cost of capital for midland energy resources inc

Midland Energy Resources, Inc.Capital Budgeting Within a Multi-Divisional Firm

Presenters in order:Ng WenyingNguyen Huong Duong (Tony)Sim Siang Huat (Ronald)Oon Zhi Xiang (Wayne)Ong Sheng Yuan (Gabriel)

WHO ARE WEJanet Mortensen (SVP of Project Finance) of Midland Energy Resources, Inc., Advisor to CFO

WHAT IS THE OBJECTIVE OF THIS CASERecommend WACC for Corporate & Divisions

ApproachStep 1: Understand operational characteristicsStep 2: Understand how WACC is usedStep 3: Compute Corporate WACCStep 4: Assess appropriateness of single hurdle rateStep 5: Compute division’s WACC

- E&P- R&M- Petrochemical

Midland Energy Resources, Inc.Year 2006: Op Rev: US$248.5B; Op Income: US$42.2B

Exploration & ProductionRev: US$22.4B | Income: US$12.6B

- Extracting Oil & Natural Gas- Most profitable business- Net margin highest amongst industry- Production has been increasing- Trends:

• Rising global demand • Demand for non-traditional

sources also increasing• Oil price at historical high

prompting more investment Higher capital spending

Refining & MarketingRev: US$203B | Income: US$4.0B

- Owns 40 refineries & distills oil- Business with largest Revenue- Revenue decreasing slightly- Margins are low- But still a Market leader due to tech

advancement & vertical integration- Trends:

- Stiffer competition Declining margins

- Difficult to obtain approvals little investment opportunities (low capital spending)

- In longer term, global shortage in refining capacity

PetrochemicalRev: US$23.2B | Income: US$2.1B

- Produces chemical products- Smallest division- Trends:

- Facilities are old Requires capital spending on replacement

- Most investment will be outside US in the form of JV

Step 1: Understand operational characteristics

It is used in Asset appraisal, Capital budgeting, Performance assessment, M&A and Stock repurchasing decision making.

Step 2: Understand how WACC is used

Step 3: Compute Corporate WACC

1 2

Weighted cost of debt

Step 3: Compute Corporate WACC

1

2 Weighted cost of equity

= weighted cost of debt + weighted cost of equity= 1.59% + 6.306% = 7.896 %

WACC

1. Single Corporate Hurdle Rate

2. Multiple Risk-adjusted discount rates

3. Specific Discount rates for individual projects

Which is the road most used

by firms?

Step 4: Assess appropriateness of Single hurdle rateEvaluating Investment Opportunities

Pure Hurdle

rate system

Pure Budget System

Full Information

System (Midland)

Step 4: Assess appropriateness of Single hurdle rateAllocating Capital Among a Firm’s Divisions: Hurdle rates versus budgets

• Survey questionnaires, 211 CEOs, 266 firms listed in SGX.• Exclude companies not registered in Singapore• Exclude companies registered in Singapore, head offices

overseas.• To improve response rate, 2 mailings were done at different

timings.

Step 4: Assess appropriateness of Single hurdle rateCapital Budgeting Practices in Singapore- Singapore Management Review (2011)

• 4 Construction firms (7.4%)• 4 Hotels (7.4%)• 16 Manufacturing (29.6%)• 3 Property (5.6%)• 3 Retail/ wholesale (5.5%)• 1 Finance (1.9%)• 23 firms in other or multiple lines of business (42.6%)

54 Survey Responses



Extract:

Step 4: Assess appropriateness of Single hurdle rateThe Engineering Economist Volume 48 No.4- “Divisional Cost of Capital: A Study of its Use by Major US Firms” by Stanley Block

Business Horizons 2001“The Trouble with Divisional Hurdle Rates” by Thode, Stephen F.

“All operating risk factors may be unique to each division so that the conglomerate firm may be viewed as a portfolio of

individual divisions. Each division contributes to the overall business risk of the firm in the same way that individual

securities contribute to the systematic risk of a portfolio of securities.”

Step 4: Assess appropriateness of Single hurdle rate

Financing decisions for resources allocation among divisions

Single corporate hurdle rate.

Specific Discount rates for

Individual Projects

Multiple Risk-adjusted Discount

Rates

Single Corporate

Hurdle Rate

Investment decisions1) Multiple risk-adjusted discount rates 2) Specific discount rates for individual projects

Large projects, new products

Central Investment Committee or Board of directors.

Step 4: Assess appropriateness of Single hurdle rateRecommendation for Midland

Compute separate cost of capital

WACC =Rd(D/V)(1-t) + Re(E/V)

Step 5: Compute Divisions’ WACC1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

Exploration & Production

Marketing & Refining

Spread to Treasury 1.6% 1.8% Debt / Value (Table 1) 46% 31%

Equity / Value 54% 69% 10 year yield for Treasury Bonds

4.66% 4.66%

Tax rate calculated from Step 2

40% 40%

Equity Beta (exhibit 5) 1.15 1.2 EMRP 5% 5%


1 For Exploration & Production

Cost of debt, Rd(D/V)(1-t) = (Spread + Yield for Treasury Bonds) *(D/V) *(1-t) = (1.6%+4.66%) * 46% * (1-40%) =1.73%

Cost of equity, Re(E/V) = {Rf+β(EMRP)} * (E/V) = (4.66% + 1.15 * 5%) * 54%= 5.62%

Cost for E&P = 1.73% + 5.62% = 7.35%

For Refining & Marketing

Cost of debt, Rd(D/V)(1-t) = (Spread + Yield for Treasury Bonds) *(D/V) *(1-t) = (1.8%+4.66%) * 31% * (1-40%) = 1.20%

Cost of equity, Re(E/V) = {Rf+β(EMRP)} * (E/V) = (4.66% + 1.2 * 5%) * 69%= 7.36%

Cost for R&M = 1.20% + 7.36% = 8.56%

Step 5: Compute Divisions’ WACC

2

1. Exploration & Production (E&P) 2. Refining & Marketing (R&M) 3. Petrochemical

Why are cost of capital for Exploration & Production and Refining & Marketing Divisions different?

• Debt/Value: Exploration & Production has higher debt/value ratio (46% compared to 31% for Refining & Marketing). Possibly, because Exploration & Production has higher margin than Refining & Marketing. Hence, financial communities are more willing to lend money.

• Rd: Spread over treasury is higher for Refining & Marketing than Exploration & Production. Reason is because Refining & Marketing has a lower credit rating (BBB) compared to Exploration & Production (A+)


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

where rd = cost of debt

re = cost of equity

D = Market value of debtE = Market value of equityV = Total assets of the company or division = D + Et = tax rate


Cost of debt, rd

= risk- free rate, rf + spread to Treasury for the

Petrochemicals Division

Since we are provided the 1 Year, 10 Year and 30 Year yields to maturity for US Treasury bonds, which one would be the most appropriate risk-free rate?


rd

In determining the most appropriate risk-free rate to be used for the Petrochemicals Division, we will need to consider the useful life of the assets replaced during the asset replacement process.

• The Petrochemicals Division is primarily involved in manufacturing and research activities, where the assets involved have an medium-term useful life (Average 10 years)

• They are also involved in capital spending projects such as replacement of facilities which generate cash flows over a long period

• Therefore, the 10-year rate shall be used.


rf

Cost of debt, rd

= risk- free rate, rf + spread to Treasury for the Petrochemicals

= 4.66% (10-Year Treasury bond) + 1.35%= 6.01%


rd

Cost of equity, re

= risk- free rate, rf (10-Year Treasury bond) + β(EMRP)

Where β= equity beta for the Petrochemicals Division EMRP = equity market risk premium

The key to calculating the cost of equity, re is to evaluate the equity beta of the Petrochemicals Division.


re

In order to evaluate the equity beta of the Petrochemicals Division, we need to:

• Obtain the unlevered beta of Midland Energy and the other 2 divisions, the E&P Division and the R&M division.

• The unlevered beta of Midland Energy Resources is the weighted average of the unlevered beta of the three divisions

Unlevered βMidland

= w1(Unlevered βE&P) + w2(Unlevered βR&M) + w3(Unlevered βPetrochemicals)

where w1= E&P earnings/ Total earnings

w2= R&M earnings/ Total earnings

w3= Petrochemicals earnings / Total earnings


β

We need to use unlevered beta for the following reasons:

• All the Divisions have never been publicly traded before, thus we need the unlevered beta of these divisions to estimate the equity beta of the Petrochemicals Division

• This will mean using the pure play method, which involves determining the average unlevered beta of many similar companies in the same industry to use as a reference. This has been done in the case study for the E&Pindustry and the R&Mindustry.


β

• Furthermore, as we are calculating the cost of equity, re, using unlevered beta allows us to remove the impact of debt on the beta.

• Lastly, once we obtain the unlevered beta of the Petrochemicals Division, we will re-lever the beta to add back the financial risk as we have been provided with the debt-equity ratio of the Petrochemicals Division in the case study.


β

• Obtain unlevered beta of Midland Energy, E & P Division and R & M

Division using Hamada’s Equation.

• Calculate the weightage of the divisions, using total earnings of each division as a ratio of Midland Energy’s total earnings.

• Once the unlevered beta of the Petrochemicals Division has been obtained, re-lever it using the debt equity ratio of the Petrochemicals Division


β

Cost of equity, re , for the Petrochemicals Division

= rf + β(EMRP)

= 4.66% + 0.840 (5%) = 8.86%


β Equity βPetrochemicals = 0.6 *[1 + (1-0.4)* 0.667] = 0.840

re

WACCPetrochemicals

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

= 6.01% (0.4)(1-0.4) + 8.86% (0.6) = 6.76%


cost of capital for midland energy resources inc

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