Case a Bulter Company

Case summary and Q1

Case summary

Janet Mortensen, the vice president of project finance of Midland Energy Resources needed to prepare for the estimation of annual cost of capital of the company in 2007.

Midland Energy Resource was a big and well established energy company with 3 business segments constituted by Exploration & Production (E&P), Refining and Marketing (R&M), and Petrochemicals. The VP was considering calculating the WACC both in consolidated basis for the whole company and in a segment basis for each of the mainstays.

Some highlights of the 3 segments are shown below. (Please see Exhibit 1 for the vertical comparison)

E&P is the most profitably business of Midland with a largest net income in 2006 accounted for $12.5 billion, and its net margin had amounted to 56.16% in 2006, the highest among the industry over the previous 5 years. For future trend prediction, Midland expected a growing demand for the products in E&P business and a heavy investment in acquisitions of promising properties, resulting in a projection of capital expenditure to exceed $8 billion in 2007 and 2008.

R&M is the largest revenue contributor of the company but a least margin generator (with a net margin around 1.99% in 2006) because of the stiff competition and highly commoditized products. Nevertheless, advance technology and vertical integration had combined to make Midland a market leader in R&M business. The company expected a consistent small margin in the long run and stable capital spending in 2007-2008.

Petrochemical is also a substantial business with 23189 revenue and net margin 9.04% in 2006. And the capital expenditure was expected to grow in short-term.

The primary calculation for Midland’s cost of capital was based on WACC formula:  where the cost of debt was define by the spread and cost of equity defined by CAPM: .[pic 1][pic 2]

Q1

The financial strategy of Midland Energy Resource was based on 4 pillars: overseas growth, value-creating investment, optimal capital structure and stock repurchase, all of which was involved in the factor of cost of capital. Specifically, cost of Capital was used in the following aspects in terms of financial and investment Policies.

1. Valuation of prospective investments

The company applied DCF model to evaluate most prospective investments by using debt-free cash flows and hurdle rate as discount rate equal to or derived from WACC. The calculation should be: . Sometimes the interest in some overseas projects were instead analyzed as streams of future equity cash flows and discounted at a rate based on the cost of equity, which can be calculated with: .[pic 3][pic 4]

1. Performance assessment

Midland measured the performance of a business or division in two main ways, the second one was based on economic value added (EVA) which was related to cost of capital because the company calculated EVA by: . [pic 5]

1. Stock repurchase decision

Basically, Midland compared the share price with intrinsic shares value to for deciding whether to repurchase stock or not. When the stock price fell below the stock’s intrinsic value, Midland considered repurchasing its shares. And the intrinsic value of the shares can be defined as: , and the fundamental value of the consolidated enterprise was estimated using DCF analyses and a comparison of the company’s trading multiples with those of its peers, in which DCF is calculated with the help of cost of capital that Mortensen estimated.[pic 6]

Besides respects above, we believe the cost of capital can also be used for decision making in capital budgeting and M&A.

Because different uses may vary from each other in terms of the financing method and cost of financing, the uses can in return affect the calculation. For example, an investment project may have a lifetime of 5 years or 10 ten years, the financing comes from both equity and bond, when calculating the WACC, we should use different cost of debt given the different debt period, specifically we need to use the interest rate of 5-year treasury bond as the base rate for the 5-year project and the interest rate of 10-year treasury bond as the base rate for the 10-year project. Not mention that it also affects the EMRP.

Q2

Base on the several uncertain inputs that are needed in calculating the WACC of the whole company, we made the following assumptions at the beginning.  First, the tax rate is derived from calculating the average of tax rates from 2004 to 2006, which is calculated by dividing tax expense to income before tax in the same year. The value of tax rate we used during the calculation is 39.73%. Second, we deemed the rate of 10-year US treasury bond as the most appropriate risk-free rate when calculating the WACC, with the 1-year rate being too narrow to conclude the discounted value of long term future cash flows, as well as 30-year treasury bond rate being unreliable when company’s core business is currently facing potential changes, and thus is not suitable to react to the volatility and changes in the future. Third, we use data 5.0%, which is the outcome of recent research and consultation from professional advisors in the industry, as EMRP to calculate total WACC. Fourth, we applied the consolidated figures of the Spread to treasury of the corporation to calculate the total WACC.  Fifth, the given equity beta in the Exhibit 5 of the case cannot properly represent the true beta of company due to the change of its target capital structure in 2007, thus we need to made some adjustments to the given beta by using the likable D/E ratio in the coming year.

When calculating the WACC, we applied the following formula:

1. rd = 10-year risk-free rate + spread to treasury
2. re = 10-year risk-free rate + β * (EMRP)
3. WACC = re * E/(D+E) + rd * (1-tax rate) * D/(D+E)

Since we already have the company’s spread to treasury and 10-year risk-free rate, showed in Table 1 and 2 in the case respectively, we can easily calculate the cost of capital of debt, as:

        rd = 4.66% + 1.62% = 6.28%

To calculate the cost of capital of equity, except for the inputs that we already perceived from making assumptions, we still need the value of β. Since the company’s preliminary estimate for debt ratio (D/D+E) in 2007 is 42.2%, we would get the up-to-date D/E ratio 73% by simply changing the equation. We first tried to removing the impact of former leverage by un-levering the equity beta given.