Midland Energy Resources Inc. Cost of Capital Dr. C ... - Instructure

Midland Energy Resources Inc. Cost of Capital

Dr. C. Bulent Aybar

Midland Energy: Highlights • Midland is a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. • On a consolidated basis, the firm had 2006 operating revenue and operating income of $248.5 billion and $42.2 billion, respectively. • Largest fraction of assets are tied in Exploration and Production, but largest share of revenues are produced by Refining and Marketing.

© Dr. C. Bulent Aybar

Division Revenues

Division Assets

Operating Revenues and Income Operating Results: Operating Revenues Plus: Other Income Total Revenue & Other Income Less: Crude Oil & Product Purchases Less: Production & Manufacturing Less: Selling, General & Administrative Less: Depreciation & Depletion Less: Exploration Expense Less: Sales-Based Taxes Less: Other Taxes & Duties Operating Income Less: Interest Expense Less: Other Non-Operating Expenses Income Before Taxes Less: Taxes Net Income

2004 2005 2006 $201,425 $249,246 $248,518 1,239 2,817 3,524 202,664 252,062 252,042 94,672 125,949 124,131 15,793 18,237 20,079 9,417 9,793 9,706 6,642 6,972 7,763 747 656 803 18,539 20,905 20,659 27,849 28,257 26,658 29,005 41,294 42,243 10,568 8,028 11,081 528 543 715 17,910 32,723 30,447 7,414 12,830 11,747 $10,496 $19,893 $18,701

Assets and Liabilities Assets: Cash & Cash equivalents Restricted Cash Notes Receivable Inventory Prepaid Expenses Total Current Assets

2005 $16,707 3,131 18,689 6,338 2,218 47,083

2006 $19,206 3,131 19,681 7,286 2,226 51,528

Investments & Advances Net Property, Plant & Equipment Other Assets Total Assets Liabilities & Owners' Equity:

30,140 156,630 10,818 244,671 Column1

34,205 167,350 9,294 262,378 Column2

Accounts Payable & Accrued Liabilities Current Portion of Long-Term Debt Taxes Payable Total Current Liabilities

24,562 26,534 5,723 56,819

26,576 20,767 5,462 52,805

Long-Term Debt Post Retirement Benefit Obligations Accrued Liabilities Deferred Taxes Other Long-Term Liabilities

82,414 6,950 4,375 14,197 2,423

81,078 9,473 4,839 14,179 2,725

Total Shareholders' Equity

77,493

97,280

Total Liabilities & Owners' Equity

$244,671

$262,378

Objective: Calculation of WACC for Midland and Its Divisions

• Why Mortensen is calculating WACC for the corporate and divisions? • WACC is used in – Routine capital budgeting metrics such as NPV, – asset appraisals for financial accounting exercises such as FAS 142 impairment testing,

– Analyses of stock repurchases – Assessment of M&A proposals.


WACC • In respective applications the WACC is intended to represent the long-term opportunity cost of funds for Midland, one of its divisions, or an acquisition target; • It is the discount rate, or a benchmark for the discount rate in a discounted cash flow (DCF) analysis. • In addition, Mortensen’s numbers likely will be used in performance assessments at the corporate and division levels and may well affect incentive compensation awards.


Capital Structure • It is generally helpful to rearrange a GAAP balance sheet before computing capital structure ratios to separate “operating” from “financial” accounts and to define “capital” as it will appear in the denominator of the capital structure ratios. • For example, trade-related liabilities, such as payables and accruals, should be grouped on the left side and netted against current assets; they generally should be thought of as part of net working capital, not funded debt. • Likewise for long-term accruals which may be netted against other longterm assets. In contrast, some assets—notably cash and marketable securities— may represent excess liquidity and should be netted against debt before the ratios are computed.


Rearranged Balance Sheet NWC

Notes Receivable

Financial Account

19,681

Net Debt

Inventory

7,286

Current Portion of Long-Term Debt

20,767

Prepaid Expenses

2,226

Long-Term Debt

81,078

Less Accounts Payable & Accrued Liabilities Deferred Taxes Net Working Capital

Less: Cash and Equivalents -26,576 -5,462

Net Debt

-2,845

Shareholder's Equity

Net Fixed Assets Investments & Advances Net Property, Plant & Equipment Other Assets

Net Capital 167,350 9,294

Post Retirement Benefit Obligations

9,473

Accrued Liabilities

4,839

Other Long-Term Liabilities

3,131 $79,508 97,280

176,788

34,205

Less

Deferred Taxes

Restricted Cash

$19,206

14,179 2,725

Net Fixed Assets

179,633

Net Operating Assets

176,788

Note that market value of the equity is given as $134.1bn in Exhibit-5. This assumes a year end share price of $45.45 and 2.951 million outstanding shares. This suggest a D/E ratio of 59.3% which corresponds to 37.2% Debt/Value ratio and 62.8% Equity/Value ratio.

Capital Structure and Component Weights • In component weight calculations it is important to use market value of debt and equity. • In this particular case we have the data on outstanding shares and the stock price for each quarter. We could use fourth quarter price listed in Exhibit-4 along with the number of outstanding shares to determine the market value of equity: • $44.11 x 2,951=$130,160 • However this does not match the market value of equity ($134,114) listed in Exhibit-5. Apparently stock price as of 12/31/2006 is $45.45 and this is different than the fourth quarter average of $44.11. • In the calculation of 59.3% of D/E ratio, book value of debt (79,508) was used (79,508/134,114=0.593)


Comparables (in $ millions) Exploration & Production:

Market Value

Debt

D/E

Equity Beta

LTM Revenue

LTM Earnings

Jackson Energy, Inc.

$57,931

$6,480 11.20%

0.89

$18,512

$4,981

Wide Plain Petroleum

46,089

39,375 85.40%

1.21

17,827

8,495

Corsicana Energy Corp.

42,263

6,442 15.20%

1.11

14,505

4,467

Worthington Petroleum

27,591

13,098 47.50%

1.39

12,820

3,506

Average

39.83%

1.15

Refining & Marketing:

Bexar Energy, Inc.

60,356

6,200 10.30%

1.70

160,708

9,560

Kirk Corp.

15,567

3,017 19.40%

0.94

67,751

1,713

White Point Energy

9,204

1,925 20.90%

1.78

31,682

1,402

Petrarch Fuel Services

2,460

(296)

-0.1

0.24

18,874

112

Arkana Petroleum Corp.

18,363

5,931 32.30%

1.25

49,117

3,353

Beaumont Energy, Inc.

32,662

6,743 20.60%

1.04

59,989

1,467

Dameron Fuel Services

48,796

24,525 50.30%

1.42

58,750

4,646

20.30%

1.20

$79,508 59.30%

1.25

$251,003

$18,888

Average Midland Energy Resources

$134,114

Capital Structure • Should we use the current capital structure, or should we consider target capital structure in WACC calculation?


Cost of Equity: Risk Free Rate • The risk-free return for U.S. dollar cash flows is conventionally derived from returns on U.S. Treasury obligations. • Ideally, the maturity of the benchmark T-bond should match the term of the subject cash flows. In theory, this implies different risk-free rate for each cash flow whenever the yield curve is not flat. More precisely, it suggests we use the forward rate derived from the zero-coupon Treasury yield curve for each discounting period in the DCF calculations. • A far more common practice is to simply take the yield on a long-term Treasury bond as the risk-free rate. © Dr. C. Bulent Aybar

What Maturity for Risk Free Rate? • The case gives the yield on the 1, 10 and 30-year T-bonds. • Should the choice of maturity depend on the projection period? • Remember that a DCF analysis of a going concern actually incorporates a terminal value intended to reflect the value derived from cash flows well beyond the discrete projection period. • In other words, many projects in companies such as Midland are indeed long-term projects, despite the fact that cash flows are not explicitly forecasted beyond a few years.

• Accordingly, the risk-free rate still should be derived from a long-term instrument.


Treasury Yields and Division Cost of Debt Maturity

Rate:

1-Year

4.54%

10-Year

4.66%

30-Year

4.98%

Business Segment: Consolidated

Credit Rating A+

Exploration & Production Refining & Marketing Petrochemicals

A+ BBB AA-

Debt/Value 42.20%

Spread over Treasury 1.62%

46.00% 31.00% 40.00%

1.60% 1.80% 1.35%

Cost of Debt for E&P Division Credit Rating

Debt/ Value

Spread to Treasury

Consolidated

A+

42.2%

1.62%

Exploration & Production

A+

46.0%

1.60%

Refining & Marketing

BBB

31.0%

1.80%

Petrochemicals

AA-

40.0%

1.35%

Business Segment:

Note: Debt/Value is based on market values.

Since the 10 year Treasury note yield is given as 4.66%, the cost of debt for E&P division is: Rd= Rf+CRS Rd= 4.66%+1.60% =0.0626 or 6.26%

Cost of Equity: EMRP • A fairly concise recent review of research and practice on the EMRP is presented by Pratt and Grabowski (2008), who review a wide variety of methods and data to support a range for the EMRP of 3.5% to 6.0%. Their point estimate for 2007 is 5.0% . • This is consistent with the premia used by auditors, appraisers, investment bankers, consultants, and other valuation specialists in realworld settings. Academics tend to favor somewhat higher rates. • Many practitioners derive estimates of the EMRP from data published in Ibbotson Associates’ Annual Cost of Capital Yearbook . These data are generally highly regarded, and used by the practitioners.


EMRP

Researcher Welch Graham & Harvey Greenwich Associates

Survey Subjects 500+ finance & economics Professors ~400 U. S. CFOs US Pension Fund Managers

Respondents’ Risk Premia Median: 3.6% 2001 Interquartile range: 2.6%-5.6% Quarterly 2000- Range: 2.5% - 4.7% 2006 Most recent survey (4Q2006): 3.3%

Dates

2006

Range-2%-4%

Cost of Equity: Beta • Equity betas vary with leverage and Midland’s reported beta of 1.25 reflects its current capital structure, which differs from its (stated) target capital structure. • If the estimated WACC is to properly reflect the target capital structure, the cost of equity must reflect it as well. • To adjust Midland’s beta to reflect the higher leverage embedded in the target capital structure we need to un-lever the current beta to remove the effect of the current capital structure, then re-lever it to reflect the target.


Estimating Project Beta using Comparables • Financial analysts use pure-play method to estimate beta for a company or project that is not publicly traded. • Pure - play method requires using a comparable publicly traded company ’ s beta and adjusting it for financial leverage differences. • This requires a process of “ unlevering ” and “ levering ” the beta. The beta of the comparable is first “ unlevered ” by removing the effects of its financial leverage. •

The unlevered beta is referred to as the asset beta because it reflects the business risk of the assets. Once we determine the unlevered beta, we adjust it for the capital structure of the company or project that is the focus of analysis. © Dr. C. Bulent Aybar

Relationship between Asset Beta and Equity Beta • Because a levered company’s risk is shared between creditors and owners, we can represent the company’s risk, basset , as the weighted average of the company ’ s creditors ’ market risk, bdebt ,and the market risk of the owners, bequity :

D E b asset  b debt  b equity DE DE • Since interest on debt is deducted by the company to arrive at taxable income, the claim that creditors have on the company ’s assets does not cost the company the full amount but rather the after - tax claim; the burden of debt financing is actually less due to interest deductibility. © Dr. C. Bulent Aybar

Asset Beta and Equity Beta • If we account for tax deductibility of interest, we can express asset beta as follows:

(1  t ) D E b asset  b debt  b equity (1  t ) D  E (1  t ) D  E • We generally assume that a company ’ s debt does not have market risk; so bdebt = 0. With this assumption asset beta reduces to the following:

1 b asset  b equity 1  (1  t )( D / E ) © Dr. C. Bulent Aybar

Unlevered Beta • From Exhibit 5, we know that Midland’s current D/E ratio is 0.593. • The target Debt/Value ratio given in Table-1 is 42.2%. This implies 57.8% Equity/Value or a D/E ratio of 0.73. • If we unlever Midland’s beta by using its current capital structure and tax rate : • βunlevered = βlevered/[1+(1-t)D/E]. Therefore • βunlevered = 1.25/[1+(1-0.385)(0.593)] = 0.92


Re-levered Beta • If we use the target capital structure ratio to re-lever the unlevered beta of 0.92: •

βlevered = [1+(1-t)D/E] x βunlevered – = [1+ (1-0.385)(.73)] x 0.92 = 1.33

• This levered beta is then used above to obtain a cost of equity of: – ke= 4.66% + 1.33(5.00%)=11.31% – ke= 4.66% + 1.25(5.00%)=10.91%

• Increasing the leverage towards the target capital structure increases the cost of equity by (11.31%-10.91%)=0.4% or 40bp © Dr. C. Bulent Aybar

Cost of Debt • Ideally, the cost of debt in a calculation of WACC should be the expected return on a traded, longterm fixed-rate obligation of a credit quality that corresponds to the capital structure ratios built into the WACC formula. Credit Spread Exploration & Production: Refining & Marketing: Petrochemicals

1.60% 1.80% 1.35%

Cost of Debt 6.26% 6.46% 6.01%


Divisional WACC • The first step in divisional WACC calculations is the divisional beta calculations. In the case, we are given data about comparable companies in Exploration and Production as well as Refining and Marketing. • We can use this data to calculate asset betas in each business segment. We can use average asset betas in segment and substitute these average asset betas for divisional asset betas.

• Consequently, we can re-lever asset betas to calculate divisional equity betas by using respective capital structure of each division.


Divisional Beta Calculations-Step-1 Exploration & Production:

Market Value

Debt

D/E

Equity Beta

Asset Beta

$57,931

$6,480

11.20%

0.89

0.83

46,089

39,375

85.40%

1.21

0.80

42,263

6,442

15.20%

1.11

1.02

27,591

13,098

47.50%

1.39

1.08

39.83%

1.15

0.93

Jackson Energy, Inc. Wide Plain Petroleum Corsicana Energy Corp. Worthington Petroleum Average

Refining & Marketing: Bexar Energy, Inc. Kirk Corp.

White Point Energy Petrarch Fuel Services Arkana Petroleum Corp. Beaumont Energy, Inc. Dameron Fuel Services Average Midland Energy Resources

60,356 15,567 9,204

6,200 3,017 1,925

10.30% 19.40% 20.90%

1.70 0.94 1.78

1.60 0.84 1.58

2,460

(296)

-0.1

0.24

0.26

18,363

5,931

32.30%

1.25

1.05

32,662

6,743

20.60%

1.04

0.93

48,796

24,525

50.30%

1.42

1.09

20.26%

1.20

1.05

59.30%

1.25

0.92

$134,114

$79,508

Divisional Beta Calculation Step-2: Weighting by Earnings

Consolidated Exploration & Production: Refining & Marketing: Petrochemicals

D/E Equity Beta 59.30% 1.25 85.19% 1.41 44.93% 1.33 66.67% 0.85

Asset Earnings Beta % 0.92 100.00% 0.93 67.14% 1.05 21.64% 0.61 11.21%

While we are given data on two segments, we do not have information on petrochemicals. We can infer asset beta from what we already know. Since Midland’s corporate asset beta should be equal to weighted average of its divisional asset betas, we can extract the third division beta from the information that we have. One practical question/issue in this approach is the determination of weights. How should attribute divisional weights? Based on asset size? Net income? Operating Income?

Weighting by Assets

Midland Energy Resources: Consolidated

D/E 59.3%

Equity Beta 1.25

Asset LTM Beta Revenue 0.92 248,518

Net Income 18,701

% Assets 100.0%

0.923


85.2%

1.41

0.93

22,357

12,556

53.4%

0.93

44.9% 66.7%

1.33 0.64

1.05 202,971 0.46 23,189

4,047 2,097

35.8% 10.8%

1.05 0.46

Divisional WACC

Target

Target

Asset

Midland Energy Resources: Target Consolidated

D/E 73.0%

D/V 42.2%

Beta 0.92

Beta Equity 1.33 11.30%

Debt WACC 6.30% 8.13%


85.2% 44.9% 66.7%

46.0% 31.0% 40.0%

0.93 1.05 0.46

1.41 11.71% 1.33 11.32% 0.64 7.85%

6.26% 6.46% 6.01%

8.05% 9.01% 6.16%

37.2%

0.92

1.25 10.92%

6.62%

8.33%

Prevailing Consolidated

Equity Cost of Cost of

WACC for Midland and Its Divisions

Division Consolidated Exploration & Production: Refining & Marketing: Petrochemicals

Assumptions Debt Beta 10-Year Treasury Bond EMRP Tax Rate

Target D/E 73.00% 85.19% 44.93% 66.67%

D/V 42.20% 46.00% 31.00% 40.00%

Equity Beta 1.33 1.41 1.33 0.85

Asset Beta 0.92 0.93 1.05 0.61

Cost of Equity 11.31% 11.69% 11.33% 8.92%

Division 0 4.66% 5.00% 40.00%

Cost of Debt 6.28% 6.26% 6.46% 6.01%

Credit Spread

WACC 8.13% 8.04% 9.02% 6.80%

Cost of Debt

Exploration & Production:

1.60%

6.26%

Refining & Marketing:

1.80%

6.46%

Petrochemicals

1.35%

6.01%

Corporate WACC vs Divisional WACC

Using a single WACC in all divisions may have two problematic implications: 1) Company invests in projects that appear positive NPV, but this happens because discount rate is set too low, in reality these projects have negative NPV (Type-1 errors) 2) Company rejects good projects, because WACC is set too high (Type-2 errors) In both cases, firm underperforms.

Midland Energy Resources Inc. Cost of Capital Dr. C ... - Instructure

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