Midland Energy Resources is a fairly successful global energy company which had been incorporated more than 120 years previously and in 2007 had more than 80,000 employees. It has three main operations, oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. E&P is the most profitable segment of Midland and its net margin over the previous five years was among the highest in the industry. Its largest division is R&M with the Petrochemical division being the smallest. The capital spending in R&M would remain stable and in petrochemicals was expected to grow. The four primary goals of Midland’s financial strategy are to fund substantial overseas growth, invest in value-creating projects, optimize its capital structure, and repurchase undervalued shares. Janet Mortensen, the senior vice president of project finance for Midland Energy Resources, has been involved in estimating the cost of capital of the company. She calculated the weighted average cost of capital (WACC) for the company as a whole, as well as each of its three divisions. The estimates are used for asset appraisals for capital budgeting and financial accounting, performance assessments; merger and acquisition proposals and stock repurchase decisions. Financial Analysis
Cost of Capital: By definition, cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk1. For companies which use a combination of debt and equity to finance their businesses, their overall cost of capital is derived from a weighted average of all capital sources, also known as the weighted average cost of capital (WACC).
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?In recent years, the range of accounting application is expanding rapidly, along with the increasing demand of economic market. As is well known, accounting is a key aspect of business. And in the accounting profession, there has been already existed interpenetration and overlapping among the different kinds of accounting. Cost accounting and financial accounting are two main components of ...
What we use “Cost of Capital” to evaluate? Cost of capital is an important component of business valuation work. Midland uses the cost of capital to evaluate value of the company and most prospective investments. For example, the fundamental value of the enterprise was estimated using DCF analysis with cost of capital as discount rate; the cost of capital rate is also used in determining whether the performance of a business or division is value creating. WACC: The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets2. How are Mortensen’s estimates used at Midland?
Mortensen’s estimates were used for many things including performance assessments, mergers and acquisition proposals, stock repurchases, asset appraisals, and financial accounting. To estimate cost of debt, Mortensen computed it for each division by adding a premium (or “spread”) over U.S. Treasury securities with an appropriate maturity depending on the division. To estimate cost of equity, Mortensen used CAPM model. She used published beta for corporate and comparable companies’ published betas for the divisions. CAPM: The capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, given non-diversifiable risk. The model takes into account the asset’s sensitivity to non-diversifiable, represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset3. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. Midland’s Corporate WACC
Cost of Debt: From Table 2, we will see the yields to maturity for U.S treasury bonds in January 2007. The 10-year risk-free rate seems more appropriate because Midland’s borrowing capacity is based primarily on its energy reserves and long-lived assets. So the short term 1 year rate would be too low. Based on the potential changes in oil reserves and production business, the 30 year maturity might be too long to compare Midland’s debt with. From Table 1, we will see the spread to treasury for the firm is 1.62%. Rd=4.66%+1.62%=6.28%
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Executive Summary of Pepsico Through my research of Pepsico, I have calculated the cost of capital. Afirm's cost of capital is imperative because it represents the funds used to finance the firm's assets and operations. First you have to estimate the cost of capital in order to minimize it. In estimating the cost of capital, you first have to find the cost of each capital component and then ...
Cost of Equity: Here we can calculate the cost of equity using the CAPM model. Mortensen and her team used betas published in commercially available databased, according to Exhibit 5, equity beta for Midland is 1.25. In 2006 Midland used an equity market risk premium of 5.0%, which is adopted after a review of recent research and in consultation with its professional advisors. Risk free rate here would be same as what we used in calculating cost of debt, which is the 10 year U.S Treasury bond yield. Re=Rf+Beta*(EMRP)=4.66%+1.25*(5%)=10.91%
From Exhibit 5, D/E ratio for Midland is 59.3%. So we can calculate that E/V =100/159.3=62.77%, D/V=59.3/159.3=37.23% WACC=Rd*(D/V)*(1-T)+Re*(E/V)=6.28%*37.23%*(1-40%)+10.91%*62.77%=8.25% Comment: Midland used 5% EMRP is mainly based suggestions from professional advisors and industry research; they think the company at that moment should have lower risk than before. From Exhibit 4, we can see that the stock price has been increasing steadily from 2001 to 2006; in 2007 both oil prices and Midland’s stock price were at historic highs. I think this indicate that investors are looking for excess returns which should be represent by higher risk premium. Also, an average of the historical data would produce an EMRP closer to 6%. This data is less influenced by individual opinions and views, so I think this would be more accurate.
WACC for Divisions
Should Midland compute different WACC for each division? The WACC differ between different divisions because the betas of each division vary and the target capital structure is different for each division. I think it is advantageous to compute different WACC for each division. Here are the reasons: 1. Midland is a very large enterprise which has three operation divisions with different capital structure. For example, each of Midland’s divisions had its own target debt ratio. Targets were set based on considerations involving each division’s annual operating cash flow and the collateral value of its assets. From Table 1, we can see that the debt rating for each division is different. E&P has the lowest cost of debt while R&M has the highest.
The Essay on Midland Energy Resources Cost of Capital
Midland Energy Resources, Inc. is a global energy company with its operations in three divisions – Oil and gas exploration, Refining and Marketing and Petrochemicals. The company has been there for 120 years and in 2007 had more than 80,000 employees. It has been a very profitable company with reported operating revenue of $248. 5 billion and operating income of $42. 2 billion in 2006. The primary ...
2. The earning trend is different for each division. For example, the E&P business is Midland’s most profitable division, and its newt margin over the previous five years was among the highest in the industry. The revenue from this division increased steadily from 2004 to 2006, from 15,931 million to 22,357 million. And Midland expected continued growth due to rising demand. While the R&M business, although the largest business of Midland faced a slight decrease of about 1.8% from 2005 to 2006. While the capital expenditure is keep increasing from 2004 to 2006 (Exhibit 3), shrinking margin is expected. This is because the division faced stiff competition and we already knew the margins had declined steadily over the previous 20 years.
3. Risk premiums for these three divisions are different. Due to different business nature discussed above, investors are seeking more returns for division which is more risky. From Exhibit 5, Mortensen selected comparable companies to derive the beta. We can see that the average beta for E&P is 1.15 and for R&M is 1.20. This is reasonable because E&P is more profitable and has steady growth rate compare to R&M. How can we get asset betas for divisions? Since the divisions did not have traded shares of stock, betas for Midland divisions were not observable. According to Mortensen, she relied on published betas for publicly traded companies she deemed comparable to each division’s business. So the method is to look for the list of comparable public companies, and to take arithmetic average of the betas. How should comps be selected? Comparable companies will usually share the similar industry, business, and financial characteristics with the target4. For E&P division, we will need to find companies engaging in exploration, development and production. Those companies should have good profit margin and about 40% to 50% debt ratio. For R&M division, we will need to find companies doing refining and distilling, mainly competitors of Midland.
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WACC for the Petrochemicals Division
Beta: Since the beta is not provided on Exhibit 5, this is possible that this is a new and growing industry and there are too few public comparative companies in this field. And Midland’s corporate beta is 1.25 while the other two divisions has beta as 1.15 and 1.20, we can see that petrochemicals division has the highest risk among all. Assumption: Midland’s corporate beta is the weighted average of beta of each division.
Conclusion
Midland Energy Resource as a large global energy company must make sure they are using proper financial strategies to accomplish its goals of maximizing shareholders’ value. So they will need to invest in more oversea projects to expand the business, invest in more value creating projects, exploit the borrowing capacity and repurchase the stocks if they find the stock is undervalued. In order to achieve those goals, a good financial analysis is needed, especially evaluation of cost of capital. We can see that computing different cost of capitals for different divisions would yield different results from computing cost of capital as a whole corporation. So when we are deciding on the discount rate of cash flows, we need to decide whether we would like to use the division one or the corporate one. Among the three divisions of Midland, Exploration& Production is the most profitable and the least risky, refining and marketing is the division that has the most severe competition and is the largest, and petrochemicals division is the newest and smallest, it is also the most risky one with the highest WACC.
References
1: http://www.investinganswers.com/financial-dictionary/stock-valuation/cost-cap
ital-112 Investing Answers 2: http://en.wikipedia.org/wiki/Weighted_average_cost_of_capital Wikipedia 3: http://en.wikipedia.org/wiki/Capital_asset_pricing_model Wikipedia 4: https://www.macabacus.com/valuation/comparable-companies
