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Midland Energy Resources, Inc.

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Whitney Pence

on 31 March 2015

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Transcript of Midland Energy Resources, Inc.

Midland Energy Resources, Inc. Cost of Capital
How are Moretensen's estimates of Midland's Cost of Capital used? How, if at all, should these anticipated uses affect the calculations?
Midland's WACC
Hurdle Rate
Should Midland use a single Hurdle Rate for evaluating investment opportunities? Why or why not?
E&P and R&M WACC
Compute a cost of capital for the E&P and Refining & Marketing Divisions.
Petrochemical WACC
How would you compute a cost of capital for the Petrochemical division?
Midland Energy Resources, Inc.
Presented By: Whitney Pence, Edward Wallace,
Fernando Mangones, Robert Rielly, and Patrick Sittenauer

Company Overview
Global Energy Company

Three Divisions

Janet Mortensen, Sr. VP of Finance
Asset Appraisals
Capital Budgeting
Financial Accounting
Share Repurchase Analyses
Performance Evaluations
Affects of Calculation
WACC represents average risk of company projects
Must adjust WACC to reflect the risk up or down based on project risk
Mortensen's user guide will aid in ensuring appropriate WACC is used by division and individual project
Cost of Equity
E = Market Value of Equity
D = Market Value of Debt
Re = Cost of Equity
Rd = Cost of Debt
T = average Corp. Tax Rate
Cost of Debt
Calculation of Rd
Table 1
Table 2
Since finding overall corporate WACC, use consolidated figures to calculate Corporate WACC
1-year is too short due to asset type (majority reserves)
30-year is too long due to volatility of industry
rd = 4.66% + 1.62%
rd = 6.28%
Actual - 2006
rf = 4.66% (10-year T-bill rate)
Beta = 1.25 (given)
EMRP= 5.0% (given)
re = 4.66% + 1.25(5.0%)
re = 10.91%
re = 4.66% + 1.32(5.0%)
re = 11.24%
rf = 4.66% (10-year T-bill rate)
Beta = 1.32
calculated from Target Debt, Equity, and Unlevered Beta
EMRP= 5.0%
Actual - 2006
re = 10.91%
rd = 6.28%
D/V = 37.92%
E/V = 62.08%
Tax = 39.73%
WACC = (62.08% * 10.91%) + (37.92% * 6.28% * (1 - 39.73%)
WACC = 8.21%
WACC = (57.80% * 11.24%) + (42.20% * 6.28% * (1 - 39.73%)
WACC = 8.09%
re = 11.24%
rd = 6.28%
D/V = 42.20% (Table 1)
E/V = 57.80%
Tax = 39.73%
EMRP Decision
Research, consultants, and an average of the last three decades shows that an
EMRP of 6.02%
would have been a better figure in calculations
Cost of Equity
Cost of Debt
Exploration & Production
re = 11.68%
rd = 6.26%
D/V = 46.0% (Table 1)
E/V = 54.0%
Tax = 39.73%
Refining & Marketing
WACC = (54.0% * 11.68%) + (46.0% * 6.26% * (1 - 39.73%)
WACC = 8.04%
WACC = (69.0% * 11.45%) + (31.00% * 6.26% * (1 - 39.73%)
WACC = 9.11%
re = 11.45%
rd = 6.26%
D/V = 31.00% (Table 1)
E/V = 69.00%
Tax = 39.73%
Exploration & Production
rf = 4.66% (10-year T-bill rate)
Spread = given in Table 1
Refining & Marketing
rd = 4.66% + 1.60%
rd = 6.26%
rd = 4.66% + 1.80%
rd = 6.46%
Exploration & Production
rf = 4.66% (10-year T-bill rate)
Beta = 1.40
calculated from Target Debt, Equity, and Unlevered Beta (Industry avg. equity Beta given)
EMRP= 5.0% (given)
Refining & Marketing
re = 4.66% + 1.40(5.0%)
re = 11.68%
re = 4.66% + 1.36(5.0%)
re = 11.45%
rf = 4.66% (10-year T-bill rate)
Beta = 1.36
calculated from Target Debt, Equity, and Unlevered Beta (Industry avg. equity Beta given)
EMRP= 5.0%
rf = 4.66% (10-year T-bill rate)
Spread = given in Table 1
Why the Difference in WACC?
The E&P division has a higher target D/V (46.0%) than the R&M division (31.0%). This higher weight on debt by the E&P division as compared R&M results in greater weighting on cost of debt in the WACC calculation.
Spread to Treasury & Credit Ratings
Largest difference between two industries
Higher spread with lower credit rating leads to an increase in Cost of Capital
Equity Beta
Equity beta is a measure of systematic risk. R&M has a slightly higher industry average equity beta (1.20) when compared to E&P (1.15) and thus has a higher level of risk
Capital Structure
Calculate Midland's Corporate WACC
Petrochemical Beta
Petrochemical WACC
Midland Corp. Beta = (weight E&P * E&P Beta) + (weight R&M * R&M Beta) + (weight Petro * Petro Beta)
rd = 4.66% + 1.35%
rd= 6.01%

re = 4.66% + 0.466(5.0%)
re = 6.99%

WACC = (60.0% * 6.99%) + (40.0% * 6.01% *(1-39.73%)
rf = 4.66% (10 year Treasury)
Spread = 1.35%
Beta = 4.66%
calculated from Target Debt, Equity, and Unlevered Beta
D/V = 40.0% (Table 1)
E/V = 60.0%
Tax Rate = 39.73%
WACC = 5.64%
Is it Adequate?
Single Hurdle Rate?
Hurdle Rate
Not Adequate
What should Midland do?
What is a Hurdle Rate?
How do we find it?
The minimum required rate of return on a project or investment
Used in discounting CF from proposed opportunity
Equal to or derived from WACC
Should consider
Riskiness of individual project
Type of Funding
Exploration & Production
A+ Credit Rating
46.0% Leverage
Expect continued global & economic growth (2007 goal)

Refining & Marketing:
BBB Credit Rating
31.0% Leverage
Relatively small margin (declining) and expected to continue
Advanced tech & vertical integration to become market leader in Long Run as global capacity decreased (2007 goal)

AA- Credit Rating
40% Leverage
Capital spending expected to grow in short term
New global investment opportunities (2007 goal)
Use Cost of Capital
Considers Funding Risk:
D/E Ratio
Considers Market Risk
Beta used in re Calculation
Why is a single hurdle rate inadequate for Midland?

Project Cost of Capital varies by division
E&P = 8.04%
M&R = 9.11%
P/C = 5.64%

Equity Beta - a single equity beta is not sufficient for projects with differing goals, risks, and sensitivities

Divisional Capital Structure:
Target debt ratio
Varying asset levels

Divisional Credit Ratings
Create divisional hurdle rates based on division WACC

Divisional Cost of Capital will be minimum Hurdle Rate

Hurdle rate should be adjusted up or down depending on the level of risk, level of financing, and investment opportunities available from each project.
Exploration and Production
Refining and Marketing
Janet Mortensen
Global Energy Strategy
4 Pillars of 2007 Financial Strategy

Fund significant overseas growth
Invest in value-creating projects across all divisions
Optimize its capital structure;
Opportunistically repurchase undervalued shares.
Exploration and Production
Operates in all phases of Exploration, Development and Production

2006 Operating Results
Revenue = $22,375M
Income = $12,556 M
2.1 MMBbl per day
7.8 Bcf Natural Gas per day
Production is main driver

Increase in Demand
Increase in Non-traditional sources
High prices to create opportunities
Refining and Marketing
Interest in 40 refineries

Small margins reflective of industry

2006 Operating Results
Revenue = $202,971M
Income = $4,047M
Distilling Capacity = 5 MMBbl per day

Advanced technology,capacity, and vertical integration in base stock lubricants to make Midland market leader
Smallest division

25 Manufacturing Facilities

5 Research Centers in 8 countries

2006 Operating Results
Revenue = $23,189 M
Income = $2,097 M

Increased capital spending
Replace old facilities
Joint ventures outside US
What is her Role?
Senior Vice President of Project Finance

Prepare annual cost of capital estimates for Midland and its 3 divisions

Estimates initially used in 2002 for large share repurchase analysis

Create a "user manual" for cost of capital estimates
Why a "user manual"?
Since 2002, cost of capital estimates have become
Widely circulated across Midland
Influential in decision making

To ensure appropriate use especially as figures have been criticized in the past and impact the entire entity
Full transcript