Midland Energy Resources Case Study

CASE 3

MIDLAND Oct.25 2017

[pic 4]

GROUP 9 [pic 5]

1155102398 LONG, Shishi           1155102407 LUO, Han

1155080655 LUO, Yuxin              1155096435 SUN, Yiqun

1155098044 TANG, Sijia

TABLE OF

CONTENTS[pic 6]

01        INTRODUCTION        [pic 7]

02        MIDLAND’S COST OF CAPITAL

Uses of cost of capital        [pic 8]

Calculation of cost of capital        

EMRP choices.        

03        HURDLE RATE         [pic 9]

04        WACC FOR E&P AND R&M         

Hurdle rate definition        

Factors cause different cost of capital        

Comments on Midland’s using hurdle rate        

The cost of debt of each division        [pic 10]

The cost of equity of each division        

The cost of capital of each division        

Differences in cost of capital

05        WACC FOR PETROCHEMICAL        [pic 11]

Calculation of WACC for Petrochemical        

Sensitivity analysis         

1. Introduction

Midland Energy Resources is a global energy company with operations in oil and gas exploration and production, refining and marketing, and petrochemical. It has been incorporated more than 120 years previously and in 2007 it has more than 80,000 employees. On a consolidated basis, the company has 2006 operating revenue and operating income of $248.5 billion and $42.2 billion.

2. Midland’s cost of capital

2.1 Uses of cost of capital

Mortensen’s estimates of Midland’s cost of capital is primarily used in asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. The annual cost of capital is calculated for Midland’s three divisions as well as the whole corporation. The analysis will provide the company with an insight in making a better decision regarding to investment and operation both at a division level and a corporate level. Besides, the cost of capital is also an essential component of Weighted Average Cost of Capital (WACC).

Regarding to the asset appraisal, the assets for Midland are mainly oil refining facilities, equipment for exploration, and storage tanks so on. We focus on the NPV of those asset when we try to evaluate. Therefore, we discount all the future cash flow based on the WACC. It helps us to have a clearer view of the potential investment opportunity, the capital budgeting plan, and whether we have paid the right price for the asset. Regarding to the performance assessment, given the formula, it evaluates the company's economic profits in excess of required return which implies the financial performance and growth potential. For the M&A, we also focus on the NPV of the target company by discounting all the future cash flow based on WACC. It provides a way to assess the benefit of the M&A and ensures that we are paying the right price for the project. For the share repurchase, Midland will implement it when the stock price falls below the intrinsic price, which is calculated by subtracting the market value of debt from the fundamental value of Midland. As for the fundamental value, it uses the DCF analysis which will discount based on WACC. Therefore, low WACC implies a high instinct value, supporting Midland to implement a repurchase plan. In other words, WACC provides a way to justify whether or not Midland should implement the share repurchase.[pic 12]

Company is financed through debt or equity, WACC is the average cost of those financing. It indicates the risk of the project as well as whether or not we should take the investment. In calculation, we may adjust the WACC to

reflect the proper risk, otherwise, we may miss a good investment opportunity or engage in a low-profitable project. For Midland, it realized the importance of using the appropriate WACC, therefore, it plans to append a “user’s guide” to apply for the calculations which will help the divisions and company to evaluate properly.

2.2 Calculation of cost of capital

The cost of capital is weighted average of cost of equity and after-tax cost of debt.

The cost of debt can be calculated by adding the risk-free rate and the spread to the treasury. We use the yield to maturity of 10-year U.S. treasury bond 4.66% as the risk-free rate. The cost of debt is：

[pic 13]

The cost of equity can be calculated by using CAPM. The equity  1.25 is Midland’s equity beta from Exhibit 5. The 5% EMRP is what Midland used in 2006 as an equity market risk premium. [pic 14]

[pic 15]

For the tax rate, we assume the tax rate will follow the trend. By using the logarithm curve to fit the tax rate, we get the tax rate estimation 37.70%. Actual WACC can be calculated by using the formula：

[pic 16]

The above actual D/V and E/V are derived from the figure D/E=59.3% which we found in Exhibit 5.

 To calculate target WACC, we use data based on the company’s target. The target D/V and E/V are from Table 1 based on Mortensen’s estimates. To find the target cost of equity, we first calculate the asset , and then we lever it into target equity  with target D/E 73%.[pic 17][pic 18]