Midland Energy Resources Case Study

FINS3625-Applied Corporate Finance

For submission to: Billy Qian, T18B

Student(s): David Looyschelder, z3460620
Chris Mugglestone, z5017424
Lisa Phung, z5018895
Shirley Shi, z5132060
Ivar Anckar, z5018022
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EXECUTIVE SUMMARY

Midland Energy Resources, Inc. is a global energy company that operated in oil and gas exploration and production
(E&P), refining and marketing (R&M), and petrochemicals. Midland’s most profitable segment is its E&P division,
which produces 67% of the company’s net income. Its largest division is R&M and the petrochemical division is its
smallest. The primary goals of Midland’s financial strategy are to fund substantial overseas growth by using its cost of
capital to analyse, evaluate and convert foreign cash flows, invest in value-adding projects by evaluating and using
cost of capital with discount project cash flows, achieve an optimal capital structure by continually evaluating its ideal
borrowing based on inherent cost and lastly, repurchase undervalued shares by determining intrinsic vales of the
shares using discounted cash flow techniques with an appropriate discount rate.

Through undertaking this case study, a corporate WACC for Midland Energy Resources of 8.26% was found based on
the capital structure actuals of 2006 as opposed to the WACC of 7.90% using the targeted capital structure based on
Midland’s bond rating. It was concluded that:
 The Equity Market Risk Premium of 5% used in the calculations was appropriate when both historical data
and values commonly used in the finance industry were considered.
 A single hurdle rate was not sufficient due to intrinsic differences between Midland’s divisions and as such, a
hurdle rate should be calculated for each division.

A WACC was found for each of Midland’s business segments. The WACC’s are as follows:
 WACC(E&P) = 8.03%
 WACC(R&M) = 9.11%
 WACC(Petrochemicals) = 4.69%

CONTENT
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Executive Summary............................................................................................................................................i

1 Uses of the Cost of Capital and its Impact..................................................................................................1

2 Midland Energy Resources’ Corporate WACC...........................................................................................1

3 Corporate Hurdle Rate................................................................................................................................2

4 E&P and R&M Costs of Capital.................................................................................................................3

5 Petrochemical Cost of Capital.....................................................................................................................3

References..........................................................................................................................................................5

Appendix A........................................................................................................................................................6

Appendix B........................................................................................................................................................8
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1 USES OF THE COST OF CAPITAL AND ITS IMPACT

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; M&A
proposals; and stock repurchase decisions. The analysis is used to make decisions at the division and corporate level.
The uses of cost of capital will remain the same in the appraisal calculations when the projects risk is unchanged.
WACC will be affected if projects have greater or less risk. High valued cost of capital may cause Midland to miss
great opportunities on investment due to undervaluing investments. Shareholders may see low return. Therefore, low
estimated cost of capital may cause the company to participate in non-profitable opportunities because overvaluation
of the investment will cause inflated returns.

2 MIDLAND ENERGY RESOURCES’ CORPORATE WACC

To calculate the weighted average cost of capital (WACC) of a company, several values are required. These
values include the capital structure of the company, the company’s cost of debt and equity and the corporate
tax rate imposed on the company.

The cost of debt is found using the risk-free rate and the spread between the risk-free rate and the company’s
bond yields. For this case study, the yield to maturity of a 10-year US Treasury Bond is used as the risk-free
rate as these bonds are seen as having little to no default risk. This risk-free rate can be seen in Table 2
located in Appendix A. As, the corporate WACC is being found, the Credit Rating and Spread of the
Consolidated department as shown in Table 1 located in Appendix A is used.

Using Equation 1 shown in Appendix B, a cost of debt of 6.28% is found.

The cost of equity is found using the risk-free rate, the equity risk beta of Midland and the equity market risk
premium (EMRP) as shown in Equation 2 shown in Appendix B. The data used is shown in Table 3 shown
in Appendix A.

Now that the cost of equity and cost of debt have been found, the WACC can be calculated. The debt and
equity weighting for Midland Energy Resources are found using Table 1. With this, it is found that Midland
has a target D/V of 42.2% and an E/V of 57.8% based on their bond rating. An average tax rate of 39.73% is
found using the Income Statement in Exhibit 1 of the case brief. With these values a corporate WACC of
7.9% is found using Equation 3 shown in Appendix B.

Exhibit 5 shows Midland’s actual debt and equity for 2006 which gives a D/V of 37.22% and a E/V of
62.78%. These values give a corporate WACC of 8.26%.

An EMRP of 5% was used in the WACC calculations as outlined in the case brief. This value is used based
on recommendations made by Midland’s financial advisors. Through independent research undertaken by
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Midland and historical market premiums, it may be said that an equity market risk premium of 5% is
appropriate. The research conducted by Midland reflected survey results conducted on different financial
sectors with a large sample group showed an average EMRP range of 2.4%-4.8%. The historical data
showed a weighted average EMRP of ~6%. This value was found by weighting the more recent EMRP’s
higher.

3 CORPORATE HURDLE RATE

A hurdle rate is the required return an investment needs to generate, and is based on the riskiness of the
investment, the higher the risk the higher the required return. Hurdle rates are important for discounting
project cash flows, as well as understanding the minimum return required for the projects investors.

The two risk factors a project faces are based on the market risk exposure of the project and the risk related
to the projects leverage, this is because an increase in debt reduces the chance equity holders will receive
their promised return, as equity holders rank lower than debt holders in their claim on cash flows.

Thus, by getting an investment’s weighted average cost of capital its hurdle rate can be arrived at as well, as
the cost of capital involves both a Beta variable and a leverage factor (expressed by the debt to equity ratio).
This can be seen by Equation 3, which includes the cost of equity.

A hurdle rate can only be used for different projects if the projects have similar characteristics (similar
market risk exposure, capital structure and similar industry). Thus, whether Midland Energy Resources can
use only one hurdle rate will depend on how similar its investments are in regard to market risk exposure,
capital structure and other investment characteristics like asset size and expected profit.

The exploration & production division is the most profitable division, with expectation of further growth in
2007. It had a A+ credit rating, 46% leverage, at total assets of $140.11 billion in 2006. Refining &
marketing was the largest revenue producing division, expected growth was to remain stable, it had a BBB
credit rating, 31% leverage, and $93.829 billion of assets in 2006. Petrochemicals was the smallest division
with expected growth in the long term, it had a AA- credit rating, 40% leverage and total assets of $28.45
billion in 2016. When looking at comparable firms to each division in exhibit 5 it is also evident that betas
vary considerably between the division comparable firms, despite the fact that the average betas across the
two industry’s are fairly close at 1.15 for Exploration and Production comparable firms, compared to 1.20
for Refining and Marketing comparable firms.

Since all three divisions have different capital structures, different risk ratings and different asset sizes, as
well as their individual industries having different beta variances, it can be seen that one hurdle rate is not
appropriate for all divisions. The cost of capital would be different for each division, and separate hurdle
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rates will be required for each division, that is a divisional Weighted Average Cost of Capital (WACC) will
need to be calculated for each division.

4 E&P AND R&M COSTS OF CAPITAL

The cost of capital for the division is often used internally by company directors to determine
the economic feasibility of expansionary opportunities and mergers. Because the capital
structures and the risk levels of divisions are often different from those of the company. That’s
why it is necessary for us to compute the cost of capital for each division here:
Division Rd D/V Re E/V WACC
46.00 11.66
E&P 6.26% % % 54.00% 8.03%
31.00 11.46
R&M 6.46% % % 69.00% 9.11%
The reasons for the difference in cost of capital are:

1) Spread to treasury: Since the two divisions have different credit ratings, their spreads to treasury differ as well. The
lower credit rating indicates higher risk of default and leads to higher spread to treasury, increasing the cost of capital.

2) Equity beta: Beta is a measure of systematic risk, which illustrates the correlation between the volatility of the
equity and that of the market portfolio. The revenues of Exploration & Production and Refining &Marketing both
have the close relationship with the crude oil price, a significant contributor to the variance of the market portfolio.
That’s why the betas of these two divisions are both larger than one. But crude oil is the direct product of the E&P
department, its levered beta(1.40) is higher when compared to the beta of R&M(1.36)

3) Capital structure: The E&P has higher D/V(46.0%) than the R&M(31.0%) which gives higher weight to the cost of
debt in the calculation of WACC.

5 PETROCHEMICAL COST OF CAPITAL

Equation 3 located in Appendix B is used to calculate the Weighted Average Cost of Capital.

The first step is to calculate the cost of debt using Equation 1 in Appendix B.

The most effective US Treasury Bond to use as the risk-free rate is the 10-year maturity due to the useful life
of the assets of the Petrochemicals division. Petrochemicals are primarily focused on research and
manufacturing processes, involving assets that have a ‘medium-term’ useful life. This results in a risk-free
rate of 4.66% seen in Table 2. From Table 1 it can be seen that the spread to the Treasury is 1.35%.

Next the cost of equity is calculate using Equation 2.

In order to compute the equity beta for the Petrochemical division, the unlevered beta of Midland Energy
Resources across the 3 divisions is required. This can be found using Equation 4 in Appendix B.
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However, since these divisions have never been traded publicly, the ‘pure play method’ is required where
companies with similar structures and in the same industry as the company in question are uses in
comparison. Through this, beta for Midland was calculated to be approximately 0.148. Substituting these
values into the original equation gives a cost of equity of 5.40%.

Having calculated both the cost of debt and cost of equity, the WACC can be calculated using Equation 3.
From this, a WACC of 4.68% is found for the Petrochemical division.
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APPENDIX A
Table 1
Credit rating of Midland Energy Resources bonds by department and their Spread to Treasury.

Credit Debt/ Spread to

Business Segment: Rating Value Treasury

Consolidate
d 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%

Table 2
Yield to maturity for US Treasury Bonds with different terms.

Maturity: Rate:

1-Year 4.54%

10-Year 4.66%

30-Year 4.98%
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Table 3
Average excess return of US Equities compared to US Treasury Bonds by period.

Average Excess
Return US Equities
Period - T Bonds

1987-2006 6.40%

1967-2006 4.80%

1926-2006 7.10%

1900-2006 6.80%

1872-2006 5.90%

1798-2006 5.10%

Average 6.02%
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APPENDIX B

r d =r Treasury Bill + Spread

(1)

r e =r f + β (EMRP) (2)

E D
WACC= × r e + × r d ( 1−t ) (3)
V V

Unlevered β = w1(Unlevered β ) + w2(Unlevered β ) + w3(Unlevered β )

Midland E&P R&M Petrochemicals

(4)