Midland Energy free essay sample

Midland Energy Resources, Inc. is a global multi-division energy company with operations in oil and gas exploration and production (EP), refining and marketing (RM), and petrochemicals. On a consolidated level, the company had 2006 operating revenue and operating income of $248. 5 billion and $42. 2 billion, respectively. Its largest division is RM with the Petrochemical division being the smallest. Midland’s most profitable segment is its PE division which generates 67% of the company’s net income (Exhibit 3). With regard to division of assets, EP is 53%, RM is 36%, and petrochemical is 11%. Midland’s financial strategies are to fund overseas growth, invest in value-creating initiatives, obtain optimal capital structure, and repurchase undervalue shares. In order to accomplish these objectives, Midland must calculate and use an accurate cost of capital that will provide reasonable valuation of their strategies. For example, funding overseas growth, Midland must use its cost of capital to analyze and evaluate the foreign cash flow; valuing projects, the cost of capital is used to discount future cash flow; optimizing capital structure, Midland continuously evaluate the cost of borrowing; and lastly determining the intrinsic value of its shares for repurchasing by valuing the company using the discount cash flow methodology. Question 1: How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations? Estimates of Midland’s cost of capital are used in analysis within the company and its three divisions. Mortensen’s estimates are used for asset appraisals for capital budgeting and financial accounting; performance assessments; MA proposals; and stock repurchase decisions. The uses of cost of capital will remain constant in the appraisal calculations when the projects risk remains unchanged. If the projects have greater or less risk, the calculations of WACC may be affected. The cost of capital is an essential component in WACC calculations. High estimated cost of capital may cause Midland to miss out investment opportunities by undervaluing the investment and shareholders may see lower return. In contrast, low estimated cost of capital may cause the company to engage in non-profitable opportunities by overvaluing the investment and shareholders may see inflated returns. The practical applications of WACC are intended to stand for the long-term opportunity cost of funds for Midland, one of its divisions, or an acquisition target. It is the discount rate and a benchmark for the discount rate in a discounted cash flow (DCF) analysis. For example, in risky merger and acquisition proposal, the company may adjust the cost of capital by including a higher risk premium. Contrarily, evaluating long-term assets, cash inflows and outflows may have lower risk compare to the company average cost of capital. In addition, Mortensen’s numbers likely will be used in performance assessments at the corporate and division levels and may well affect the incentive compensation awards. Whether the same WACC should be used for both asset and performance assessment is certainly questionable. 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, what recommendations would you make and why? The formula for weighted average cost of capital will be used to find Midland’s corporate cost of capital. WACC = rd(D/V) (1-t) + re(E/V) = 8. 12% == rd = Cost of debt = 6. 28% Mortensen computed the cost of debt for each division by adding a premium, or spread, over U. S. Treasury securities of similar maturity. The cost of debt of 6. 28% is calculated by the 10-year rate on U. S. Treasury bonds (Table 2) plus the spread to Treasury calculated by Mortensen for the consolidated company (Table 1). The 10-year risk free rate seems appropriate for the company ability to borrow based on its energy resources, growth, and long-term assets. As such 1-year rate is too short and 30-year rate is too long and may not be appropriate based on the potential changes in the industry. Rd = rf(risk-free rate) + spread to treasury 6. 28% = 4. 66% + 1. 62% == D=Market value of debt E= Market value of equity V= D+E = Value of the company or division Current Ratios: D/E = 59. 3% Beta = 1. 25 D/V = 37. 2% and E/V = 62. 8% (Exhibit 5) Target Ratios: D/E = 73% Beta = 1. 33 D/V = 42. 2% and E/V = 57. 8% (Table 1) == re = Cost of equity = 11. 31% The cost of equity is calculated using the same risk-free rate of 4. 66%, a relevering beta of 1. 33, and an EMRP of 5. 0% used by management. Current re= 4. 66% + 1. 25(5%) = 10. 91% Current Ratios: D/E = 59. 3% Beta = 1. 25 D/V = 37. 2% and E/V = 62. 8% (Exhibit 5) Target Ratios: D/E = 73% Beta = 1. 33 D/V = 42. 2% and E/V = 57. 8% (Table 1) BL = BU (1+(1-t) D/E) Bu = 1. 25/(1+(1-. 4)(. 593) = 0. 922 unleveraged beta Relevering Beta with target ratios: BL = 0. 922(1+(1-. 04) x 0. 73) = 1. 33 The new beta was calculated by un-levering the old beta of 1. 25 (based on D/E ratio of 59. 3% Exhibit 5) and relevering based on the target capital structure of 57. 8% equity to correspond to D/E ratio of 73%. The unlevered beta for the company is calculated as 0. 922. In the calculation of asset beta for relevering, beta of debt is assumed at zero based on Midlan’s credit rating of A+ at a consolidated level (Table 1). The assumption is that the company has little risk of default. The ratios of debt and equity are the target ratios as set by management. re = rf + B(EMRP) Target re = 4. 66% + 1. 33(5. 0%) = 11. 31% == T= Tax rate = 40% Tax rate is calculated based on Exhibit 1 as average of taxes paid divided by income before taxes over 2004, 2005, 2006. Tax rate = Midlands Income taxes/Midland’s Income before taxes Operating Results: 2004 2005 2006 Income Before Taxes 17,910 32,723 30,447 Taxes 7,414 12,830 11,747 0. 414 0. 392 0. 386 Average tax rate 0. 397 = = Target WACCMidland = rd(D/V) (1-t) + re(E/V) = . 0628(. 422)(1-. 40) + . 1131(. 578) = 0. 0159 + 0. 0653 = . 0812 or 8. 12% == Based on Exhibit 6, the historical data on U. S. stock returns have an average rate of EMRP closer to 6. 0% with minimal average standard error of 2. 2%. The EMRP of 5% used by Midland is conservative and may have put some weight on the survey results in Exhibit 6B from financial managers and professors. The surveys showed lower EMRP of 2. 5% to 4. 7% based on recent results for the year end of 2006. Midland’s choice of EMRP is appropriate in term of balancing between the optimistic historical average of 6. 0% and the lower numbers from third party consultants. I would recommend staying with the conservative number of 5% to be cautious and avoid over or undervaluing the cost of capital. 3. Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or Why not? The single hurdle rate does not take into consideration of different debt structures and the nature of assets existed across divisions. When using single hurdle rate for every division, we assume that every division within the company is similar. In such case, Midland is a global multi-division organization with different risky units. According to Exhibit 5, the equity beta represents the risk factor for each division. Since the risk profile is different per division, the hurdle rates for those divisions should also be different. Midland should not use one single corporate hurdle rate as this could cause misevaluation of investments and may result on the company invest on risky projects. The WACC calculated above should only be used if the company invests on a corporate level. For example, the EP division has assets of oil reserves and has higher demand of working capital expenses (Exhibit 3). Furthermore, the company has target debt ratio for each division which altering the cost of capital amongst divisions. With regard to RM division, it is currently operates on a smaller margin and this make its profit less certain adding more risk to the business. RM division has less capital expenditure; therefore this could also alter the cost of debt financing. With great effort of determining an accurate hurdle rate for investments that will add value to the company, it is more precise to use different rates across divisions. By doing so, we may able to yield advantage results to reflect the correct risk and benefits of those investments. Using different hurdle rates will allow the organization to make better decision by taking into consideration the unique industry risk factors that applicable per division. 4. Compute a separate cost of capital for the EP and Marketing Refining divisions. What causes them to differ from one another? EP Division Cost of Capital: 8. 05% == rd = Cost of debt = 6. 26% Rd = rf(risk-free rate) + spread to treasury 6. 26% = 4. 66% + 1. 60% (Table 1) == Industry Ratios for EP: D/E = 39. 8% Beta = 1. 15 E/V = 71. 5% D/V = 28. 5% (Exhibit 5) Target Ratios for segment: D/E= 85% E/V = 54. 0% D/V = 46. 0% (Table 1) BL = BU (1+(1-t) D/E) Bu = 1. 15/(1+(1-. 4)(. 398) = 0. 933 unleveraged beta Relevering Beta with target ratios: BL = 0. 933(1+(1-. 04) x 0. 852) = 1. 41 re = rf + B(EMRP) re = 4. 66% + 1. 41(5. 0%) = 11. 71% == T= Tax rate = 40% Target WACCEP = rd(D/V) (1-t) + re(E/V) = . 0626(. 46)(1-. 40) + . 1171(. 54) = . 0805 or 8. 05% RM Division Cost of Capital: 9. 01% == rd = Cost of debt = 6. 46% Rd = rf(risk-free rate) + spread to treasury 6. 46% = 4. 66% + 1. 80% (Table 1) == Industry Ratios for EP: D/E = 20. 3% Beta = 1. 20 E/V = 83% D/V = 17% (Exhibit 5) Target Ratios for segment: D/E= 45% E/V = 69. 0% D/V = 31. 0% (Table 1) BL = BU (1+(1-t) D/E) Bu = 1. 20/(1+(1-. 4)(. 203) = 1. 07 unleveraged beta Relevering Beta with target ratios: BL = 1. 07(1+(1-. 04) x 0. 45) = 1. 36 re = rf + B(EMRP) re = 4. 66% + 1. 36(5. 0%) = 11. 46% == T= Tax rate = 40% WACCRM = rd(D/V) (1-t) + re(E/V) = . 0646(. 31)(1-. 40) + . 1146(. 69) = . 09 or 9. 0% MIDLAND ENERGY RESOURCES Equity Net Equity LTM LTM Exploration Production: Market Value Debt D/E Beta Revenue Earnings Average 39. 8% 1. 15 Refining Marketing: Average 20. 3% 1. 20 Midland Energy Resources 134,114 79,508 59. 3% 1. 25 251,003 18,888 EP Division 85% 1. 41 RM Division 45% 1. 36 For the EP division, the average industry unlevered beta is 0. 933 which produces an equity beta of 1. 41 after applying the division target debt/equity ratio (Table 1). Using the unlevered beta yields a cost of equity of 11. 71% for EP. The cost of debt for EP is 6. 26% based on the risk-free rate of 4. 66% and the division Treasury spread of 1. 60% (Table 1). The Refining Marketing division has a higher cost of debt of 6. 46% and a higher unlevered beta of 1. 36. The cost of equity is also slightly higher at 11. 46%. The same tax rate of 40% applied for both divisions which seem appropriate based on historical tax payments. The WACC’s differ between the two divisions due to the use of different betas and target capital structures. The two divisions operate in different industries; therefore they have different risk profiles (Betas) and also have different credit ratings. As a result, the EP and RM have different WACC’s (8. 05% and 9. 01% respectively). 5. How would you compute a cost of capital for the Petrochemical division? To calculate the cost of capital for the Petrochemical division, the weight for each division can be computed using the total asset for the year of 2006 in Exhibit 3. The weight for EP division is 0. 53, the RM division is 0. 36, and the Petrochemical division is 0. 11. MIDLAND ENERGY RESOURCES Exploration Production: 2006 Total Assets 140,100 Percentage 53% Refining Marketing: 2006 Total Assets 93,829 Percentage 36% Petrochemicals: 2006 Total Assets 28,450 Percentage 11% Total Asset for all divisions 262,378 To solve for the unknown asset beta of the Petrochemical division, we multiply the unlevered asset beta of each division times the respective weight of that division and set the sum equal to the total corporate asset beta. Asset betaMidland = Asset betaEP (0. 53) + Asset betaRM (0. 36) + Asset betaPetro (0. 11) 0. 922 = (0. 933)(0. 53) + (1. 07)(0. 36) + Petro Asset Beta(0. 11) 0. 922 = 0. 49 + 0. 39 + Petro Asset Beta(0. 11) Asset betaPetro = 0. 38 Next we then compute the cost of equity and the cost of debt for the Petrochemical division. Target Ratios for segment: D/E= 67% E/V = 60. 0% D/V = 40. 0% (Table 1) Equity betapetro = 0. 38 x (1 + (1 – 0. 4) x 0. 67) = 0. 53 Cost of equitypetro = 4. 66 + 0. 53(5) = 7. 31% Cost of debtpetro = 4. 66 + 1. 35 = 6. 01% The cost of debt is based on the 10-year Treasury risk-free rate (Table 2) plus the spread to Treasury for the division (Table 1). T= Tax rate = 40% Finally, the resulting WACC for the Petrochemical division is 6. 1%. WACCPetro = rd(D/V) (1-t) + re(E/V) WACCPetro = . 061 (0. 4)(1-. 4) + 0. 0731 (0. 6) = . 05 or 5% In conclusion, calculating separate WACC for each division will allow Midland to accurately reflect the specific risks and benefits of the projects in the various industries. Using specific discount rate to value projects and proposals will help the company make better investment decision. For example, the Petrochemical division has a lower cost of capital (5%) which corresponds to the potential growth opportunities in its industry. In contrast, the cost of capital for EP (8. 05%) is less than the company hurdle rate of 8. 12%, while the cost of capital for RM is slightly higher (9. 01%). These variations attribute by better usage of leverage of the target debt and equity structure and the risks associated with in the individual industry. Other notes: MIDLAND ENERGY RESOURCES Net Working Capital Financial Note Receivables 19,681 New Debt 0 Inventory 7,286 Current Portion of Long-term debt 20,767 Prepaid Expenses 2,226 Long-term Debt 81,078 Less: Less: Cash and Equivalent (19,206) Accounts payable and accrued liabilities (26,576) Restricted Cash (3,131) Deferred taxes (5,462) Net Debt 79,508 Net Working Capital (2,845) Shareholders Equity 97,280 Net Capital 176,788 Net Fixed Assets Investments and Advances 34,205 Net, Property Plant Equipment 167,350 Note: The market value of equity in Exhibit 5 is $134. 1 million Other Assets 9,294 This assumes a year end share price $45. 45 and 2. 951 million Less: outstanding share. This suggest a D/E ratio of 59. 3% which Post Retirement Benefit Obligations (9,473) corresponds to 37. 2% Debt/Value ratio and 62. 8% Equity/Value ratio Accrued Liabilities (4,839) Deferred taxes (14,179) Other long-term Liabilities (2,725) Net Fixed Assets 179,633 Net Operating Assets 176,788 In component weight calculations it is important to use market value of debt and equity. In this particular case we have the data on outstand shares and they 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. This calculation does not match the market value of equity of $134,114 listed in Exhibit 5. Apparently, the stock price as of the end of December 2006 is $45. 45 is different than the fourth quarter average of $44. 11. In the calculation of 59. 3% of D/E ratio, book value of debt (79,509) was used (79,508/134,114 = 0. 593). Current ratios are D/E = 59. 3% Beta = 1. 25 D/V = 37. 2% and E/V = 62. 8% (Exhibit 5)