Case study: Midland Energy Resources, Inc.

Company Background: Midland Energy Resources, Inc. (Midland) has a history of more than 120 years. There are three main business segments within the company: Exploration & Production, Refining & Marketing and Petrochemicals.

Objectives: In this report, I am going to estimate and calculate the cost of capital for Midland and each of its three divisions.

Assumptions: 1. CAPM Model is used in calculating re. Since we chose CAPM model to calculate re, then the assumptions of the CAPM Model have to be followed correspondingly. (Some important assumptions of the CAPM Model: 1) Investors are rational and risk-averse 2) Investors are price takers 3) There is no transaction or taxation costs 4) Investors may lend and borrow unlimited amounts using the risk free rate 5) Investors have the same information at the same time, etc. 2. rd and re remain constant for Midland and each of its three divisions For simplicity, I assume rd and re remain constant. 3. Tax rate remains constant. 4. D/V remains constant. 5. remains constant 6. US Treasury bonds are risk-free and the rates are constant for each maturity. Although US Treasury bonds might not be free of risk in reality, I assume they are free of risk in this report for simplicity, which is in fact a commonly used assumption. I also assume that the T-bond rates remain constant for each different maturity.

7. Costs of capital to be calculated are effective in project evaluation in 2007 only. They cannot be used in evaluation after 2007. This is to help guarantee projects are accurately elevated based on the most current data provided.

the two tables below are given in the case: | |Consolidated |Exploration & Production |Refining & Marketing |Petrochemicals |Spread to Treasury |1. rd According to the case. There are other assumptions which will be mentioned later in the Calculation and Analysis part. Calculation and Analysis: To calculate the cost of capital for Midland and each of its three business segments.60% |1.35% | | | | | YTM for US treasury bonds (January 2007) |Maturity |Rate | . rd for each division is calculated by adding a premium/spread over US Treasury securities of a similar maturity: rd =rf+ Spread to Treasury (Additional assumption: spread to treasury for each division and the company remain constant) Besides. the formula for weighted average cost of capital (WACC) will be used as shown below: [pic] D=market value of debt E=market value of equity V=D+E=the value of the company or the division rd=cost of debt re=cost of equity t=tax rate 1.80% |1.8.62% |1.

bond rate is a good estimate. Therefore.35%=5. This is because the two divisions usually carry out long-term projects.|1-Year |10-Year |30-Year |4.80%=6. rd for Exploration & Production =rf+ Spread to Treasury=4.78% rd for Petrochemicals: I use the risk free rate of 1-Year US Treasury bonds as the rf of Petrochemicals. This is because Midland s Refining and Marketing s business was the company s largest and Refining and Marketing usually carries out long-term projects.66% |4.98%+1.54% |4.98% | | | rd for 1) Exploration & Production and 2) Refining & Marketing: I use the risk free rate of 30-Year US Treasury bonds as the rf of 1) Exploration & Production and 2) Refining & Marketing. and I assume that 1-Year T.58% rd for Refining & Marketing = rf+ Spread to Treasury=4. Therefore. and I assume that 30-Year T. This rate is equal to 4. This is because this division usually carry out projects with a shorter duration.6% . This rate is equal to 4. Therefore. rd for Midland = rf+ Spread to Treasury=4.89% rd for Midland: I use the risk free rate of 30-Year US Treasury bonds as the rf of Midland. rd for Petrochemicals = rf+ Spread to Treasury=4.54%.54%+1.98%.62%=6.98%+1.6%=6.bond rate is a good estimate.98%+1.

Based on my assumption at the very beginning.40% |15.73% as shown below.6 |0.73% |39.40% |D/E |Equity Beta |0. re Capital Asset Pricing Model (CAPM) is used to calculate re: [pic] Rf=risk-free rate of return. which was 1.25. for Midland s three divisions are not given.20% |47.30% |19. and its calculation will be shown in the report) |Exploration & Production |Jackson Energy |Wide Plain Petroleum |Corsicana Energy |Worthington Petroleum |Average | | | | | |39. is assumed to remain constant.11 |1.20% |85.02 |1.73% |39.84 | | | |0.73% |39. =a measure of systematic risk EMRP=Equity market risk premium (According to the definition shown on the case report: it is the amount by which the return on a broadly diversified portfolio or risky assets is expected to exceed the risk-free return over a specific holding period) for Midland is given. then for Midland is 1.83 |0. By using Exhibit 5 and the formula below.73% |39.50% |1.39 |0.8% | | |10. Asset = Equity / [1 + (1-T)*(D/E)] Tax rate is 39. and I m going to estimate them by using published for publicly traded companies as stated in the case.2.89 |1.8 |1.21 |1. I m going to show the adjusted .15 | |Refining and Marketing |Bexar Energy |Kirk .7 |0.25) However.08 | | | |Asset Beta | | | |11.94 | |1.73% |39.93 | | |1.73% |Tax rate t |39.

33 (85.30% |20.73% |39. When we want to calculate a portfolio .73% |39.73%)*85.19% and 44.93 |1.25 Equity for Exploration & Production=0.04 |1.58 |0.41 Equity for Refining and Marketing =1.00% |32.90% |-12. (My assumption: The arithmetic average is an effective method for this calculation.05 |1.05 |0.05*[1+(1-39.09 | | | | | | summary: (I assume that D/E remain constant for Midland and its three divisions) Equity for Midland = 1.93*[1+(1-39.) .25 |1.3% |20.26 |1. In our case: The shadowed parts are figures of Total Assets.73% |39.73% |39.73%)*44. we use the weighted average of its different assets.78 |0.93%]=1.60% |50.93% are calculated based on Table 1) In order to get for Petrochemicals. w3=weights that three divisions have in the company respectively. w2.42 |1.30% |1.19%]=1.24 |1.|White Point Energy |Petrarch Fuel Services |Arkana Petroleum |Beaumont Energy |Dameron Fuel Services |Average | |39. while the bolded parts are the weights of the division s assets divided by the Total Assets of Midland.25 |1. (Average weights are good estimates for project evaluation in 2007.73% |59. I m going to use the following expression: for Midland =w1* for Exploration & Production+w2* for Refining & Marketing+w3* for Petrochemicals (w1. the weights are based on Total Assets of a specific division to the Total Asset of Midland) The logic behind the expression is similar to the calculation of of a portfolio.

37.943 |US$157.829 |US$28. As far as I am concerned.32 EMRP As shown in the case.37 |0. W3=0. then it has to satisfy some very important considerations: not biased.11 Therefore.671 |Average |US$140.37 |0.688 |Petrochemicals (3) |Midland (4) |W1=(1)/(4) |W2=(2)/(4) |W3=(3)/(4) |US$19.866 |(1) | | |Refining & Marketing (2) |US$60.12 Now.41+ w2*1.51 |0. the survey results in the case cannot reflect objective facts because the sample size (the number of survey . W1=0.36 |0. not misleading.042 | | |US$91.51.497 |0.33+0.53 |0.100 | |US$93.450 |US$262.| |2004 |2005 |2006 |US$125. etc.629 |US$28.25= w1*1. there are two ways to calculate Midland s EMRP: 1) Historical date on stock returns and bond yields 2) Survey results Below are my thoughts about the two ways: a.000 |US$244.49 |0.13 | | | | | |0.33+ w3* for Petrochemicals 1.51 |0. has sufficient sample size.51*1.39 |0.25=0.379 |0.12 | | | | | | | |Exploration & Production |US$76. I can use the formula below to generate the for Petrochemicals for Midland =w1* for Exploration & Production+w2* for Refining & Marketing+w3* for Petrochemicals ( 1.41+0. If a survey is regarded as a good one.37*1.12* for Petrochemicals ( for Petrochemicals=0.11 |0. W2=0.

Therefore.2%) is the smallest among all the periods. I think Midland s current estimate of 5% should be more reasonable. EMRP=5% and I assume that remains constant. re I will use the expression below to calculate re: [pic] re for Midland=4.32% re for Exploration & Production=4.25=11.subjects) is not big enough no matter which researcher s result we are looking at.1%) is similar to what Midland adopted (5 %).98%+5%*1.41=12. WACC I will use the expression below to calculate WACC: [pic] 1) Marginal tax rate =( tax2004/IBT2004+ tax2005/IBT2005 +tax2006/IBT2006) * (2006-2004+1)-1 = 39.32 =6. Considering that Midland adopted its 5% estimate after reviewing recent research and consulting with professionals. As the sample size becomes larger and larger.98%+5%*1.98%+5%*1. their survey results are subjective. Historical data can reveal objectively what has happened in the past.03% re for Refining & Marketing=4. Therefore.33=11.54%+5%*0.73% (IBT=Income before tax) 2) D/V . EMRP obtained from historical dates from 1798 to 2006(5.63% re for Petrochemicals=4.14% 3. b.1%) because its corresponding Standard Error (1. the result generated will get closer and closer to the real parameter we are looking for. I am more convinced by the figure collected for a period from 1798 to 2006 (EMRP=5.

0% and 40.27%+11. 46.73%=60.29% WACC for Petrochemicals =5.32%*(1-0.6%*0. (At the beginning of the report.0% respectively. 31.2%.422*60.46) =8.89%*0.31*60.4*60.03%*(1-0.D/V figures for Midland.14%*(1-0. Exploration & Production. Exploration & Production.422) =8.10% WACC for Midland= =6.27%+6.22% .78%*0. They are 42.46*60.4) =5.0%.27%+12.31) =9.58%*0.63%*(1-0.27% WACC for Exploration & Production =6.27%+11. Refining & Marketing and Petrochemicals are provided in Table 1. Refining & Marketing and Petrochemicals) 3) WACC cost of capital we want to get 1-t=1-39. I assumed that D/V remain constant for Midland.32% WACC for Refining & Marketing =6.

Global revenue from 2006 was $203 billion. Capital spending in petrochemicals was expected to grow in the short-term project.000 individuals within the company. refining and marketing and petrochemicals.2 billion. Although the margins had been declining over the previous 20 years. Petrochemicals Petrochemicals were Midland s smallest but most promising division. With the high price of oil in 2007 and fierce competition from other places of the world such as the Middle East. investing in value-creating projects across all divisions. the organization restructured its financial strategy with an emphasis in four different areas: funding significant overseas growth. including the industry s most profitable operation in exploration and production.S producers. Midland owned equity interests in 25 manufacturing facilities and five research centers in eight countries around the globe. Financial Strategy In 2007. Refining and Marketing Midland had ownership interests in 40 refineries around the world. Midland had been in existence for more than 120 years and employed more than 80. Midland and its foreign partners shared the equity interest. Midland s capital spending in refining and marketing would remain stable according to the project. Russia and West Africa. Inc. Midland s capital investment in E&P was expected to be more than $8 billion in 2007 and 2008.5 billion and an operating income of $42. in 2006 the company registered an operating revenue of $248. A profitable organization. Midland s Operation Structure Scenarios Exploration & Production Midland Energy Resources has been incorporated more than 120 years. Oil exploration and Production (E&P) is Midland s most profitable business. Midland is still a market leader in the business owing to its advanced technology and vertical integration. with the foreign partner generally receiving at least 50% plus a preferred return. optimizing its capital structure and the repurchasing of undervalued shares. the largest of the company. Overseas Growth Overseas investments were the main engine of growth for most large U. Midland usually invested in foreign projects as a foreign business or a local business partner. and its net margin was among the highest in the industry over the previous five years before 2007. was a global energy company with operations in oil and gas exploration. Midland enjoyed great success within all three divisions.Midland Energy Resources. Central Asia. Value-Creating Investment .

Midland Energy can use this computation to see if the projects available to them are worthwhile investments. These securities represent sources of finance and are projected to generate different returns for the organization. This method typically involved debt-free cash flow and a hurdle rate equal to or derived from the WACC for the project or division. Midland multiplies the before-tax rate by one and subtracts the marginal tax rate. convertible debt. pension liabilities executive stock options. the cost of borrowing. owners and other providers of capital. riskier companies generally have a higher cost of debt. Components of the WACC Cost of Debt Midland uses this computation to measure the effective rate that it pays on its current debt or simply. warrants. preferred equity. This calculation provides the company with an idea of the overall rate being paid by the company to use debt financing. Midland repurchased its own shares on occasion and revealed that whenever an attractive opportunity became available. Midland obtains money from a number of sources including common equity. Optimal capital structure Midland optimized its capital structure in large part by exploiting the borrowing capacity in energy reserves and in long-lived productive assets such as refining facilities. as an increase in WACC notes a decrease in valuation and a higher risk. Each division had its own target debt ratio and these targets were set on considerations involving each division s annual cash flow and the collateral value of its identifiable assets. Generally. a computation of the minimum return that the company must earn on existing assets to satisfy its creditors. the WACC of Midland increases as the beta and rate of return on equity increases. The WACC is calculated by taking into account the relative weights of each component of the capital structure. When the stock price fell below the stock s intrinsic value. options. All capital sources including common stock. Stock Repurchases In the past. Weighted Average Cost of Capital In this report. In order to obtain the cost of debt. etc. in which each category of capital is proportionately weighted. preferred stock. Midland Energy explains the importance of the weighted average cost of capital (WACC). bonds and any other long-term debt are included in a WACC calculation. . Midland would always consider repurchasing its share. It also gives investors of Midland Energy an indication of how risky a company can be. straight debt. A calculation of Midland s cost of capital. All else equal.Midland used discounting cash flow methodologies to evaluate the most prospective investment. it would take advantage. exchangeable debt.

Providers are usually rational. For example. risk-free investment over a certain period of time. Both figures tend to be above their respective averages together. respectively. marginal tax rates and average tax rates. Typically. The investor will not accept additional risk unless the potential rate of return is greater than the risk-free rate. Tax Rates The tax rate describes the burden ratio at which Midland Energy was taxed. Beta Beta represents the number that describes the relation of its returns with that of the financial market as a whole. Lenders are rewarded through interest. Individuals and organizations who were willing to provide Midland with their funds. Organizations obtain initial capital from two kinds of sources. want to be rewarded for their investments. Weighted Average The weights in the formula are. marginal tax rates are relevant for financial decision making.Cost of Equity A much more complex computation. an asset that has a Beta of zero indicates that the asset s returns generally follow the market s returns. or on the contrary. Capital providers expect reward for offering their funds to Midland. obviously. Corporations endure taxable incomes. tend to be below their respective averages. Referred to the cost of capital. Each quantity to be averaged has to be assigned a weight. A company needs to acquire capital from individuals or other partners to operate and grow. Risk-Free Rate The risk-free rate represents the interest an investor would expect from a completely. These weightings determine the relative importance of each quantity on the average. its cost of capital increases. preferring safety over peril. . lenders and equity investors. even the most harmless investments carry some sort of risk. while investors seek dividends or appreciation in value proportional to their investment. the cost of equity refers to the return Midland provides to its equity investors such as shareholders to obtain their capital. Taxes can be one of the largest cash outflows that an organization experiences. The risk-free rate is the minimum return an investor expects for any capital investment. In theory. as Midland s risk increases. the proportion of total value represented by equity and the proportion on total value represented by debt. Midland must pay for the funds it obtained from lenders and investors. Unfortunately.

622= 62.622 Weight of debt= D/E= $79.114+$79. enticing riskier investments.78% Weight of equity= E/V= $134. Higher risk investments are reimbursed with a higher premium.508/$213.22% Re= Where: Es: The expected return for a security Rf: The expected risk-free return in that market (government bond yield) s: The sensitivity to market risk for the security RM: The historical return of the stock market/ equity market .622= 37. This return compensates investors for taking on the higher risk of the equity market.114/$213.Equity Market Risk Premium The equity market risk premium refers to the excess return that an individual stock or overall stock market provides over a risk-free rate.508= $213. Midland Energy Resources Weighted Average Cost of Capital Calculation Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate V= E+D= $134.

66%+ 1.78%* 6.22%* 10.91% =0.5% .28%* (1-0.024+ 0.(RM-Rf): The risk premium of market assets over risk free assets. Re= 4.66%= 6.28% Tax rate= $11.747/ $30.25*5%=10.39) + 37.041 =6.91% Rd=1.62%+ 4.447= 39% WACC= 62.

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