Midland Energy

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From Exhibit 5, we knew that the firm now has a D/E ratio of 0.593, so the D/V and E/V ratio can be calculated.

2006($ in millions)

Percentage

D/E ratio

0.593

D/V ratio

37.23%

E/V ratio

62.77%

Tax rate is based on the average of the past 3 years, so t=39.7%.

2004

2005

2006

Average

Income Before Tax

17,910

32,723

30,447

Taxes

7,414

12,830

11,747

Tax rate

41.4%

39.2%

38.6%

39.7%

3.1.2 Cost of Equity

As for the Cost of Equity, we use the Capital Asset Pricing Model(CAPM) to calculate.[pic 13]

We use 10-Year U.S. Treasury bonds yields to maturity rate as the risk-free rate, which is 4.66%. and use the Midland’s beta 1.25.

The EMRP we use the current adopted estimate of 5.0%. Another way to calculate the market excess return is using the historical data.

period

average excess return US Equities- T-Bonds

Standard Error

95% confidence interval

1987-2006

6.40%

3.70%

-0.85%

13.65%

1967-2006

4.80%

2.60%

-0.30%

9.90%

1926-2006

7.10%

2.20%

2.79%

11.41%

1900-2006

6.80%

1.90%

3.08%

10.52%

1872-2006

5.90%

1.60%

2.76%

9.04%

1798-2006

5.10%

1.20%

2.75%

7.45%

However, due to the large standard error, the estimation using historical data have large difference. So to be more precise, we choose the 5% market premium based on research and advise from expert. So the we calculate is 10.91%. [pic 14]

Overall, we get the actual WACC of the consolidated in 2006 is 1.41%+6.85%=8.26%

3.3 Corporation’s Targeted WACC

A change on capital structure has effects on WACC parameters, so we need to calculate the cost of capital differently.

3.3.2.1 Cost of Debt

The targeted is the same as the actual one in 2006. 4.66%+1.62%= 6.28%[pic 15]

The targeted D/V ratio is given by the company, which is 42.2% and the E/V ratio is

1-42.4%=57.6%

3.3.2.2 Cost of Equity

Since , and is estimated on the market situation, so the new capital structure has no effect on these two parameters. However, beta has to change to reflect the forthcoming risks of this company.[pic 16][pic 17][pic 18]

First, we calculate the unleveraged beta in the consolidated level.

(D/E is using the current capital structure)[pic 19]

So the unleveraged beta for this company is 0.92.

Then, calculate the new beta using the target capital structure, whose D/E is 42.2%/57.8%=0.73

So the new beta is 1.32.

Overall, using the target capital structure and new beta, we calculate the targeted WACC= 1.60%+6.51%=8.10%

If the company change its current capital structure, its cost of capital in a consolidated level will decrease from 8.26% to 8.10%.

4 Division Analysis

4.1 Introduction of different divisions

4.1.1 Exploration& production

Midland engaged in all phases of exploration, development, and production. E&P was the the most profitable business of the company and the company has the leading position due to its highest net margin in the industry.

The industry was expected to have a promising future with the increasing of global population and growth of economy. And the company will continue to invest aggressively in this field.

4.1.2 Refining & marketing

Refining marketing earned the largest proportion of revenue for the company. However, due to high competition the margin is small and declining. The company is market