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Midland Energy Essay

1228 words - 5 pages

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Midland Energy Resources, Inc.
Cost of Capital

Table of Contents

I. Executive Summary
II. Introduction
III. Cost of Capital
IV. Risk & Tax Rate
V. Capital Structures
VI. WACC
VII. Conclusion
VIII. References

I. Executive Summary

Midland Energy Resources is a global energy company with operations in oil and gas exploration and production(E&P) providing a broad array of products and services to upstream oil and gas customers worldwide including refining and marketing (R&M), natural gas, and petrochemicals. Janet Mortensen, the senior vice president of project finance for Midland Energy Resources must determine the weighted ...view middle of the document...

Petrochemicals are chemical products made from raw materials of petroleum. Although, petrochemical is a very large growing business Midland’s Petrochemical Division was small having revenue of $23 billion and after tax earnings of $2 billion.

As reading and reviewing this case we will focus on Janet Mortensen, the Senior Vice President undertaking this assignment of Midlands Cost of Capital. As an analyst in 2002, Mortensen calculated the Cost of Capital for an initial share repurchase and later provided the Cost of Capital for Executive management performance evaluation. Mortensen’s calculations have become very significant in everyday business decision within Midland. It is important to evaluate the value added in how the calculation is utilized throughout the company and provide a user guide to ensure the correct use and valuation.

III. Cost of Capital

Cost of Capital is the cost of obtaining funds for the required return necessary to meet its cost of financing a capital budgeting project determining how a company can raise money. Cost of capital encompasses two fundamental sources of financing such as cost of debt and cost of equity. Therefore the cost of capital is the weighted average of the financial components within a firm’s financial model. It is practical that the cost of capital is included in financial decisions for financial and budgeting performance. For an investment to be successful the expected return on capital has to be greater than the cost of capital.

Cost of debt is the effective rate that a company pays on its current debt before or after tax returns. To calculate Cost of debt the formula is (Rf + credit risk rate)(1-T), where T is the corporate tax rate and RF is the risk free rate. In this case Mortensen computed the cost of debt for each division by adding a premium, or spread, over U.S. Treasury securities of a similar maturity [1].
Mortensen computed the cost of debt for each division by adding a premium, or spread, over U.S. Treasury securities of a similar maturity [1]. Midlands E&P division is profitable and has positive prospects for continued growth; however, Midland must consider the risk exposure in the E&P division. The political charged issues such as nationalization or forced renegotiation of rights have an impact on the financial capacity of otherwise healthy reserves [1].
Cost of Equity is the return that stockholders require for a company. A company’s cost of equity represents the compensation that the market demands in exchange for owning the assets and bearing the risk of ownership. Based on capital markets the cost of equity varies in direct relation to the assumed risk in that specific market. The distinctive of the firm is the sensitivity to market risk (β) which depends on everything from management to its business and capital structure. Therefore past performances and present conditions have a direct effect on the overall...

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