E-2020
Midland Energy Case Analysis
Rohith Kori
MIDLAND ENERGY Midland Energy is a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. The primary goals of Midland’s financial strategy are to fund substantial overseas growth, invest in value-creating projects, achieve an optimal capital structure, and repurchase undervalued shares. To meet these goals, Midland must calculate an appropriate cost of capital. In funding overseas growth, Midland uses the cost of capital estimated by Mortensen to analyze, evaluate, and convert foreign cash flows. In evaluating value-adding investments, the cost of capital is used to discount project cash flows. In evaluating the performance of a business or division based on the economic value added model, the capital charge is computed as the cost of capital for the business or division times the amount of capital it employed during the period. To optimize its capital structure, Midland continuously evaluated its ideal borrowing based based on its inherent cost. Lastly when deciding when and how to repurchase shares or evaluating M&A proposals, Midland’s management used an
appropriate discount rate while determining the value of the company or proposal using DCF techniques. The cost of capital determined by Mortensen was also used to analyze asset appraisals in capital and financial accounting as well as performance assessments to determine c ompensation. If all anticipated uses of Midland’s cost of capital exhibited the same average risk, then no c hange is required in the calculation of the the cost of capital. But each of the Midland’s Midland’s three division’s exhibit
different risk profiles due to their nature of business. If the projects are of greater or lesser risk, then the calculations of WACC may be affected. For example in evaluating a risker M&A proposal presented by the exploration and production division, the company may need to adjust the cost of capital by including a higher risk premium. On the other hand, appraisals of certain long lived assets, cash inflows or outflows may be at a lower risk than the company average and hence the numbers contributing to the cost of capital should be adjusted ac cordingly.
Midland’s Corporate Cost of Capital The following assumptions are made in calculating Midla nd’s corporate WACC: 1. The corporate tax rate is assumed to be 39.72% (which is the average of the tax rate for years 2005 to 2007) 2. The cost of debt is calculated as the 10 year rate on U.S. Treasury Bonds (Case study - table 2) plus the spread to Treasury for the consolidated company calculated as presented in Case Study - Table 1. This makes the cost of debt as 4.66%+1.62% = 6.28%. The 10 year rate is used since Midland’s borrowing capacity capacity is based primarily on energy energy reserves and long lived assets. The 1-
year rate does not capture the assets financing the borrowing and the 30 year rate is not appropriate given the changes that are possible in the industry in that timeframe that Midland cannot adequately capture and model in its business. Calculation of Cost of Equity
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E-2020
Midland Energy Case Analysis
Rohith Kori
Levered Beta = UnLevered beta (1+(1-T)D/E) Levered Beta = 1.25% (exhibit 5) D/E = 0.593 (exhibit 5) Tax rate = 39.72% (average of tax rates from 2004,2005,2006 from exhibit 1) Unlevered Beta (or asset beta) = 0.921 Target equity capital structure = 57.8% (from case study - table 1) Implies new D/E ratio = 73% Calculating new Levered Beta (for target capital structure of 42.2% debt) New equity Beta = 0.921 (1+(1-.3972)*.73) = 1.33 rD = 4.66 +1.62 = 6.28% Using EMRP of 5%
rE = 4.66 + 1.33 (5) = 11.31% WACCmidland = (1-t) rD (D/V) + rE (E/V) = ((1-0.3972)*0.0628*0.422)+(0.1131*0.578)
WACCmidland = 0.08134 = 8.13% Midland is using EMRP of 5%. Based on the historical data presented in Exhibit 6A, the average of historical data would result in EMRP closer to 6%. Especially in the more recent time period of 1987 to 2006, the average excess return (6.4%) is higher than Midland’s projection of 5%.
Giving more weight to historical data would decrease any bias by individual viewpoints or survey results. As the economy has been more uncertain, investors are demanding higher return to compensate for the increased risk. Hence it would be more appropriate for Midland to use EMRP closer to 6%.
Divisional Cost of Capital The use of a single corporate hurdle rate for evaluating investment opportunities in all its divisions would assume that the risk and return for each investment would be the same across all divisions. Midland operates 3 divisions with very different debt structures and assets within each division. Midland’s target debt ratio for each division also varies which would change the cost of capital across divisions. The Exploration and Production division has a higher demand for capital expenditures (exhibit 3) for development but also offers higher margin of return (an average of 54.23% from exhibit 3). Midland’s Petrochemicals division is investing mostly in overseas markets that carry different risks like exchange
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E-2020
Midland Energy Case Analysis
Rohith Kori
rate risk, political risk and interest rate risk compared to the more mature Refining and Marketing business. The Refining and Marketing division is the largest (contributing 81.67% of revenue in 2006) but also has the lowest margin (1.99% in 2006) that is decreasing (exhibit 3). The division profits are more risky due to the declining margins but cash flows might be more certain due to the mature nature of business. The R&M division also does not project any increased need for c apital. This implies the amount and cost of debt financing for the R&M division could be different fr om the cost of debt financing for the refining and marketing division. Mortensen accurately assess that due to the nature of the business of each division and their current financial position the credit rating of each division will be different. Thus using different hurdle rates for each division would allow Midland to more accurately reflect the risks and benefits of each investment and allow the company to make comparisons based on factors that are unique to each industry that the divisions operate in.
Cost of Capital for E&P and Marketing and Refining Divisions E&P and the Marketing and Refining divisions have different betas and target capital structures. For E&P, the average industry unlevered beta is 0.9275 whereas the M&R division has an average industry unlevered beta of 1.0692. This produces an equity divisional beta of 1.404 for E&P and 1.359 for M&R taking into account their target capital structure. A 39.72% tax rate is assumed in unlevering each company’s beta. The risk free rate is assumed to be 4.66% (10 year treasury yield). Table 1 shows the calculation of unlevered beta, cost of debt, cost of equity and the WACC of both the divisions.
Table 1: Cost of Capital for E&P and Marketing and Refining divisions
Exploration and Production
Refining and Marketing
Levered Beta (of portfolio) D/E
1.15 39.8000%
1.2 20.3000%
Tax Rate
39.7283%
39.7283%
0.9275
1.0692
46% 85.19%
31.00% 44.93%
New Levered Equity Beta (of division)
1.404
1.359
Cost of Debt (r D): 10 year treasury rate + spread to treasury
6.26%
6.46%
11.68%
11.45%
8.04%
9.11%
Unlevered Beta Target Debt/Value Target D/E
Cost of Equity (r E): r f+Beta (EMRP). r f is 4.66%. EMRP = 5% WACC of division: rd (D/V)(1-t) + re(E/V)
While the cost and debt and the cost of equity does not var y much between the two divisions, the tar get capital structure of the divisions influences the cost of capital. E&P is able to take advantage of a lower
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Midland Energy Case Analysis
Rohith Kori
cost of debt by using greater leverage (46%) compared to Refining and Marketing (31%) which results in lower divisional cost of capital for E&P.
Cost of Capital for Petrochemicals The cost of capital for petrochemicals can be calculated by finding the unlevered asset beta for petrochemicals and using that to calculate the equity beta for petrochemicals divisions. The equity beta is used to calculate the cost of equity. Using data in Table 1 of the case, we can determine the cost of debt. Subsequently the WACC of petrochemicals can be calculated. To find the unlevered asset beta, we can assign a weight to each division based on the contribution of assets by each division to total assets for 2006. Based on this, the weights of each division is – Assets as % of total assets in 2006
Exploration and Production Refining and Marketing
0.5340 0.3576
Petrochemicals
0.1084
Unlevered Beta of Midland Energy = Weight of E&P * Asset Beta of E&P + Weight of R&M * Asset Beta of R&M + Weight of Petrochemicals * Asset Beta of Petrochemicals 0.921 = .5340*.9275+.3576*1.0692+.1084* Asset Beta of Petrochemicals Solving, Asset Beta of Petrochemicals = 0.400083764 Table 2 below shows the calculation of Equity Beta for Petrochemicals, the cost of debt, cost of equity and WACC for Petrochemicals division (using data from Table 1 in case)
Petrochemicals Tax Rate
39.7283%
Unlevered Beta Target Debt/Value
0.400083764
Target D/E
40%
66.67%
New Levered Equity Beta (of division)
0.561
Cost of Debt (r D): 10 year treasury rate + spread to treasury
6.01%
Cost of Equity (r E): r f+Beta (EMRP). r f is 4.66%. EMPR = 5%
7.46%
WACC of division: rd (D/V)(1-t) + re(E/V)
5.93%
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E-2020
Midland Energy Case Analysis
Rohith Kori
Thus the cost of capital for Petrochemicals division is 5.93%. In summary, the cost of capital for each of the divisions of Midland energy varies as shown in the table below. For Midland energy to achieve its financial goals it must deploy a sound investment strategy that takes into account the appropriate cost of capital for each project and must continuously evaluate this against changing business needs. It is recommended that Midland Energy undertake this exercise at a minimum annually and also when any significant events take like that affect the capital structure of the division or company.
Division
WACC of division
Credit Rating
Target Debt / Value
Operating Margin (2006)
Exploration and Production Refining and Marketing Petrochemicals
8.04%
A+
46.00%
56.16%
9.11% 5.93%
BBB AA-
31% 40%
1.99% 9.04%
Midland Energy (Consolidated)
8.134%
A+
42.20%
7.52%
As evident from the table the cost of capital of each division of the company varies based on the type of capital structure employed, the amount of risk involved in the business of each division, the certainty of cash flow and the capital expenditure needs of the division. Midland Energy can take advantage of the low cost of debt for Petrochemicals to increase growth in this division to compensate for the lack of growth exhibited by Refining and Marketing.
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