Midland Energy Resources [Final]

Carlson School of Management

Midland Energy Resources, Inc.: Cost of Capital

Fig Financial Consulting: Santosh Kumar Cheekatmalla Gauri Jadhav Vincent Roczniak Brandon Sather

Carlson School of Management Ms. Mortensen, We here at Fig Financial Consulting have reviewed the current financial and economic situation of Midland Energy Resources, Inc. and have presented our findings below. Included in our analysis are the methods we used for our calculations. Please be advised that these calculations are not “one size fits all” and that there may be significant consequences if a single calculation were to be used across the company as a whole as the three operating divisions are inherently different in their operations, and have different risks associated with them. Our first task was to determine the consolidated WACC for the firm. In order to do this we reviewed current practices in conjunction with historical and survey data. The first element in developing the firm’s WACC was to determine the proper risk free rate, and in our estimation this rate should be set at 4.98%. This is currently the rate on the longest available rate with a negligible default risk, and is the current 30 year t-bond rate. Our calculation of the EMRP significantly factored in historical averages, and was set at 5.1%. We understand that much of the history considered in these calculations is not directly applicable to current market conditions, however with a smaller standard error we more confident that it would be a better approximation that a more current historical estimate with a larger standard error. In addition, your firm has been using 5% in recent years based on a “review of recent research and consultation with its professional advisors” and did not have sufficient evidence to suggest a major change in the EMRP. In regards to the consolidated capital structure, we did make some adjustments based on recent data. We saw significant variation in the debt ratio from 2005 to 2006; these ratios were 44.12% and 37.22% respectively. It is our opinion that the current targeted consolidated debt ratio of 42.2% is elevated, and our recommendation is to lower this ratio to 40%. Our debt ratio calculations can be seen in the table below. 2006

2006

2005

closing stock price ($):

44.11

38.32

shares outstanding (M):

2,951.00

2,945.00

MVE (M): Cash/Equivalents (M):

134,114.00 130,168.61 112,852.40 19,206.00 19,206.00 16,707.00

Restricted Cash (M):

3,131.00

3,131.00

Current Portion of Long T erm Debt (M):

20,767.00

26,534.00

Long-T erm Debt (M):

81,078.00

82,414.00

Net Debt (M): Enterprise Value (M):

79,508.00 79,508.00 89,110.00 213,622.00 209,676.61 201,962.40

Debt Ratio:

0.3722

0.3792

0.4412

Carlson School of Management Due to the capital structure adjustment, we are no longer able to use the firm’s historical beta of 1.25; the change in structure causes a change in risk and this must be factored into the new beta. We adjusted your historical beta by un-levering and re-levering it with the structure in mind. Based on our calculations, the firm’s new consolidated beta is 1.217, again our calculations are below. Risk free rate 30 year T Bond Market Risk Premium Weights for cost of capital Current Debt Target Debt Current Beta Levered Beta at current weights Tax rate Un levered Beta Re levered Beta at target weights

0.0498 0.051 0.422 0.4 1.25 0.4 0.8692 1.2169

rf emrp Current Equity Target Equity

0.58 0.6

With the new beta and adjusted and our recommendations for the risk-free rate and EMRP, we have estimated the firm’s consolidated cost of equity to be 11.19%. Along the same lines, we estimate that the firm’s cost of debt is currently 6.6%; this was calculated by adding the firm’s target spread to treasury of 1.62% to the risk-free rate. With these new debt and equity costs we were then able to calculate the firm’s new WACC to be 8.3%. Our calculations are below, please note that ( [

is the WACC.

) (

)]

(

)

Please be mindful that this number is only useful for the firms consolidate operations. We understand that you intend to create “users guide” of sorts for further use by your divisions. To help you in this process, we have analyzed the Exploration and Production division separate from the rest of the firm. You should be able to follow the steps in this process in the creation of your guide. It is clear that this division requires significantly more capital on a yearly basis that the other divisions, and consequently we do not consider the debt ratio for the consolidated firm to be a sufficient target for the Exploration and Production division. The firm uses a target debt ratio for this division of 46%, and we agreed that this was a reasonable target. The major issue in analyzing this division separate

Carlson School of Management from the whole is that we have no information on a divisional beta. In this case we have systematically estimated this beta using comparable firms with published betas.

We unlevered the betas four

comparable firms using the same process as we used for the consolidated operations, then averaged these un-levered betas to get an estimated divisional beta of .9322. Exploration & Production:

Unlevered Beta

Jackson Energy, Inc.

0.8340

Wide Palin Petroleum

0.7999

Corsicana Energy Corp.

1.0170

Worthington Petroleum Average

1.0819 0.9332

Using this average beta in conjunction with the target capital structure for Exploration and Production we calculated a re-levered divisional beta for the division of 1.4102. Using the same process from earlier, we calculated the divisional cost of equity and debt to be 12.17% and 6.58% respectively. Plugging the divisional numbers into the WACC formula from earlier, we get a divisional WACC of 8.39%.