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: 2004 2005 2006

Operating Revenues $201,425 $249,246 $248,518
Plus: Other Income 1,239 2,817 3,524
Total Revenue & Other Income 202,664 252,062 252,042
Less: Crude Oil & Product Purchases 94,672 125,949 124,131
Less: Production & Manufacturing 15,793 18,237 20,079
Less: Selling, General & Administrative 9,417 9,793 9,706
Less: Depreciation & Depletion 6,642 6,972 7,763
Less: Exploration Expense 747 656 803
Less: Sales-Based Taxes 18,539 20,905 20,659
Less: Other Taxes & Duties 27,849 28,257 26,658
Operating Income 29,005 41,294 42,243
Less: Interest Expense 10,568 8,028 11,081
Less: Other Non-Operating Expenses 528 543 715
Income Before Taxes 17,910 32,723 30,447
Less: Taxes 7,414 12,830 11,747
Net Income $10,496 $19,893 $18,701
 Assets and Liabilities
Assets: 2005 2006
Cash & Cash equivalents $16,707 $19,206
Restricted Cash 3,131 3,131
Notes Receivable 18,689 19,681
Inventory 6,338 7,286
Prepaid Expenses 2,218 2,226
Total Current Assets 47,083 51,528

Investments & Advances 30,140 34,205

Net Property, Plant & Equipment 156,630 167,350
Other Assets 10,818 9,294
Total Assets 244,671 262,378
Liabilities & Owners' Equity: Column1 Column2

Accounts Payable & Accrued Liabilities 24,562 26,576

Current Portion of Long-Term Debt 26,534 20,767
Taxes Payable 5,723 5,462
Total Current Liabilities 56,819 52,805

Long-Term Debt 82,414 81,078

Post Retirement Benefit Obligations 6,950 9,473
Accrued Liabilities 4,375 4,839
Deferred Taxes 14,197 14,179
Other Long-Term Liabilities 2,423 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.

Dr. C. Bulent Aybar

 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, Mortensens numbers likely will be used in
performance assessments at the corporate and division levels
and may well affect incentive compensation awards.

Dr. C. Bulent Aybar

 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 long-
term assets. In contrast, some assetsnotably cash and marketable
securities may represent excess liquidity and should be netted against
debt before the ratios are computed.

Dr. C. Bulent Aybar

 Rearranged Balance Sheet
NWC Financial Account
Notes Receivable 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 Less: Cash and Equivalents $19,206
Accounts Payable & Accrued Liabilities -26,576 Restricted Cash 3,131
Deferred Taxes -5,462 Net Debt $79,508
Net Working Capital -2,845 Shareholder's Equity 97,280
Net Fixed Assets Net Capital 176,788
Investments & Advances 34,205
Net Property, Plant & Equipment 167,350
Note that market value of the equity is
Other Assets 9,294
given as $134.1bn in Exhibit-5. This
Less
assumes a year end share price of
Post Retirement Benefit Obligations 9,473
$45.45 and 2.951 million outstanding
Accrued Liabilities 4,839
shares. This suggest a D/E ratio of
Deferred Taxes 14,179
59.3% which corresponds to 37.2%
Other Long-Term Liabilities 2,725
Debt/Value ratio and 62.8%
Net Fixed Assets 179,633 Equity/Value ratio.
Net Operating Assets 176,788
 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)

Dr. C. Bulent Aybar

 Comparables (in $ millions)

Equity LTM LTM

Exploration & Production: Market Value Debt D/E Beta Revenue 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

Average 20.30% 1.20

Midland Energy Resources $134,114 $79,508 59.30% 1.25 $251,003 $18,888
 Capital Structure

Should we use the current capital structure, or should we

consider target capital structure in WACC calculation?

Dr. C. Bulent Aybar

 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.

Dr. C. Bulent Aybar

 Treasury Yields and Division Cost of Debt

Maturity Rate:
1-Year 4.54%
10-Year 4.66%
30-Year 4.98%
Spread over
Business Segment: Credit Rating Debt/Value Treasury
Consolidated A+ 42.20% 1.62%

Exploration &
Production A+ 46.00% 1.60%
Refining & Marketing BBB 31.00% 1.80%
Petrochemicals AA- 40.00% 1.35%
 Cost of Debt for E&P Division

Spread
Credit Debt/ to
Rating Value Treasury

Business Segment:
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%

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 real-
world 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.

Dr. C. Bulent Aybar

 EMRP

Researcher Survey Subjects Dates Respondents Risk Premia

500+ finance & Median: 3.6%
Welch economics Professors 2001 Interquartile range: 2.6%-5.6%
Graham & Quarterly 2000- Range: 2.5% - 4.7%
Harvey ~400 U. S. CFOs 2006 Most recent survey (4Q2006): 3.3%
Greenwich US Pension Fund
Associates Managers 2006 Range-2%-4%
 Cost of Equity: Beta

Equity betas vary with leverage and Midlands 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 Midlands 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.

Dr. C. Bulent Aybar

 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 companys risk is shared between

creditors and owners, we can represent the companys 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
DE DE
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 Midlands 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 Midlands beta by using its current capital
structure and tax rate :
unlevered = levered/[1+(1-t)D/E]. Therefore
unlevered = 1.25/[1+(1-0.385)(0.593)] = 0.92

Dr. C. Bulent Aybar

 Re-levered Beta

If we use the target capital structure ratio to re-lever the

unlevered beta of 0.92:
levered = [1+(1-t)D/E] x unlevered
= [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 Cost of
Spread Debt
Exploration &
Production: 1.60% 6.26%
Refining & Marketing: 1.80% 6.46%
Petrochemicals 1.35% 6.01%

Dr. C. Bulent Aybar

 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.

Dr. C. Bulent Aybar

 Divisional Beta Calculations-Step-1
Exploration &
Production: Market Value Debt D/E Equity Beta Asset Beta
Jackson Energy, Inc. $57,931 $6,480 11.20% 0.89 0.83
Wide Plain
Petroleum 46,089 39,375 85.40% 1.21 0.80
Corsicana Energy
Corp. 42,263 6,442 15.20% 1.11 1.02
Worthington
Petroleum 27,591 13,098 47.50% 1.39 1.08

Average 39.83% 1.15 0.93

Refining & Marketing:

Bexar Energy, Inc. 60,356 6,200 10.30% 1.70 1.60
Kirk Corp. 15,567 3,017 19.40% 0.94 0.84
White Point Energy 9,204 1,925 20.90% 1.78 1.58
Petrarch Fuel
Services 2,460 (296) -0.1 0.24 0.26
Arkana Petroleum
Corp. 18,363 5,931 32.30% 1.25 1.05
Beaumont Energy,
Inc. 32,662 6,743 20.60% 1.04 0.93
Dameron Fuel
Services 48,796 24,525 50.30% 1.42 1.09

Average 20.26% 1.20 1.05

Midland Energy
Resources $134,114 $79,508 59.30% 1.25 0.92
Divisional Beta Calculation Step-2: Weighting by Earnings

Asset Earnings
D/E Equity Beta Beta %
Consolidated 59.30% 1.25 0.92 100.00%
Exploration & Production: 85.19% 1.41 0.93 67.14%
Refining & Marketing: 44.93% 1.33 1.05 21.64%
Petrochemicals 66.67% 0.85 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
Midlands 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

Equity Asset LTM Net %

Midland Energy Resources: D/E Beta Beta Revenue Income Assets
Consolidated 59.3% 1.25 0.92 248,518 18,701 100.0% 0.923

Exploration & Production 85.2% 1.41 0.93 22,357 12,556 53.4% 0.93
Refining &
Marketing 44.9% 1.33 1.05 202,971 4,047 35.8% 1.05
Petrochemicals 66.7% 0.64 0.46 23,189 2,097 10.8% 0.46
 Divisional WACC

Target Target Asset Equity Cost of Cost of

Midland Energy
Resources: D/E D/V Beta Beta Equity Debt WACC
Target Consolidated 73.0% 42.2% 0.92 1.33 11.30% 6.30% 8.13%

Exploration & Production 85.2% 46.0% 0.93 1.41 11.71% 6.26% 8.05%
Refining & Marketing 44.9% 31.0% 1.05 1.33 11.32% 6.46% 9.01%
Petrochemicals 66.7% 40.0% 0.46 0.64 7.85% 6.01% 6.16%

Prevailing Consolidated 37.2% 0.92 1.25 10.92% 6.62% 8.33%

 WACC for Midland and Its Divisions

Target Equity Asset Cost of Cost of

Division D/E D/V Beta Beta Equity Debt WACC
Consolidated 73.00% 42.20% 1.33 0.92 11.31% 6.28% 8.13%
Exploration & Production: 85.19% 46.00% 1.41 0.93 11.69% 6.26% 8.04%
Refining & Marketing: 44.93% 31.00% 1.33 1.05 11.33% 6.46% 9.02%
Petrochemicals 66.67% 40.00% 0.85 0.61 8.92% 6.01% 6.80%

Assumptions Division Credit Spread Cost of Debt

Debt Beta 0 Exploration & Production: 1.60% 6.26%
10-Year Treasury Bond 4.66%
Refining & Marketing: 1.80% 6.46%
EMRP 5.00%
Petrochemicals 1.35% 6.01%
Tax Rate 40.00%
 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.