Evaluating Cost of Capital: A Case Study of Midland Energy Resources

This case study provides an analysis of the cost of capital for Midland Energy Resources, a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. The memorandum aims to determine the appropriate cost of capital to be used across the organization and its divisions. It calculates the weighted average cost of capital (WACC) for various divisions, considering the cost of debt and equity, and recommends using an overall WACC of 8.12% for evaluating projects at the organizational level. The analysis also suggests divisional WACCs of 8.05% for E&P and 9.01% for R&M, reflecting their respective growth expectations. Furthermore, the study discusses the impact of changes in capital structure, interest rates, and tax rates on WACC, recommending recalculation when these factors change. It also explores the potential improvement in WACC calculation by using a 30-year Treasury rate instead of a 10-year rate, resulting in revised WACCs. Desklib offers a platform for students to access this and other solved assignments.

Running head: COST OF CAPITAL
Cost of capital
Name of the Student:
Name of the university:
Authors note:

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Memorandum
To
Janet Mortensen
Subject: Propriety of application of Midland cost of capital.
The main aim of the Memo is to determine the rate of cost of capital that should be
used across the organisation. It is attempted to provide a recommendation about the final cost
of capital that should be used by the division and the organisation as a whole. The suggestion
is provided in the manner in which the calculation for cost of capital can be improved.
The cost of capital is calculated for various divisions which are comprised of
exploration and production, refining and marketing and petrochemicals. The weighted
average cost of capital is calculated after determining the cost of debt and cost of equity
(Buehlmaier & Whited, 2016). The WACC is the used by the company to determine the
required rate of return for evaluating the economic viability of the project. The appropriate
weighted average cost of capital for the entire organisation will help the business to
determine the project at the organisational level. The Appendix shows that the WACC that
should be used across the organisation is the 8.12%. It is determined after calculating the
WACC based on the consolidated figures of the both the exploration & production division
and Refining & Marketing division. Based on the above discussion it can be said that for
evaluating the project at the organisation level the project that has return above 8.12% will be
selected (Rigamonti et al., 2015).
The calculation of the WACC is provided in the Appendix. The calculation shows the
WACC at the consolidated level and the divisional level. The calculation of the consolidated
WACC is based on the consolidated financial information. On the other hand WACC of the

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division is determined based on the financial information of each of the division. The
recommended WACC for the divisions are for the exploration and production department is
8.05%. In case of refining and marketing division based on the calculation the recommended
WACC for the division is 9.01%. There are certain stable segments of the company like the
E&P business and the petrochemicals segment while the growth or spending in respect of
R&M is expected to grow over the period (Sullivan et al., 2015). The WACC determined is
appropriate after taking into consideration the growth of the division. It can be seen that for
E&P division as the growth is expected to remain stable than the R&M division so the
WACC is 8.05% for E&P and 9.01% for R&M.
The Weighted Average Cost of capital of the company has two components the debt
and equity. If the capital structure of the company changes then WACC of the organisation
should be re estimated. It can be said that if the debt components changes then the WACC of
company should be revised and increased as the risk factor has increased. On the other hand
if the debt component in the capital structure decreases then the WACC of the company
should be reduced. This principle is applicable to both the organisational and divisional level.
Therefore it can be said that if the capital structure of the company is changing then the
organisation should recalculate the WACC. It can be said that if the factors that effects the
calculation of the WACC changes then the WACC of the company should also be revaluated.
In this case the factors that affect the calculating of WACC are 10 year T bond, equity market
risk premium and tax rate. Therefore if the interest rate of 10 year T Bond changes then the
WACC should be recalculated. On the other hand if the tax rate changes then the WACC
should be re estimated.
The currently computed WACC has been made after taking into consideration the
factors. However the calculation of the WACC can be improved if the Treasury rate of the 10
years 4.54% is changed to 30 years Treasury rate 4.98%. The use of 30 years treasury rate

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indicates that the company will taken into account the long term effects so that a more stable
WACC can be measured. The changed WACC is provided in the appendix. On changing the
10 year T bond rate the revised WACC of the consolidated organisation is 8.39%. The
revised WACC for Exploration and production department is 8.31% and refining &
marketing division is 9.29% (Vogel, 2014).
It is ex-expected that this memo has been able to address to all the queries of the
management and at the same time establish the relevance of using different cost of capital
from different divisions of the company.
Thanking You

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Reference
Buehlmaier, M. M., & Whited, T. M. (2016). Are financial constraints priced? Evidence from
textual analysis.
Rigamonti, L., Ferreira, S., Grosso, M., & Marques, R. C. (2015). Economic-financial
analysis of the Italian packaging waste management system from a local authority's
perspective. Journal of Cleaner Production, 87, 533-541.
Sullivan, S. D., Mauskopf, J. A., Augustovski, F., Caro, J. J., Lee, K. M., Minchin,
M., ...&Shau, W. Y. (2014). Budget impact analysis—principles of good practice:
report of the ISPOR 2012 Budget Impact Analysis Good Practice II Task Force. Value
in health, 17(1), 5-14.
Vogel, H. L. (2014). Entertainment industry economics: A guide for financial analysis.
Cambridge University Press.

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Appendix
WACC (original)
WACC Calculation
WACC (Revised)
WACC Calculation