Midland Energy Resources Inc.

KEY

Midland Energy Partners

Andrew Picone Will

McDermott Taylor Appel Liam Joy

Purpose of the CaseThe purpose of the Midland Energy Resources case is to determine the Weighted Average Cost of Capital (WACC) for the company as a whole, as well as each of the company’s divisions. This is done as a part of the annual capital budgeting process the company must go through. To find the WACC for the company and its divisions, we needed to first calculate the cost of debt and the cost of equity. In calculating the cost of debt, we needed to determine the appropriate risk free rate whereas for calculating the cost of equity, we needed to determine whether to use the Dividend Discount Model or the Capital Asset Pricing Model (CAPM). In addition, we needed to determine an appropriate Equity Market Risk Premium (EMRP), as well as appropriate betas to use; some of which required taking out the debt (un-levering) and then adding back the debt (re-levering). Following these calculations we needed to calculate the appropriate tax rate for the company. To wrap this up, we needed to analyze the given market values of debt and equity in order to calculate the enterprise value of the company and use them to find the ratios of debt to enterprise value (D/V) as well as equity to enterprise value (E/V). With all of that information we then had to calculate the WACC for both the company and its divisions and answer the following questions:

WACC Cost of Capitalrd Cost of Debtre Cost of Equityrf Risk Free RateSpread Spread to TreasuryEMRP Market Risk PremiumD DebtE EquityV Value T TaxesEVA Economic Value AddedNOPAT Net Operating Profit

After TaxesMV Market ValueOI Operating IncomeLTD Long Term Debt

1. How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations?

2. Calculate Midland’s corporate WACC. Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why?

3. Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or why not?

4. Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from one another?

5. How would you compute a cost of capital for the petrochemical division?

Background on Midland Energy ResourcesMidland is a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. The company was incorporated over 120 years ago and as of 2007 it has more than 80,000 employees. In 2006, the company’s operating revenue totaled $248.5 billion, with operating income totaling $42.2 billion. Starting in the early 1980s, Midland’s corporate treasury staff started preparing annual cost of capital estimates for the company and its divisions. The estimates included asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. These estimates, however, were often criticized, with the assumptions and inputs questioned by Midland’s divisions presidents and controllers. Starting in 2002, Janet Mortensen, a senior analyst, prepared estimates of Midland’s cost of capital in connection with a large proposed share repurchase. Soon after she was asked to calculate both corporate and divisional costs of capital that would be incorporated in planned performance evaluations. She has since been calculating these estimates every year, but has recently questioned whether the calculations are appropriate for all applications.

Midland’s Divisions

Exploration and ProductionExploration and production is Midland’s most profitable division, with after tax earnings of $12.6 billion. In 2006, the company extracted roughly 2.10 million barrels of oil per day and roughly 7.28 billion cubic feet of natural gas per day. Midland expected demand for their products to increase in the future due to global population increase and economic growth. As a result, they increased production from deep-water drilling, heavy oil recovery, liquefied natural gas, and arctic technology. Their capital spending in E&P is expected to exceed $8 billion in 2007 and 2008.

Refining and MarketingRefining and Marketing is Midland’s second most profitable division, with after tax earnings totaling $4 billion. This division had the largest revenue, however, out of their three divisions, with global revenue in 2006 totaling $203 billion. Most of Midland’s refinery output was gasoline, sold as fuel for automobiles. Thanks to Midland’s advanced technology and vertical integration, the company has the manufacturing capacity to produce 120,000 barrels of base-stock lubricants per day. As a result, they

have become a market leader in this business. Due to historical trends of low and shrinking margins and increased difficulty obtaining approvals for refinery expansions, Midland’s capital spending in this division is projected to remain stable in 2007 and 2008.

PetrochemicalsPetrochemicals, Midland’s smallest division, was their least profitable division, with after-tax earnings totaling $2.1 billion. With ownership/interests in 25 manufacturing facilities and five research centers around the world, this division produces a myriad of chemicals, aromatics, and fuel and lubricant additives. Capital spending is expected to grow in the near-term due to facility upgrades and new facility purchases to increase capacity efficiency.

In order to make the calculations for Midland Energy Resources current Capital Structure we needed to find the individual components that make up that computation: Cost of Debt (rd), Cost of Equity (re), the Equity to Value ratio (E/V), the Debt to Value ratio (D/V), and finally the tax rate of the firm. Before getting into these individual calculations however we want to stress the importance of the WACC. For example, say the company was debating implementing a new project in its Exploration & Production division and wanted to know if the project would bring value to the firm. In order to make this decision, it would not make sense to use the Corporate WACC, but instead we must find the individual WACC for the E&P division. The same would apply for all other divisions, and so it is essential that we calculate the WACC not just for Corporate, but also each of our individual divisions in the case that this situation arises.

So, to dissect the WACC formula let’s begin with Corporate. In order to calculate the Cost of Debt of the firm we look at its formula: rd = rf + spread. When analyzing the risk free rate, we decided to choose 4.98%. As represented in Exhibit 1 this rate corresponded to a yield to maturity on US Treasury bonds of 30 years. Our underlying reason for choosing this is merely because it represented the longest duration. Assuming we chose a project for Midland Energy Corporate, or one of its divisions, the duration of that project would assumedly be lengthy and thus this rate would be the safest and most accurate assumption. Moving on now to the other aspect of our equation we need to find the spread. As displayed in Exhibit 2 we were given unique spread to treasury for the consolidated business as well as each division. Thus now putting together our whole formula we come up with a cost of debt equal to the following:

Corporate rd=rf+spread rd=4.98%+1.62% rd=6.6%E&P rd=rf+spread rd=4.98%+1.60% rd=6.58%R&M rd=rf+spread rd=4.98%+1.80% rd=6.78%Petro rd=rf+spread rd=4.98%+1.35% rd=6.33%

The next aspect of the WACC formula we need to look at is the Cost of Equity. Again dissecting this formula requires the risk free rate, which as we just explained above was 4.98%. This number will hold throughout the duration of this project. Moving on to the next part of this equation is finding the EMRP and the Beta. First let’s start with the Beta. If you look at Exhibit 3 you will find a variety of Market Risk Premiums available based on “historic US stock returns minus Treasury bond yields” as well as market risk premium survey results from Researching Companies. Out of all the options available we chose 5.10% as our EMRP due to it having the longest period of time as well as a low standard error. In addition, this EMRP will remain constant throughout all necessary calculations.

So now looking at Beta. Exhibit 4 displays the Beta for Corporate, E&P and R&M, but fails to provide us with the Beta for our Petro division. To make the most accurate decision, we took the average between our other two divisions (1.20 and 1.15) to calculate a projected beta of 1.18 (rounded) for our Petro division. So now, putting the Cost of Equity equation together we find the following:

Corporate re=rf+B(EMRP) re=4.98%+1.25(5.10%) re=11.36%E&P re=rf+B(EMRP) re=4.98%+1.20(5.10%) re=10.85%R&M re=rf+B(EMRP) re=4.98%+1.15(5.10%) re=11.10%Petro re=rf+B(EMRP) re=4.98%+1.18(5.10%) re=11..00%

Now that we have fully calculated the Cost of Equity and the Cost of Debt for Corporate as well as each of our divisions the only task that remains to find each individual WACC calculations is to calculate the tax rate of Midland Energy and then calculate both the D/V and E/V ratios. Let’s look at taxes first. To most accurately calculate the taxes of Midland Energy we need to find the average Tax Rate over the course of its years. Looking at Exhibit 5 we are provided with the company’s Income Statement for years 2004, 2005, and 2006. Under each statement we are provided with two very important pieces of information to help calculate each year’s Tax Rate; Income before taxes & Taxes. To find each year’s tax rate we only have to divide the taxes by the income before taxes. Once we have each individual calculation we can average them out over 3 years to find the tax rate we project for our WACC calculations. See calculations below.

2004 2005 2006Taxes/Income Before Taxes

= $7,414/$17,910 $12,830/$32,723 $11,747/$30,447

Tax Rate =41.40% =39.21% =38.58%

Midlands Tax Rate (41.40% + 39.21% +38.58%)/3 =39.73%

Now that we have the tax rate of Midland Energy we just need to compute the D/V and E/V ratios. Taking a look back at Exhibit 4 we are given the D/E ratio for Corporate, E&P, and R&M; not the Petro division. Similar to how we previously calculated the beta of the Petro division, we took up a similar tactic, calculating the average D/E ratio between both our R&M and E&P division, (20.3% and 39.8%) giving us a D/E ratio of 30.05%. Now that we have the D/E ratio for each firm we can start to calculate both the D/V and E/V ratios by creating an algebraic assumption. We will provide an example for Corporate below, explaining each step along the way.

Corporate

*Known: Firm has a current D/E ratio of 0.593

Step 1: Solve for D (assume E=1 for simplicity)

D/E = 0.593

D/1 = 0.593

D = 0.593

Step 2: Solve for V

D+E=V

0.593+1=1.593

Step 3: Solve for D/V

*We now know both D and V under our simplified assumptions

D/V = 0.593/1.593

D/V = 0.3722

Step 4: Solve for E/V

*We also know E and V under our simplified assumptions

E/V = 1/1.593

E/V = 0.6277

Now that we know how to calculate both the D/V and E/V ratios we can follow the same step by step logic and apply it to each division. Below see D/V and E/V ratios for each division.

Corporate E&P R&M PetroD/V 37.23% 28.47% 16.87% 23.11%E/V 62.77% 71.53% 83.13% 76.89%

Now that we have all of the components we can calculate the WACC of Corporate as well as our divisions: E&P, R&M, and Petro. We start by looking at our formula and plugging the appropriate data in. See calculations in table below.

Corporate WACC=re(E/V)+rd(D/V)(1-T) =.1136(.6277)+.0660(.3723)(1-.3973) =8.61%E&P WACC=re(E/V)+rd(D/V)(1-T) =.1085(.1687)+.0658(.8313)(1-.3973) =8.89%R&M WACC=re(E/V)+rd(D/V)(1-T) =.1110(.2847)+.0678(.7153)(1-.3973) =9.92%Petro WACC=re(E/V)+rd(D/V)(1-T) =.1100(.2311)+.0633(.7689)(1-.3973) =9.34%

The calculations displayed above represent the current weighted average cost of capital incurred through Midland Energy Corporate and each of divisions based on its current capital structure. However, as requested from the company, Midland would prefer to operate under a new capital structure with targeted D/V ratios that are displayed in Exhibit 2. We will now address their new structure and the associated WACC calculations that will be incurred due to these changes.

As we mentioned earlier, Midland Energy was exploring the option of a capital structure change. When debating a change in capital structure, there are a number of factors that need to be considered, such as:

An increase in debt means a higher risk of bankruptcy Firms can deduct interest expenses Debt holders have prior claims on cash flows compared to stockholders Additional debt can affect the behavior of managers Net effect on WACC?

In this case, Midland Energy was determining the net effect of an increase in their D/E ratio on their WACC. Midland’s goal was to decrease their Weighted Average Cost of Capital throughout all divisions and as a corporation. You can see their current and potential values below:

CURRENT: Corporate E&P R&M PetroD 0.3722 0.1690 0.2850 0.2270E 0.6278 0.8310 0.7150 0.7730V 1 1 1 1WITH CAPITAL STRUCTURE CHANGE:D 0.4220 0.4600 0.3100 0.4000E 0.5780 0.5400 0.6900 0.6000V 1 1 1 1

A change in capital structure has a number of effects on the WACC rate. The cost of equity for instance, is tied to a company’s debt levels. The cost of equity or re=rf+β(EMRP) changes with different capital structure allocations because part of the calculation for Beta contains the debt-to-equity ratio. For Midland, we had to first get their unleveraged beta or their beta without debt, and then calculate the leverage beta with capital structure changes. To calculate the firms unleveraged beta we used the formula below:

BU = BL/(1+(1-T)*(DE )

We used the Betas and debt-to-equity ratios determined earlier for each division and the firm as a whole, to strip out the debt. Below are the calculations and unleveraged beta for each division:

Corporate: 1.25/(1+(1-.3973)*(.37.63 ) = 0.92

E&P: 1.15/(1+(1-.3973)*(..28.72 ) = 0.93

R&M: 1.2/(1+(1-.3973)*(.17.83 ) = 1.07

PETRO: 1.18/(1+(1-.3973)*(.23.77 ) = 1.00

Now we had to leverage the unleveraged beta with the changed capital structure from the chart above. The formula and calculations for leveraging the unleveraged beta are below:

Corporate: 0.92*(1+(1-.3973)*(.42.58) = 1.32

E&P: 0.93*(1+(1-.3973)*(.46.54 ) = 1.40

R&M: 1.07*(1+(1-.3973)*(.31.69) = 1.36

PETRO: 1.00*(1+(1-.3973)*(.4.6 ) = 1.38

We then plugged the new leverage Betas into the formula for the cost of equity and as you can see from our chart below, the WACC dropped for each segment.

Corporate E&P R&M PETRO7.50%

8.00%

8.50%

9.00%

9.50%

10.00%

10.50%

8.61%

8.88%

9.91%

9.37%

8.46% 8.38%

9.48%

8.74%

WACC Comparison

WACC with Current Structure

WACC with Capital Structure Change

Given the data, we would recommend that Midland Energy make the capital structure change.

When building the excel file to make these calculations, we made the file dynamic so that we could play with the capital structure to see how it changed the WACC and make our own recommendation. After playing with the ratios for a little while, we realized that the higher the debt-to-equity ratio, the lower the WACC. In the real world, debt is cheaper than equity up to a certain point. The cost of debt should become higher once the debt ratio of a firm reaches a certain level. Unfortunately, with the information given to us by the case, we were not able to add this element. Most companies have a debt ratio of 25%-50%, so we recommended Midland have a debt level of 50% given the information from the case. With this 50% debt level or D/E ratio of 1, the resulting WACC rates are:

Corporate WACC = 8.24% E&P WACC = 8.26% R&M WACC = 8.90% PETRO WACC = 8.48%

To expand further on potential determining factors that would allow Midland to decide whether or not to implement a project to their company we could address how the particular project would impact the company’s Economic Value Added (EVA). To calculate this we need NOPAT, the WACC, and Invested Capital. The EVA equation is

displayed below along with the individual equations for each component. We will be looking at Exhibit 6 to calculate NOPAT, and Exhibit 7/Exhibit 8 to calculate Invested Capital. Then we will use the above WACC and Tax Rate calculated under Midland Energy’s Ideal Corporate Cost of Capital Structure.

To refresh your memory (WACC = 8.24%, Tax Rate = 39.73%)

EVA = NOPAT – (WACC) (Invested Capital)

NOPAT = OI (1-T)

Invested Capital = MV Equity + Net Debt

MV Equity = Po x # Shares Outstanding

Net Debt = Long Term Debt -Current Portion Long Term Debt+Cash & Cash Equivalents + Restricted Cash

Placing these formulas together in the following table we calculate the EVA for Midland Capital. Please consider all information provided throughout this case thoroughly before making the decision to implement a project or not.

NOPAT OI (1-T) $42,243(1-.3973) $25,459.86WACC 0.0824MV Equity Po x # Shares

Outstanding$44.11 x 2951 $130,168.61

Net Debt LTD-Cash ($20,767+$81,078)-($19,206 + $3,131)

$79,508

EVA NOPAT-(WACC)(MV Equity + Net Debt)

$25,459.86 – (0.0824)($130,168.61 + $79,508)

$8,184.82

Appendixes

Exhibit 1

Exhibit 2

 Maturity Rate

1 Year 4.54%

10 Year 4.66%

30 Year 4.98%

Exhibit 3

Exhibit 4

Exhibit 5

Exhibit 5

Exhibit 6

Exhibit 7

Exhibit 8