Weighted Average Cost of Capital and Midland Energy

Executive Summary inland might Resources, Inc. is a global energy company with a broad array of products and serfeeblenesss. The company ope ordains within three various operations including oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. inland has proven to be a rattling profit able-bodied company, with reported operating revenue of $248. 5 billion and operating income of $42. 2 billion. The company has been in business for over 120 years and employed more than 80,000 individuals.Janet Mortensen, the senior vice president of project finance for Midland Energy Resources, has been asked to calculate the weighted average woo of crown (WACC) for the company as a whole, as advantageously as individually of its three divisions as bulge out of an annual budgeting process. Midlands Three Divisions Exploration & Production Oil exploration and production (E&P) is Midlands most profitable business, and its net margin over the previous five years was among the highest in the diligence.With oil prices at historic highs in early 2007, Midland anticipated heavy investment in acquisitions of promising properties, in development of its proved undeveloped reserves, and in expanding production. They also shooted to account for contention from argonas such as the Middle East, Central Asia, Russia, and West Africa. Refining and commercialiseing Midland had ownership interests in forty refineries rough the world with distillation capacity of five million barrels a day. metrical by revenue, this side of the business was Midlands largest. The relatively small margin was consistent with a long-term trend in the industry.Margins had declined steadily over the previous twenty years. Petrochemicals Petrochemicals is Midlands smallest just now most promising and undervalued division. Midland owned twenty-five manufacturing facilities and five research centers in eight countries around the world. Capital spending in petrochem icals was expected to grow in the near term. Midland Energy Case Analysis managerial Finance 1 In graze to stick the follow of capital for Midland Energy Resources and all(prenominal) of the three divisions within the company, we will need to subprogram the formula or weighted average comprise of capital (WACC) which is ( )( rd= Cost of debt re= Cost of equity D= Market value of debt E= Market value of equity V= D+E= Value of the company (or division) T= Tax outrank First, we can calculate rd for each division as it is outlined in the case by adding a premium/spread over US Treasury securities of a similar maturity. In other haggle ( The two tables in the case be as follows Table 1 Business Segment amalgamated E&P R&M Petrochemicals Credit Rating A+ A+ BBB AATable 2 due date 1-Year 10-Year 30-Year Rate 4. 54% 4. 66% 4. 8% Debt/Value 42. 2% 46. 0% 31. 0% 40. 0% beam to Treasury 1. 62% 1. 60% 1. 80% 1. 35% ) ) ( ) *For my calculation, I employ the 30-year maturity for E&P , R&M, and Midland as a whole as they take on longer term projects. I used the 1-year for petrochemicals as they tend to take on short term projects. Midland Energy Case Analysis managerial Finance 2 Calculations are as follows rd for Exploration & Production rd for Refining & Marketing rd for Petrochemicals rd for Midland Second, we need to calculate re for the three divisions as well as Midland as a whole.To find re, we will use the CAPM model outlined in the case ( ) In order to compute this equivalence, we need to find beta for the three divisions. The case already outlines Midlands overall beta at 1. 25. However, the case does not state the beta for the three divisions. We can calculate this using beta for publicly traded companied outlined in the case. Using the following formula, as well as exhibit 5 in the case, we can calculate beta for the three divisions * ( ) ( )+ Midland Energy Case Analysis Managerial Finance 3 Exhibit 5(from case) Exploration & Production Jackson Energy, Inc.Wide Plain Petroleum Corsicana Energy Corp Worthington Petroleum amount Refining & Marketing Bexar Energy, Inc. Kirk Corp. White Point Energy Petrarch Fuel run Arkana Petroleum Corp. Beaumont Energy, Inc. Dameron Fuel Services Average Midland Energy Resources Equity Market Value 57,931 46,089 42,263 27,591 Net Debt 6,480 39,375 6,442 13,098 D/E 11. 20% 85. 40% 15. 20% 47. 50% 39. 80% Equity Beta 0. 89 1. 21 1. 11 1. 39 1. 15 LTM Revenue 18,512 17,827 14,505 12,820 LTM Earnings 4,981 8,495 4,467 3,506 60,356 15,567 9,204 2,460 18,363 32,662 48,796 6,200 3,017 1,925 -296 5,931 6,743 24,525 0. 30% 19. 40% 20. 90% 12. 00% 32. 30% 20. 60% 50. 30% 20. 30% 1. 7 0. 94 1. 78 0. 24 1. 25 1. 04 1. 42 1. 2 160,708 67,751 31,682 18,874 49,117 59,989 58,750 9,560 1,713 1,402 112 3,353 1,467 4,646 134,114 79,508 59. 30% 1. 25 251,003 18,888 Again the calculation to find Asset ? is * Equity ? for Midland= 1. 25 ( ) ( )+ Equity ? for E&P= 0. 93*1+ (1-39. 73%)*85. 19% =1. 41 Equity? for R&M= 1. 05*1+ (1-39. 73%)*44. 93% = 1. 33 *85. 19% and 44. 93% come from Exhibit 1 in the case In order to get Equity ? for Petrochemicals, we will need to take a weighted average of the three divisions.The equation would be as follows (w1, w2, w3 are based on the total assets of a division divided by Midlands total assets). To find this, we will use the frames from Exhibit 3 in the case Midland Energy Case Analysis Managerial Finance 4 2004 E&P 76,866 R&M 60,688 Petro 19,943 Midland 157,497 2005 125,042 2006 140,100 Avg 114,002. 67 91,629 93,829 82,048. 67 28,000 28,450 25,464. 33 244,671 262,378 221,515. 33 Calculation for w1-3 W1= 114,002. 67/221,515. 33= 0. 51 W2= 82,048. 67/221525. 33= 0. 37 W3= 25,464. 33/221,515. 33= 0. 2 Now we can use the formula from earlier to find the ? for Petrochemicals Lastly, we need to find EMRP to find re for Midland and the three divisions. We can find our EMRP number by looking at exhibit 6 in the case Period 1987-2006 1967-2006 1926-2006 1900 -2006 1872-2006 1798-2006 Average scanty return US Equities T-Bonds 6. 4% 4. 8% 7. 1% 6. 8% 5. 9% 5. 1% Standard mistake 3. 7% 2. 6% 2. 2% 1. 9% 1. 6% 1. 2% I will choose to use the average return from the time period of 1798-2006. That is the longest sample size in regards to time, as well as having the lowest standard of error.I will round down to 5% for ease of calculation Midland Energy Case Analysis Managerial Finance 5 ( re for Midland= 4. 98%+5%*1. 25= 11. 23% re for E&P= 4. 98%+5%*1. 41= 12. 03% re for R&M= 4. 98%+5%*1. 33= 11. 63% re for Petrochemicals= 4. 54%+5%*0. 32= 6. 14% ) With this information, we are able to finally calculate the weighted average cost of capital (WACC) for Midland and the 3 divisions of the company. The formula and calculations are as follows ( )( ) ( ) *D/V are provided in Table 1 for Midland, E&P, R&M, and Petrochemicals. They are 42. 2%, 46. %, 31. 0%, 40. 0% respectively. WACC-cost of capital we need WACC for E&P ( =8. 32% WACC for R&M ( =9. 29% WACC for Petrochemicals ( =5. 10% WACC for Midland ( =9. 17% Midland Energy Case Analysis Managerial Finance 6 ) ) ) ) The cost of capital (as shown above) will differ for the three divisions because the business operates in different industries. By being in different industries, the companies have different risk exposure and betas, while also having different credit ratings. wholly of these components will affect a companys cost of capital differently.Further Analysis Mortensens estimates were used for many things including performance assessments, mergers and acquisition proposals, stock repurchases, asset appraisals, and financial accounting. As stated in the case, cost of capital is a very important component in WACC calculations. These calculations were being used to evaluate at a divisional take aim as well as at a collective level as a whole. In my calculations for the case, I solved for both levels. In regards to Midlands corporate WACC, Mortensen computed the cost of debt for each division by adding a premium (or spread) over U.S. Treasury securities with an abstract maturity depending on the division. For Exploration and Production (E&P), Refining and Marketing (R&M), as well as Midland as a corporation, Mortensen used a 30 year maturity TBond self-confidence as those divisions tended to centre on longer term projects. She decided on a 1 year T-Bond maturity assumption for Petrochemicals as they tended to focus on shorter term projects. Another assumption was that the tax rate (39. 73%) remained ageless throughout the case as well as an EMRP of 5%.The EMRP was based on exhibit 6 of the case which examined TBonds during a certain period of time and with a certain standard of error. With a very low standard of error (based on the chart) and advisors, bankers, and investors covering the industry agreeing with 5% as an estimate, I consider the estimate to be appropriate. Analysts on the industry, bankers, and investors tend to have a broader l ook on companies within an industry as a whole. Lastly, Midland should not use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions because each division is different.Midland is too large of a corporation, with different divisions, each containing its own unique set of risks. Due to the fact that the risk for each division will be different, I believe the corporate hurdle rates for those divisions should also be different to reflect a more accurate corporate assessment. I believe Mortensen did a great job with the information she was presented with in the case and I believe Midland Energy will continue to be a heavy(a) company within the industry. Midland Energy Case Analysis Managerial Finance 7