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Case Stu Cas tud dy: M i dl an d En E n er gy Res Re sou ourr ce ces s, I n c. c.:: Cos Costt of Capital
The case is about the Midland Energy Resources Inc. which has 2006 operating revenue of $248.5 billion and operating income of $42.2 billion. In late January 2007, Janet Mortensen, senior vice president of project finance for Midland Energy Resources, was preparing her annual cost of capital estimates for Midland and each of its three divisions. Midland was a global energy company with operations in oil Janet Mortensen, the senior vice president of project finance has to prepare annual cost estimates for the company and its 3 divisions: exploration and production, refining and marketing, and petrochemicals. In the following sections we are going to answer the questions related to the cost of capital estimates. 1. How are Mortensen’s estimates of Midland’s cost of capital used? How, i f at al l, shoul d these anti cipated uses aff ect the calcul ation s?
Section 1: Estimates of cost of capital
Estimates of the cost of capital were used in many analyses within Midland, including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. Some of these analyses were performed at the division or business unit level, while others were executed at the corporate level. The cost of capital needs to be adjusted if the project is more or less risky in comparison to the firm risk. The cost of capital should be used in performance assessments of the firm, taking into consideration the factors such as economic scenario, industry cost of capital, size of the company etc. Also, cost of capital should be calculated in order to include the latest changes of stock prices. 2.
Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations. Is Midland’s choice of EMRP appropriate? If not, wh at recommendati ons woul d you mak e and why?
Section 2: WACC of the company
To calculate Midland’s company WACC, a 39.72% tax rate is assumed based on an average , of taxes paid divided by income before taxes, over the last three years (Exhibit 1). The cost of debt of is calculated as the 10-year rate (Table 2) on U.S. Treasury bonds plus the spread to Treasury (Table 1). The 10-year risk-free rate seems more appro priate because Midland’s borrowing capacity is based primarily on its energy reserves and long-lived assets. The short-term 1-year rate would be less for calculating the risk. Then, 30-year rate will more applicable for a real estate companies, but not appropriate based on the prospective changes in the production business.
The new beta was calculated by un-levering the old beta of 1.25 (which was based on a D/E ratio of 59.3% seen in exhibit 5) and new levering based on the target capital structure of 57.8% equity which corresponds to a D/E ratio of 73%. The unlevered beta for Midland is calculated as .922. In calculating the asset beta for new levering, the beta of debt is assumed to be zero based on Midland’s consolidated A+ credit rating (Table 1). This assumes that the company as a whole has little or no risk of default. The ratios of debt and equity are the target ratios for the consolidated company as set by management. Midland’s WACC is calculated at and is as follows: Levered Beta = Unlevered beta (1+(1-T)D/E) Levered Beta = 1.25% (exhibit 5) D/E = 0.593 (exhibit 5) Equity Market Risk Premium:
Exhibit 6 shows historical data on U.S. stock returns and bond yields supporting higher estimates of EMRP. On the other hand, survey results shown in Exhibit 6 support lower figures. Midland adopted its current estimate of 5 % after a review of recent research and in consultation with its professional advisors, bankers and auditors, as well as Wall Street analysts covering the industry. Tax rate is calculated according to the Exhibit 1 taking the average tax rates of 2004, 2005 and 2006. Tax rate=Income taxes/income before taxes
(7414/17910+12830/32723+11747/30447)/3≈0.3972
Tax rate: 39.72% 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 Using EMRP of 5% R(e) = 4.66 + 1.33 (5) = 11.31%
R(d)= 4.66 +1.62 = 6.28% WACCmidland = (1-t) r D (D/V) + r E (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%. 3.
Shoul d M idl and use a sin gle corporate hur dle rate for evalu atin g in vestment opportuni ties in all of i ts divisions? Why or why not?
Section 3: Differentiating hurdle rates
If the company used the single cost of capital or hurdle rate it would assume that all divisions are similar. Using single hurdle rate doesn’t consider each division’s different debt structures and nature of assets. For example, Midland’s E&P division has assets of oil reserves and higher demand for capital expenditures for development (Exhibit 3). Also, target debt ratio differs among divisions. For divisions, operating in different specific industries also can differentiate business risks. For example, R&M division operates on smaller margins, so that it has more risk. However, if we take into account that it operates long time before, the probability of decreases. Also, this division requires not much capital taking into account its maturity in the market.
Considering the explanation given above, it is better to use different hurdle rates for each division since it will provide company with more accurate and detailed information about the expected riskiness.
4.
Compute a separate cost of capital f or th e E& P and M arketing & Refi ni ng divisions. What causes them to dif fer f rom one another ?
Section 4: Cost of capital for E&P and R&M 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.
Calculating new Levered Beta (for target capital structure of 46% debt):
Exploration & Production Division: Unlevered Beta for E&P division: 0.9275 New levered beta is thus: Unlevered*/ (1+ (1-T)*D/E)= 1.404 Using EMRP of 5% R(e) = 4.66 + 1.404*5%= 11.68%
R(d)= 4.66 +1.60= 6.26%
WACC of division: R(d)*(D/V)*(1-t) + R(e)*(E/V)= 8.04%
Refining & Marketing Division: Unlevered Beta for E&P division: 1.06 New levered beta is thus: Unlevered*/ (1+ (1-T)*D/E)= 1.359 Using EMRP of 5% R(e) = 4.66 + 1.36*5% = 11.46%
R(d)= 4.66 +1.80= 6.46%
WACC of division: R(d)*(D/V)*(1-t) + R(e)*(E/V)= 9.11%
Following table shows summary of calculations:
Table 1: Cost of Capital for E&P and Marketing and Refining divisions
Exploration and Production Levered Beta (of portfolio) D/E Tax Rate Unlevered Beta Target Debt/Value Target D/E New Levered Equity Beta (of division)
Refining and Marketing
1.15 39.8000% 39.7283% 0.9275 46% 85.19%
1.2 20.3000% 39.7283% 1.0692 31.00% 44.93%
1.404
1.359
Cost of Debt (r D): 10 year treasury rate + spread to treasury
6.26%
6.46%
Cost of Equity (r E): r f+Beta (EMRP). r f is 4.66%. EMRP = 5%
11.68%
11.45%
8.04%
9.11%
WACC of division: r d (D/V)(1-t) + r e(E/V)
While the cost and debt and the cost of equity does not vary much between the two divisions, the target capital structure of the divisions influences the cost of capital. E&P is able to take advantage of a lower 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.
5.
H ow would you compute a cost of capital f or th e Petr ochemi cal divi sion ?
Section 5: Cost of Capital for Petrochemical Division
For calculating the cost of capital for Petrochemical division, the weight of each division can be found using the information about the total assets in 2006, described in Exhibit 3. According to this information, the weights are 0.534, 0.358, 0.108 for the E&P division, R&M division and Petrochemical division respectively. The following step is to find the unlevered asset beta for Petrochemical division. Since we found the weights based on the assets, using unlevered beta would be more appropriate. To find the unlevered beta for Petrochemical division, first, we should find unlevered betas for 2 remaining divisions of company. Although the Midland Energy Resources, Inc. does not have exact information about the sensitivity of stocks’ returns, it can define betas by looking at competitors’ betas and analysts’ reports. For this purpose, we first need to multiply the beta of each division by respective weight. Then we add all the products and set it equal to the total beta of the company. Finally, we find the unknown beta for Petrochemical division from the equation we formulated. To understand the information given above let’s see calculations: a) Calculations of weights:
Divisions:
Assets (2006):
E&P
140,100
R&M
93,829
Petrochemical
28,450
Total Assets: 140,000+93,829+28,450=262,279 Weight of E&P: 140,000/262,279=0.533782≈0.534 Weight of R&M: 93,829/262,279=0.357744≈0.358 Wight of Petrochemical: 28,450/262,279=0.108472≈0.108
b) Calculations of beta (Petrochemicals):
The company has already calculated the levered betas for total and for each division by finding arithmetic mean. (For E&P: 1.15; for: R&M: 1.2; for Midland: 1.25)To find unlevered ones we have following formula: Levered Beta = Unlevered beta* (1+ (1-T)*D/E)
D/E stands for debt to equity ratio
Unlevered beta= Levered beta/ (1+ (1-T)*D/E) Unlevered beta for E&P division: 1.15/ (1+(1-0.3972)*0.398≈0.9274 Unlevered beta for R&M division: 1.2/ (1+(1-0.3972)*0.203≈1.0692 Unlevered beta for company: 1.25/ (1+(1-0.3972)*0.593≈0.921 Note: Tax rate = 39.72% was calculated as the average of tax rates from 2004, 2005, 2006 from exhibit 1 Now we have equation: 0.921 = 0.5340*0.9275+0.3576*1.0692+.1084* unlevered Beta of Petrochemicals So, from this equation we can find that unlevered beta for Petrochemicals is approximately 0.4 Using the formula above: Levered beta= 0.4* (1+(1-0.3972)*0.6667)≈0.561 Relevering is based on the target capital structure of 60 equity which corresponds to a D/E ratio of 66.67%.
c) Then we have following information to calculate WACC for Petrochemical division: Cost of Equity R(e): R(f)+Beta (EMRP) where R(f) is 4.66% and EMPR = 5%
R(f)-risk-free rate or treasury rate EMRP-Equity market risk premium
Cost of equity is thus: R(e)=4.66% (10-year treasury bond)+0.561*5%≈7.46% Cost of debt R(d): 10 year treasury rate + spread to treasury (from table 1)
Cost of debt is thus: R(d)=4.66% +1.35%=6.01% WACC for Petrochemicals division: R(d)*(1-T)*(D/V)+ R(e)*(E/V) where D/V=0.4 and E/V=1-
D/V=0.6 (from table 1) WACC for Petrochemicals is thus: 6.01*(1-0.3972)*0.4+7.46*0.6≈5.93
The resulting WACC of 5.93% for the Petrochemical division represents the discount rate that can be used to value specific projects of average risk within the division.
