yields for bonds to determine this rate was the best course of action for all calculations. The cost of debt is then determined by adding the spread to Treasury of A+ rated companies to the rate of 30-year treasury bonds in 2007. Finally, the cost of equity was determined. The EMRP of 5% was an estimate agreed upon by many industry analysts, so the company has decided to use it in this instance. The company’s tax rate of 39% was derived from the average of taxes paid between the years 2004-2006, and is used for all calculations. The corporate beta of 1.25 is also used in calculating WACC. Calculating WACC for each of Midland’s divisions is more complicated, however, due to differing hurdle rates between those divisions. These rates differ for a variety of reasons, but one of the primary reasons is that both the beta and the spread to Treasury of each division fluctuate. For the E&P division, the average industry equity beta is 1.15, which is less than the 1.25 used to calculate corporate WACC. This is the main difference between the E&P industry and Midland as a company, as the influence of individual company debt is removed in this situation. Additionally, the spread to Treasury is slightly lower for E&P than it is for the corporate level. The WACC for the E&P division is 8.23%. The Refining & Marketing division has a higher beta than E&P at 1.20, and its

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