Executive Summary Midland Energy Resources is a leading global energy developer dedicated to providing advanced power systems and energy services around the world. Midland Energy Resources has three divisions Exploration & Production, Refining & Marketing, and Petrochemicals. They have been incorporated more than 120 years previously and they have 80,000 employees in 2007. Janet Mortensen, the senior vice president of project finance for Midland Energy Resources must determine the weighted average cost of capital (WACC) for the company as a whole and each of its divisions as part of the annual capital budgeting process. As each division has different functions and risk associations, the company needs separate discount rate to evaluate its projects. This report is prepared to find out the realistic measures for assessing cost of capital for Midland Energy Resources. After careful evaluation of available information and using finance literature and relevant course lectures, the analysis is prepared to offer appropriate recommendations for Midland Energy Resources to make future capital budgeting decisions. Company Overview 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. Exploration & Production business, including oil and natural gas exploration and field development and production, is its most profitable business with the highest net margin in the industry over the previous 5 years. With continued growth expectations, Midland is set to increase capital spending to meet growing demand. However, Midland’s refining and marketing business covers a comprehensive range of refined oil products worldwide, it ranks the largest division of the firm and investments will remain steady. Finally, Petrochemicals are chemical products made from raw materials of petroleum. Although, petrochemical is a very large growing business, Midland’s petrochemical performance is relatively low. Overall, Midland is a profitable company with a strong capital structure. Its stock price has increased continuously over time. Moreover, Midland’s earning per share and dividend per share have been grown up uninterruptedly. According to Exhibit 4, its earning per share has increased from $5.65 to $6.34 from 2002-2006 and dividend per share has also raised up from $1.11 to $1.46 from 2001-2006. Exhibit A and Exhibit B show profit margin comparison and size comparison among those three business units respectively. Exhibit A Exhibit B Risk Factors Midland Energy Resources is a high capital-spending company since this business’s nature requires heavy investment. This condition reflects both favorable and disadvantageous views. High capital investment is beneficial since it will be a
newcomer’s barrier by preventing potential competitors to easily access market. However, it is risky for company itself to remain high performance due to the fact that high-cost of capital company requires high rate of return. If any unexpected situations happen, it will slowly recover but double-dip recession. Furthermore, Midland’s business associates with natural resources, social acceptance and corporate social responsibility (CSR) have to be seriously considered. In Midland business climate, firm needs to tread carefully to maintain the trust of the public. Rearranging Financial Statements Beyond separating assets and liabilities on balance sheet, I am making a further distinction between real and financial activities of the firm to facilitate financial analysis. On the above side of Balance sheet will show net working capital and net fixed assets, both reflecting "real" activities, while on the below side will show debt and equity, both reflecting financial activities. Exhibit C is Midland’s rearranged Balance sheet. After rearranged the Balance sheet, Midland’s net working capital is 2,846 millions, net fixed assets is 179,634 millions, and net debt is 79,508 millions. Exhibit C Reorganized Midland Balance Sheets, at December 31 ($ in millions) Operating Account Working Capital Notes Receivable 19,681 Inventory 7,286 Prepaid Expenses 2,226 Less : Accounts Payable & Accrued Liabilities Taxes Payable 5,462 Net Working Capital (2,846) Working Asset Investments & Advances 34,205 Net Property, Plant & Equipment 167,350 Other Assets 9,294 Less : Post Retirement Benefit Obligations Accrued Liabilities 4,839 Deferred Taxes 14,179 Other Long Term Liabilities 2,725 Net Fixed Assets 179,634 Net Operating Assets
176,788
Financial Account Current Portion of Long Term Debt 20,767 Long Term Debt 81,078 Less : Cash & Cash equivalents 19,206 Restricted Cash 3,131 Net Debt 79,508
26,576
9,473
Shareholders' Equity Net Capital
97,280 176,788
Statement of problems To obtain an accurate cost of capital, various considerations have to be evaluated as risk factors. As the company’s cost of equity is calculated by using the Capital Asset Pricing Model (CAPM), the calculation of beta requires significant judgment. Industry data is used to calculate the beta, but such data is not available for one of the divisions. As a result, an alternative method must be determined. There is also some controversy in using the market risk premium since the historical equity risk premium for US stocks significantly differs from the risk premium used in the industry. Key assumption 1. Tax rate is 38.58%. 2. The risk-free rate used in the WACC calculations is 4.98%, the rate of 30-year U.S. Treasury bonds in 2007. 3. In stead of 5%, the equity market risk premium used in the WACC calculations is 5.32%, the arithmetic average rate of intermediate horizon historical equity risk premiums (1977-2006) Calculation Equity Beta Since divisions’ betas are not provided, it is reasonable to use comparable companies to estimate betas for each operating division. According to Exhibit 5, Petrach Fuel Services Company’s data should be excluded from Refining and Marketing calculation as its unusual debt to equity ratio. It might be resulting from special circumstances that should not be included in calculation. Therefore, Refining and Marketing’s beta after adjustment is 1.36. Corporate equity beta is 1.25. Exploration and Production’s beta is 1.15. In order to estimate beta for each division, we need to unlevered those betas to make them independent from capital structure. Then, we can have Petrochemicals’ beta estimated by weighting its total assets with those of other divisions and the whole company. The unlevered beta is calculated by following formula; βunlevered = βstock * E/V Then we can calculate the effect of Midland’s capital structure on its beta by relevering the unlevered betas for consolidated and its three divisions. The levered beta is calculated by the following formula; βlevered = 1/(E/V) * βunlevered Exhibit D: Relevered beta calculations of consolidated and its three division. Business Segment: Bunlevered Equity/Value Blevered Consolidated 0.88 57.80% 1.52 Exploration & Production 0.79 54.00% 1.46 Refining & Marketing 1.03 69.00% 1.50 Petrochemicals 0.83 60.00% 1.38 Cost of Equity
To calculate the cost of equity, we use the Capital Asset Pricing Model, calculating by the following formula; Ke = Risk Free Rate + (βl*EMRP)
Exhibit E: Cost of Equity of Midland and its divisions Business Segment: Risk Free Rate Equity Beta EMRP Cost of Equity (Ks) Consolidated 4.98% 1.52 5.32% 13.08% Exploration & Production 4.98% 1.46 5.32% 12.74% Refining & Marketing 4.98% 1.50 5.32% 12.95% Petrochemicals 4.98% 1.38 5.32% 12.31% Cost of Debt Midland’s basic approach to compute cost of debt (Kd) is by adding the Spread to Treasury over the 30-year US Treasury bond yield of 4.98% Exhibit F: Cost of Debt of Midland and its divisions Business Segment: 30-Year US. Treasury Bond Rate Spread to Treasury Kd Consolidated 4.98% 1.62% 6.60% Exploration & Production 4.98% 1.60% 6.58% Refining & Marketing 4.98% 1.80% 6.78% Petrochemicals 4.98% 1.35% 6.33% Weighted Average Cost of Capital (WACC) WACC = [(Wd * kd * (1 - t)] + (We* ks ) Where, Wd= Percentage of capital structure at market value constituting debt Debt / (Debt + Equity), also interpreted as D/V We= Percentage of capital structure at market value constituting equity, also interpreted as E/V kd = Cost of debt for company ks = Cost of equity for company t = tax rate The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. Due to the fact different business units have different risks, a single cost of capital cannot be applied across its three divisions in order to determining investment opportunities. The division’s WACC should be adjusted to reflect the division’s risk. Exhibit G : Weight average cost of capital of Midland’s consolidated and its three divisions. Business Segment: D/V E/V kd Tax Rate ks WACC Consolidated 42.00% 58.00% 6.60% 38.58% 13.08% 9.29% Exploration & Production 46.00% 54.00% 6.58% 38.58% 12.74% 8.74%
Refining & Marketing 31.00% 69.00% 6.78% 38.58% 12.95% 10.23% Petrochemicals 49.00% 51.00% 6.33% 38.58% 12.31% 8.18% The company WACC is 9.29%, while Exploration & Production, Refining & Marketing, and Petrochemicals’ WACC are 8.74%, 10.23%, and 8.18% respectively. It indicates that Refining & Marketing division’s market risk is greater than firm’s average risk, while Exploration & Production and Petrochemicals’ market risks are lower than the firm’s average risk. The projects within those divisions would be accepted if their returns are above their divisions’ WACC. Refining and Marketing’s cost of capital is high because of its high equity in capital structure. The high WACC of Refining and Marketing division indicates that this division requires a high capital spending and company should be careful in investing in this division since it demands for high required rate of return compared to those of Exploration & Production and Petrochemicals division. Conclusion The adjusted components of weight average cost of capital do impact on Janet Mortensen’s weight average cost of capital estimation. First, Janet used 1.25 of beta in calculation and estimated betas for the divisions relying on comparable companies’ financial data. Generally, it was proper to utilize financial data from companies that have similar risk profiles in the same business; however, their betas must be unlevered first and then relever them with the company’s cost of capital. Moreover, unusual capital structure of comparable companies should be excluded. In this case, the betas of Midland corporate and its three divisions after adjusted are higher than they were. Second, equity market risk premium of 5.0% seem to be not appropriate, I would suggest Midland to get one by using historical equity risk premium. As a result, a higher betas and equity risk premium make cost of equity (Ks) of the divisions and company as a whole get higher. Finally, all those factors lead the weight average cost of capital of Midland and its divisions to be higher than they were. This increasing in WACC would help company to not underestimate market risk and cost of capital. Moreover, a hurdle rate of return cannot be used to evaluate division’s cost of capital due to difference in division risks. The division’s WACC essentially specifies cost of capital of company’s divisions.
