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Midland Energy Resources, Inc.

Capital Budgeting Within a Multi-Divisional Firm

Presenters in order:
Ng Wenying
Nguyen Huong Duong (Tony)
Sim Siang Huat (Ronald)
Oon Zhi Xiang (Wayne)
Ong Sheng Yuan (Gabriel)
WHO ARE WE
Janet Mortensen (SVP of Project Finance) of Midland Energy Resources, Inc.,
Advisor to CFO

WHAT IS THE OBJECTIVE OF THIS CASE


Recommend WACC for Corporate & Divisions

Approach
Step 1: Understand operational characteristics
Step 2: Understand how WACC is used
Step 3: Compute Corporate WACC
Step 4: Assess appropriateness of single hurdle rate
Step 5: Compute division’s WACC
- E&P
- R&M
- Petrochemical
Step 1: Understand operational characteristics
Midland Energy Resources, Inc.
Year 2006: Op Rev: US$248.5B; Op Income: US$42.2B

Exploration & Production Refining & Marketing Petrochemical


Rev: US$22.4B | Income: US$12.6B Rev: US$203B | Income: US$4.0B Rev: US$23.2B | Income: US$2.1B

- Extracting Oil & Natural Gas - Owns 40 refineries & distills oil - Produces chemical products
- Most profitable business - Business with largest Revenue - Smallest division
- Net margin highest amongst industry - Revenue decreasing slightly - Trends:
- Production has been increasing - Margins are low - Facilities are old  Requires
- Trends: - But still a Market leader due to tech capital spending on
• Rising global demand advancement & vertical integration replacement
• Demand for non-traditional - Trends: - Most investment will be
sources also increasing - Stiffer competition  outside US in the form of JV
• Oil price at historical high Declining margins
prompting more investment  - Difficult to obtain approvals
Higher capital spending  little investment
opportunities (low capital
spending)
- In longer term, global
shortage in refining capacity
Step 2: Understand how WACC is used
It is used in Asset appraisal, Capital budgeting, Performance assessment, M&A and Stock
repurchasing decision making.
Step 3: Compute Corporate WACC

1 2
Step 3: Compute Corporate WACC
1 Weighted cost of debt

2 Weighted cost of equity

WACC = weighted cost of debt + weighted cost of equity


= 1.59% + 6.306% = 7.896 %
Step 4: Assess appropriateness of Single hurdle rate
Evaluating Investment Opportunities

Which is the
road most used
by firms?

1. Single Corporate Hurdle 2. Multiple Risk-adjusted


Rate discount rates

3. Specific Discount rates


for individual projects
Step 4: Assess appropriateness of Single hurdle rate
Allocating Capital Among a Firm’s Divisions: Hurdle rates versus budgets
Step 4: Assess appropriateness of Single hurdle rate
Capital Budgeting Practices in Singapore
- Singapore Management Review (2011)

• Survey questionnaires, 211 CEOs, 266 firms listed in SGX.


• Exclude companies not registered in Singapore
• Exclude companies registered in Singapore, head offices
overseas.
• To improve response rate, 2 mailings were done at different
timings.
Step 4: Assess appropriateness of Single hurdle rate
Capital Budgeting Practices in Singapore
- Singapore Management Review (2011)

54 Survey Responses
• 4 Construction firms (7.4%)
• 4 Hotels (7.4%)
• 16 Manufacturing (29.6%)
• 3 Property (5.6%)
• 3 Retail/ wholesale (5.5%)
• 1 Finance (1.9%)
• 23 firms in other or multiple lines of business (42.6%)
Step 4: Assess appropriateness of Single hurdle rate
Capital Budgeting Practices in Singapore
- Singapore Management Review (2011)

Extract:
Step 4: Assess appropriateness of Single hurdle rate
The Engineering Economist Volume 48 No.4
- “Divisional Cost of Capital: A Study of its Use by Major US Firms” by Stanley Block
Step 4: Assess appropriateness of Single hurdle rate

Business Horizons 2001


“The Trouble with Divisional Hurdle Rates” by Thode, Stephen F.

“All operating risk factors may be unique to each division so that


the conglomerate firm may be viewed as a portfolio of
individual divisions. Each division contributes to the overall
business risk of the firm in the same way that individual
securities contribute to the systematic risk of a portfolio of
securities.”
Step 4: Assess appropriateness of Single hurdle rate
Recommendation for Midland

Single
Multiple Risk- Corporate
adjusted Hurdle Rate
Discount
Rates

Specific Large projects, new products


Discount
rates for
Individual Central Investment
Projects
Committee or Board of
directors.

Financing decisions for resources Investment decisions


allocation among divisions 1) Multiple risk-adjusted discount rates
 Single corporate hurdle rate. 2) Specific discount rates for individual
projects
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

Compute separate cost of capital

WACC =Rd(D/V)(1-t) + Re(E/V)

Exploration & Marketing & Refining


Production
Spread to Treasury 1.6% 1.8%
Debt / Value (Table 1) 46% 31%
Equity / Value 54% 69%
10 year yield for 4.66% 4.66%
Treasury Bonds
Tax rate calculated 40% 40%
from Step 2
Equity Beta (exhibit 5) 1.15 1.2
EMRP 5% 5%
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

1 For Exploration & Production

Cost of debt, Rd(D/V)(1-t)


= (Spread + Yield for Treasury Bonds) *(D/V) *(1-t)
= (1.6%+4.66%) * 46% * (1-40%)
=1.73%

Cost of equity, Re(E/V) = {Rf+β(EMRP)} * (E/V)


= (4.66% + 1.15 * 5%) * 54%
= 5.62%

Cost for E&P = 1.73% + 5.62% = 7.35%


Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

2 For Refining & Marketing

Cost of debt, Rd(D/V)(1-t)


= (Spread + Yield for Treasury Bonds) *(D/V) *(1-t)
= (1.8%+4.66%) * 31% * (1-40%)
= 1.20%

Cost of equity, Re(E/V) = {Rf+β(EMRP)} * (E/V)


= (4.66% + 1.2 * 5%) * 69%
= 7.36%

Cost for R&M = 1.20% + 7.36% = 8.56%


Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

Why are cost of capital for Exploration & Production and Refining & Marketing
Divisions different?

• Debt/Value:
Exploration & Production has higher debt/value ratio (46% compared to 31% for
Refining & Marketing). Possibly, because Exploration & Production has higher
margin than Refining & Marketing. Hence, financial communities are more willing
to lend money.

• Rd:
Spread over treasury is higher for Refining & Marketing than Exploration &
Production. Reason is because Refining & Marketing has a lower credit rating (BBB)
compared to Exploration & Production (A+)
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

WACCPetrochemicals = rd(D/V)(1-t) + re (E/V)

where rd = cost of debt


re = cost of equity
D = Market value of debt
E = Market value of equity
V = Total assets of the company or division = D + E
t = tax rate
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

rd Cost of debt, rd
= risk- free rate, rf + spread to Treasury for the
Petrochemicals Division

Since we are provided the 1 Year, 10 Year and 30 Year


yields to maturity for US Treasury bonds, which one would
be the most appropriate risk-free rate?
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

In determining the most appropriate risk-free rate to be used for the


rf Petrochemicals Division, we will need to consider the useful life of the assets
replaced during the asset replacement process.

• The Petrochemicals Division is primarily involved in


manufacturing and research activities, where the assets involved
have an medium-term useful life (Average 10 years)

• They are also involved in capital spending projects such as replacement of


facilities which generate cash flows over a long period

• Therefore, the 10-year rate shall be used.


Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

rd Cost of debt, rd
= risk- free rate, rf + spread to Treasury for the Petrochemicals
= 4.66% (10-Year Treasury bond) + 1.35%
= 6.01%
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

re Cost of equity, re
= risk- free rate, rf (10-Year Treasury bond) + β(EMRP)

Where
β= equity beta for the Petrochemicals Division
EMRP = equity market risk premium

The key to calculating the cost of equity, re is to evaluate the equity beta of the
Petrochemicals Division.
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

β In order to evaluate the equity beta of the Petrochemicals Division, we need to:

• Obtain the unlevered beta of Midland Energy and the other 2 divisions, the E&P
Division and the R&M division.

• The unlevered beta of Midland Energy Resources is the weighted average of the
unlevered beta of the three divisions

Unlevered βMidland
= w1(Unlevered βE&P) + w2(Unlevered βR&M) + w3(Unlevered βPetrochemicals)

where w1= E&P earnings/ Total earnings


w2= R&M earnings/ Total earnings
w3= Petrochemicals earnings / Total earnings
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

We need to use unlevered beta for the following reasons:


β
• All the Divisions have never been publicly traded before, thus we need the
unlevered beta of these divisions to estimate the equity beta of the
Petrochemicals Division

• This will mean using the pure play method, which involves determining the
average unlevered beta of many similar companies in the same industry to
use as a reference. This has been done in the case study for the E&Pindustry
and the R&Mindustry.
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

β • Furthermore, as we are calculating the cost of equity, re, using unlevered


beta allows us to remove the impact of debt on the beta.

• Lastly, once we obtain the unlevered beta of the Petrochemicals Division,


we will re-lever the beta to add back the financial risk as we have been
provided with the debt-equity ratio of the Petrochemicals Division in the
case study.
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

β • Obtain unlevered beta of Midland Energy, E & P Division and R & M


Division using Hamada’s Equation.

• Calculate the weightage of the divisions, using total earnings of each


division as a ratio of Midland Energy’s total earnings.

• Once the unlevered beta of the Petrochemicals Division has been


obtained, re-lever it using the debt equity ratio of the Petrochemicals
Division
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

β Equity βPetrochemicals = 0.6 *[1 + (1-0.4)* 0.667] = 0.840

re Cost of equity, re , for the Petrochemicals Division


= rf + β(EMRP)
= 4.66% + 0.840 (5%)
= 8.86%
Step 5: Compute Divisions’ WACC
1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

WACCPetrochemicals

= rd(D/V)(1-t) + re (E/V)
= 6.01% (0.4)(1-0.4) + 8.86% (0.6)
= 6.76%

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