FM

Midland Energy Resources Inc.

Cost of Capital

Rishabh Mulani – 365Nikhil Nair- 366

Akshat Parashari – 367Suparna Rao – 210Saumya Goel – 208Pranay Jain – 209

Rishabh Golcha – 309Rushabh Gala - 308

Midland Energy Resources

• A global energy company which operated in:

i. Exploration and production (E&P),

ii. Refining and marketing (R&M), and

iii. Petrochemicals

Midland Energy Resources

• Used cost of capital for:

• Capital Budgeting

• Financial Accounting

• Performance Assessments

• M&A Proposals

• Stock Repurchase decisions

• Cost of capital prepared by- Janet Mortensen

The 3 divisions

• Exploration & Production (E&P)

• Refining & Marketing (R&M)

• Petrochemicals

Division 1: Exploration & Production

• Production segment dominated E&P’s results

• Most profitable business for Midland

• Midland was one of the highest margin gainers in the industry for this segment

• Revenue Generated: $22.3 Billion

• After-Tax earnings: $12 BIllion

• Forecasted capital spending: Expected to exceed $8 Billion

Oil Natrual Gas

• 2.1 million barrels per day• 6.3% increase over 2005

• 7.28 billion cubic feet per day• Nearly 1% increase over 2005

Division 2: Refining & Marketing

• Ownership of 40 refineries worldwide

• Distilled 5 million barrels a day

• This was the company’s largest business

• Severe competition due to commoditization

• Midland was the market leader

• Revenue generated: $203 Billion

• After Tax earnings: 4 billion

• Forecasted Capital Spending: Expected to remain stable in 2007-08. Greater expenditure anticipated in long term.

Division 3: Petrochemicals

• Smallest division in Midland

• Had ownership & equity in 25 manufacturing facilities & 5 research centers

• Revenue Generated: $23 Billion

• After-Tax Earnings: $2 Billlion

• Forecasted capital expenditure: Expected to grow in the short term

The 4 pillars of Midland

• To fund significant overseas growth

• To invest in value-creating projects across all divisions

• To invest in value-creating projects across all divisions

• To opportunistically repurchase undervalued shares

1st Pillar: Overseas Growth

• “Overseas investments were the main engine of growth for most large U.S. producers, & Midland was no exception”

• Midland acted as lead developer of projects

• Earnings from equity affiliates: $4.75 Billion

• 77% of these earnings came from overseas investments

2nd Pillar: Value creating investments

• To calculate the most prospective investment, Midland used discounted cash flow.

• How did Midland measure the performance of a business division? Two ways:• Performance against plan (over 1, 3, & 5-year periods)

• Economic Value Added (EVA)

3rd Pillar: Optimize capital structure

• Midland optimized its capital structure mainly by exploiting the borrowing capacity for its energy reserves & long-term productive assets like refining facilities.

• Debt ratings for each division had been established by Mortensen

• Also, a corresponding spread over treasury bonds was also established to estimate divisional & corporate costs of debt.

• Rated A+ by Standard & Poor

4th Pillar: Stock Repurchases

• Had been known for repurchasing its own undervalued shares

• Repurchase could be done by• Purchasing a small number of shares from the

open market• Purchasing large blocks of shares via self-tenders

• Had a high share price since 2002, hence no large share repurchases

• Intrinsic value of the shares had risen as well

Estimation of the Cost of Capital

• Used WACC

WACC = rd(D/V) (1-t) + re(E/V)

• Where

D=Market Value of Debt

E=Market Value of Equity

V=Firm’s or division’s Enterprise value (V=D+E)

rd=Cost of Debt

re=Cost of Equity

Estimating the cost of Debt

• The cost of Debt was computed by adding a premium, or

spread over U.S. Treasury securities of similar maturity.

• This spread depended on a variety of factors:

• Division’s cash flow from operations

• Collateral value of division’s assets

• Overall credit market conditions

• Some properties supported lesser borrowing than others

Estimating the cost of Equity

• CAPM (Capital Asset Pricing Model) was used:

re=rf + (EMRP)β

• Mortensen was dependent on the Betas published for publicly traded companies, which she felt were comparable to each division’s business.

• The risk premium adopted (after review & consultation) was 5%.

COST OF CAPITAL

Cost Of Capital

• Required rate of return on invested funds.

• It is also referred to as a “hurdle” rate

• Any investment which does not cover the firm’s cost

of funds will reduce shareholder wealth

• Referred to as the firm’s Weighted Average Cost of

Capital, or WACC.

Importance Of Cost Of Capital

Designing the optimal Capital structure

Assisting in investment decisions

Helpful in evaluation of expansion projects

Helps in evaluating the financial performance of top management

Helps in formulating Dividend policy and Working capital policy

It is the firm’s required rate of return which will just satisfy all capital providers

Components Of Cost Of CapitalCOST OF CAPITAL

COST OF DEBT

Bank Loans

Commercial Papers

Debentures

COST OF PREFERENCE

COST OF EQUITY

Issue of additional shares

Retention earnings

Cost Of Debts

The cost of debt is the rate of return the firm’s lenders demand when they loan money to the firm.

Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity

After tax= Before tax ( 1- tax rate)

Cost Of Preferred Equity

The cost of preferred equity is the rate of return

investors require of the firm when they purchase its

preferred stock.

The cost is not adjusted for taxes since dividends are

paid to preferred stockholders out of after-tax

income.

Cost Of Equity

The cost of common equity is the rate of return investors expect to receive from investing in firm’s stock.

This return comes in the form of cash distributions of dividends and cash proceeds from the sale of the stock.

Cost of common equity is harder to estimate since common stockholders do not have a contractually defined return similar to the interest on bonds or dividends on preferred stock.

WACC• WACC incorporates the required rates of return of the firm’s lenders

and investors and the particular mix of financing sources that the firm uses.

• Multiply specific cost of each source of financing by its proportion in capital structure and add weighted values

• WACC=wErE+wprp+wDrD(1-tc)

WACC=weighted average cost of capital

wE=proportion of equity

rE=cost of equity

wp=proportion of preference

rp=cost of preference

wD=proportion of debt rD=cost of debt

tc=corporate tax rate

Determining Proportions

• Proportions=target capital structure weights stated in market value terms

• Ideally, the weights should be based on observed market values. However, not all market values may be readily available. Hence, we generally use book values for debt and market values for equity

Book-value Weights

• One potential source of these weights is the firm’s balance sheet, since it lists the total amount of long-term debt, preferred equity, and common equity

• We can calculate the weights by simply determining the proportion that each source of capital is of the total capital

Market-value Weights

• The problem with book-value weights is that the

book values are historical, not current, values

• The market recalculates the values of each type of

capital on a continuous basis. Therefore, market

values are more appropriate

Capital Structure

• Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity.

• At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity.

• This is because adding debt increases the default risk - and thus the interest rate that the company must pay in order to borrow money.

• Management must identify the "optimal mix" of financing – the capital structure where the cost of capital is minimized so that the firm's value can be maximized.

Question 1.)

How are Mortensen's estimates of Midland's cost of

capital used?

Answer• Mortensen’s Estimates are used for;• Asset appraisal for Capital Budgeting and Financial Accounting

• Performance Assessment

• M&A Proposals

• Stock Repurchase Decisions

• At Division or business Level as well as Corporate Level

How, if at all, should these anticipated uses affect the calculations?

Question 2.)

• For a project with the same average risk as all company projects, no effect to the cost of capital calculations.

• If the projects are of greater or less risk, the calculations of WACC may be affected.

• EXAMPLE :

For a riskier merger & acquisition proposal, the company may need to adjust the cost of capital by including a higher risk premium.

Conversely, in appraisals for certain long-lived assets, the numbers contributing to the cost of capital should be adjusted accordingly since the risk is very low.

• When used at the divisional rather than corporate level,

Special consideration should be given to the fact that Midland’s divisions do not have individual Beta figures.

• Mortensen collected beta estimates from several businesses with operations similar to those of Midland’s divisions and used the average to derive a beta estimate for Midlands’s divisions.

QUESTION

Compute a separate cost of capital for Exploration & Production division and Marketing & Refining and Petrochemicals divisions. What causes them to differ from one another?

EXPLORATION AND PRODUCTION DIVISION

• Given data :

• = 1.15β

• EMRP = 5%

• Tax rate, t = 39%

• D/E ratio = 39.8%

• Maturity = Long term of 30 years

• Rf = 4.98%

• Calculation of cost of equity -

• Re = Rf + * EMRPβ

• = 4.98 + 1.15*5

• = 10.73%

• Calculation of Enterprise Value -

• We know that D/E ratio for E&P department to be 39.8%

• let the equity, E be 100 units and hence D is 39.8 units.

• V = E + D = 139.8 units

• Calculation of Cost of debt -

• To find Rd we use the interest rate that we currently pay for new loans.

• Spread to treasury for E&P division = 1.60%

• Rd = Rf + Spread to treasury

• Rd = 4.98 + 1.60

• = 6.58 %

Calculation of Cost of Capital

=

Marketing & RefiningDivision

• Given data :

• = 1.20β

• EMRP = 5%


• D/E ratio = 20.3 %


• Rf = 4.98%



• = 4.98 + 1.20*5

• = 10.98 %




• V = E + D = 120.3 units





• Rd = 4.98 + 1.80

• = 6.78 %


=

PetrochemicalDivision

• Given data :

• Corporate =Average (E&P , R&M , Petrochemical ) β β β β

• 1.25=Average(1.15, 1.20, Petrochemical )β

• Petrochemical = 1.40β

• EMRP = 5%


• D/E ratio = 20.3 %


• Rf = 4.98%



• = 4.98 + 1.40*5

• = 11.98 %

• Calculation of Petrochemical D/E -

• Corporate D/E=Average (E&P D/E , R&M D/E , Petrochemical D/E)

• 59.3=Average(39.8, 20.3, Petrochemical D/E)

• Petrochemical D/E=117.8%




• V = E + D = 217.8 units





• Rd = 4.98 + 1.35

• = 6.33 %


• WACC

= 6.33*(1 - 0.39) 117.8 + 11.98 * 100

217.8 217.8

• WACC = 7.588 %

DIFFERENCE IN COSTS OF CAPITAL

They differ from each other because –• The business units operate on different industries.

• Case clearly states that the risk was most apparent in the E&P division as the productive assets and proven reserves were located in politically volatile countries.

• They have different values of systematic risks, .β

• The E&P and R&M divisions have different credit ratings, A+ and BBB respectively.

FM

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