Midland Energy Resource Report for Cost of Capital
October 16, 2014 Abstraction
General Analysis of Midland Energy Resources

Cost of Debt
• • • • Consolidated Company Exploration & Production Refining and Marketing Petrochemicals

Cost of Equity
Equity market risk premium of 5% is reasonable. According to the Exhibit 6, the U.S. stock return minus Treasury bond yields for each period varies. Since each period has different standard error, it will be better to take the weighted average of the data, then EMRP is approximately 5.9% or lets say 6.0%. Comparing to the EMRP that Midland would use in the calculation of WACC which is 5%, the historical data reflects a higher EMRP. But from the market risk premium survey results, we see that finance professors, CFOs and fund managers advocate a lower rate on risk premium. Because these people have better understanding in the performance of the market and be more aware of how economics works, then the analysis from them should be taken into great consideration. Therefore, 6.0% from the past data balanced with some lower rates that suggested by bankers, auditors as well as Wall Street analysts, 5% should be appropriate.

Weighted Average Cost of Capital
WACC = λ(1 − t)KD + (1 − λ)KE

The Effect of Leverage on the Cost of Equity and WACC Cost of Equity
The relation between cost of equity and leverage can be shown as follows: βEquity = 1 βU (1 − λ) Asset

Cost of Equity = Risk Free Rate + βEquity × (Risk Premium) We further illustrate the effect of leverage on consolidated company’s cost of equity in 1. As can be seen from 1, the cost of equity increases at an increasing rate as the leverage (debt fraction) becomes larger, which means leverage will increase the risk of the firm and raise its cost of equity. 1

100 Cost of Equity (%) 80 60 40 20 0 0

0.2

0.4 0.6 Debt Fraction

0.8

1

Figure 1: Cost of