Midland Energy Resources, Inc.

Midland Energy Resources, Inc.:

Cost of Capital Analysis Report

By:

CAI Jinghong

CAO Yu

DENG Yuxin

LI Yuanshan

Executive Summary

Midland Energy Resources, Inc., incorporated more than 120 years, was a global energy company with operations in oil and gas across three business segments: Exploration and Production (E&P), refining and marketing(R&M) and petrochemicals. Among these three business segments, E&P was the Midland’s most profitable business with net margin the highest among in the industry over the past five years.  R&M was the company’s largest business by revenue. Due to strong competition, R&M’s margin was relatively small that was consistent with long-term industry trend. Petrochemical was Midland’s smallest division yet a considerable one. Since 2002, Janet Mortensen, now a senior vice president of project finance for Midland Energy Resources, had been undertaking to estimate Midland’s cost of capital for many analyses within Midland either at division level or corporate level. By 2007, Mortensen realized her calculation of cost of capital become widely adopted and she wondered whether her calculations were truly appropriate for all application and wanted to add a “user’s guide” to the 2007 set of calculations. Midland’s financial strategy in 2007 were to fund significant overseas growth; to invest in value0creating projects across all divisions; to optimize its capital structure’ and to opportunistically repurchase undervalue shares. The purpose of this report is to assist Mortensen to estimate the cost of capital (WACC) for the company as well as for the as each of division considering the actual conditions of Midland’s Energy Resources.

How are estimates of Midland’s Cost of Capital used?

The estimates of the cost of capital, as claimed in the material, have been utilized in four sorts of analyses and in three levels of business organizations. These three levels of business organizations includes business units such as production and marketing, divisions of Midland Energy which covers Exploration & Production, Refining and Marketing and petrochemicals and the whole corporate. Different levels of organizations differ in strategy it employs, function it has and analyses it conducts. In these three levels of organizations, asset appraisals, performance assessments, M&A proposals and stock repurchase decisions have been conducted with the help of the cost of capital. While asset appraisals regarding capital budgeting and financial accounting and performance assessments are usually utilized in the division and business unit level, other two analyses concerning mergers and acquisition proposals and stock repurchase are considered in corporate level.

Actually, the estimate of cost of capital plays a significant role in all these four sorts of analyses. In capital budgeting which mainly concerns with calculation of Net present value or Internal rate of return, the estimate of the cost of capital is the interest rate manager uses to discount the cash flow. And if managers employ IRR(Internal rate of return), the estimate of the cost of capital serves as the bench mark with which the internal rate compared. An accurate estimate of the cost of capital would help the company evaluate and identify projects that will add value to firm. When it comes to performance assessment, we generally use EVA to measure whether the whole company is creating economic value. The formula is EVA= NOPAT- (WACC*Capital) where NOPAT stands for net operating profit after tax. EVA can gauge the firm’s economic profit generated in excess of required return. This figure is a proper reference for shareholders when they consider the firm’s financial performance and growth potential and make investment decision. In Mergers and Acquisition analysis, WACC is the discount rate in the NPV calculation, which indicates the appropriate bidding price and potential benefits of the merger. This method can be applied to the stock repurchase as well. The management would execute stock repurchase when they find the market price of their stock is lower than the stock price calculated using WACC and Discounted Cash Flow model.

In conclusion, the estimate of the cost of capital is widely utilized in various kinds of corporate analyses and has huge impact on management decision and relevant assessment.

Estimation Midland’s corporate cost of capital

Cost of Debt

In order to calculate Midland’s corporate WACC, firstly we should start with the cost of debt.

[pic 1]

Based on the case, consolidated spread to treasury equals to 1.62%, and 10-year U.S. Treasury bonds is 4.66%, making up corporate’s cost of debt of 6.28%. We use 10-year U.S Treasury bonds rate since we want to maintain a long-horizon perspective in calculating the cost of debt. The maturity of 1-year U.S Treasury bonds rate is too short, and the maturity of 30-year U.S. Treasury bonds is too long, so using 10-year U.S Treasury bonds rate is better in under this circumstance.

Cost of Equity

Later, we got the re by using the Capital Asset Pricing Model (CAPM).

[pic 2]

We take risk free rate based on the same 10-year Treasury bonds rate of 4.66% mentioned before, and Equity Market Risk Premium (EMRP) of 5%, which is provided by the case. In the past, Midland used higher EMRPs, which ranges from 6% to 6.5%. But now it used a 5% EMRP instead, adjusted the rate after a review of recent research and in consultation with its professional advisors. The result is convincing, since the research comes from professional advisors who have brooder information and knowledge of the industry. By analyzing the selected market risk premium survey results provided in the case. We calculate the average EMRP from different researchers and got the results showing in the following table. No matter the range of EMRP of simply average EMRP shows that 6% to 6.5% used in the past is higher than what it should be now. So Midland’s choice of 5% of EMRP is an appropriate choice.

Midland’s corporate beta is already informed in the case, which is 1.25. Therefore we can get the Cost of Equity  =4.66%+1.25*5%=10.91% (See table 1&2)[pic 3]

Also note that as same as the other large U.S producers, the overseas investments were the main engine of growth for Midland, therefore the foreign exchange risk and political and regulation risk, especially in emerging market would influence the risk exposure to Midland. Therefore, we must take the country risk premium (CRP) in to consideration when we estimate the cost of equity.  Country risk premium is the additional associated with investing in an overseas company rather than domestic country. When investing in overseas country, things such as volatile exchange rate, geopolitical factors, etc wary investors, thus requires a higher premium. Note that investing in emerging market requires a higher country risk premium than developed countries. Cost of equity considering country risk premium is calculated as following: