Weighted Average Cost of Capital and Midland Energy

decision maker Summary upcountry zip Resources, Inc. is a global energy bon ton with a broad array of products and services. The confederation operates within 3 divergent operations including oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. upcountry has proven to be a very economic participation, with inform operating revenue of $248. 5 billion and operating income of $42. 2 billion. The company has been in business for everywhere 120 familys and employed much than 80,000 individuals.Janet Mortensen, the senior vice pre emplacementnt of project finance for home(a) capability Resources, has been asked to calculate the burden average cost of capital (WACC) for the company as a whole, as well as each of its lead characters as part of an annual budgeting process. Midlands Three Divisions Exploration & fall Oil exploration and production (E&P) is Midlands most profitable business, and its net margin over the preliminary f ive years was among the highest in the industry.With oil prices at historic highs in early 2007, Midland anticipate heavy investment funds in acquisitions of promising properties, in development of its proven undeveloped reserves, and in expanding production. They overly regarded to account for competition from aras such(prenominal) as the Middle East, Central Asia, Russia, and West Africa. Refining and Marketing Midland had ownership interests in forty refineries about the world with distillation competency of five million barrels a day. Measured by revenue, this side of the business was Midlands largest. The relatively small margin was logical with a long- destination trend in the industry.Margins had declined steadily over the previous twenty years. Petrochemicals Petrochemicals is Midlands smallest but most promising and undervalued year. Midland owned twenty-five manu itemuring facilities and five research centers in eight countries around the world. Capital spending in petrochemicals was expected to grow in the skillful term. Midland capability end Analysis Managerial finance 1 In state to find the cost of capital for Midland Energy Resources and each of the three divisions within the company, we bequeath motive to use the formula or weighted average cost of capital (WACC) which is ( )( rd= Cost of debt re= Cost of right D= Market value of debt E= Market value of loveliness V= D+E= Value of the company (or division) T= tax revenue rate First, we can calculate rd for each division as it is outline in the subject by adding a premium/spread over US Treasury securities of a similar maturity. In other haggle ( The two tables in the case are as follows Table 1 Business Segment Consolidated E&P R&M Petrochemicals Credit Rating A+ A+ BBB AATable 2 Maturity 1-Year 10-Year 30-Year come in 4. 54% 4. 66% 4. 8% Debt/Value 42. 2% 46. 0% 31. 0% 40. 0% Spread to Treasury 1. 62% 1. 60% 1. 80% 1. 35% ) ) ( ) *For my calculation, I used the 30-year mat urity for E&P, R&M, and Midland as a whole as they take on longer term projects. I used the 1-year for petrochemicals as they tend to take on condensed term projects. Midland Energy Case Analysis Managerial Finance 2 computations are as follows rd for Exploration & employment rd for Refining & Marketing rd for Petrochemicals rd for Midland Second, we consider to calculate re for the three divisions as well as Midland as a whole.To find re, we will use the CAPM position adumbrate in the case ( ) In order to solve this equation, we need to find important for the three divisions. The case already outlines Midlands overall beta at 1. 25. However, the case does not state the beta for the three divisions. We can calculate this using beta for publicly traded companied outlined in the case. Using the following formula, as well as submit 5 in the case, we can calculate beta for the three divisions * ( ) ( )+ Midland Energy Case Analysis Managerial Finance 3 Exhibit 5(from case) Explor ation & Production Jackson Energy, Inc.Wide Plain Petroleum Corsicana Energy Corp Worthington Petroleum ordinary Refining & Marketing Bexar Energy, Inc. Kirk Corp. White Point Energy Petrarch Fuel service Arkana Petroleum Corp. Beaumont Energy, Inc. Dameron Fuel Services Average Midland Energy Resources loveliness Market Value 57,931 46,089 42,263 27,591 Net Debt 6,480 39,375 6,442 13,098 D/E 11. 20% 85. 40% 15. 20% 47. 50% 39. 80% fair play Beta 0. 89 1. 21 1. 11 1. 39 1. 15 LTM Revenue 18,512 17,827 14,505 12,820 LTM wage 4,981 8,495 4,467 3,506 60,356 15,567 9,204 2,460 18,363 32,662 48,796 6,200 3,017 1,925 -296 5,931 6,743 24,525 0. 30% 19. 40% 20. 90% 12. 00% 32. 30% 20. 60% 50. 30% 20. 30% 1. 7 0. 94 1. 78 0. 24 1. 25 1. 04 1. 42 1. 2 160,708 67,751 31,682 18,874 49,117 59,989 58,750 9,560 1,713 1,402 112 3,353 1,467 4,646 134,114 79,508 59. 30% 1. 25 251,003 18,888 Again the calculation to find Asset ? is * Equity ? for Midland= 1. 25 ( ) ( )+ Equity ? for E&P= 0. 93*1+ (1-39. 73%)*85. 19% =1. 41 Equity? for R&M= 1. 05*1+ (1-39. 73%)*44. 93% = 1. 33 *85. 19% and 44. 93% come from Exhibit 1 in the case In order to get Equity ? for Petrochemicals, we will need to take a weighted average of the three divisions.The equation would be as follows (w1, w2, w3 are based on the total assets of a division divided by Midlands total assets). To find this, we will use the numbers from Exhibit 3 in the case Midland Energy Case Analysis Managerial Finance 4 2004 E&P 76,866 R&M 60,688 Petro 19,943 Midland 157,497 2005 125,042 2006 140,100 Avg 114,002. 67 91,629 93,829 82,048. 67 28,000 28,450 25,464. 33 244,671 262,378 221,515. 33 Calculation for w1-3 W1= 114,002. 67/221,515. 33= 0. 51 W2= 82,048. 67/221525. 33= 0. 37 W3= 25,464. 33/221,515. 33= 0. 2 Now we can use the formula from forwards to find the ? for Petrochemicals Lastly, we need to find EMRP to find re for Midland and the three divisions. We can find our EMRP number by fashioning at manifest 6 in the c ase Period 1987-2006 1967-2006 1926-2006 1900-2006 1872-2006 1798-2006 Average excess proceeds US Equities T-Bonds 6. 4% 4. 8% 7. 1% 6. 8% 5. 9% 5. 1% Standard Error 3. 7% 2. 6% 2. 2% 1. 9% 1. 6% 1. 2% I will choose to use the average return from the time period of 1798-2006. That is the longest sample size in regards to time, as well as having the lowest standard of geological fault.I will round buck to 5% for ease of calculation Midland Energy Case Analysis Managerial Finance 5 ( re for Midland= 4. 98%+5%*1. 25= 11. 23% re for E&P= 4. 98%+5%*1. 41= 12. 03% re for R&M= 4. 98%+5%*1. 33= 11. 63% re for Petrochemicals= 4. 54%+5%*0. 32= 6. 14% ) With this information, we are able to in the end calculate the weighted average cost of capital (WACC) for Midland and the 3 divisions of the company. The formula and calculations are as follows ( )( ) ( ) *D/V are provided in Table 1 for Midland, E&P, R&M, and Petrochemicals. They are 42. 2%, 46. %, 31. 0%, 40. 0% respectively. WACC-cost of capital we need WACC for E&P ( =8. 32% WACC for R&M ( =9. 29% WACC for Petrochemicals ( =5. 10% WACC for Midland ( =9. 17% Midland Energy Case Analysis Managerial Finance 6 ) ) ) ) The cost of capital (as shown above) will take issue for the three divisions because the business operates in different industries. By being in different industries, the companies have different risk exposure and betas, while also having different credit ratings. All of these shares will affect a companys cost of capital differently.Further Analysis Mortensens estimates were used for some(prenominal) things including performance assessments, mergers and acquisition proposals, stock repurchases, asset appraisals, and financial accounting. As tell in the case, cost of capital is a very important component in WACC calculations. These calculations were being used to evaluate at a divisional level as well as at a bodily level as a whole. In my calculations for the case, I solved for two levels. In reg ards to Midlands corporate WACC, Mortensen computed the cost of debt for each division by adding a premium (or spread) over U.S. Treasury securities with an trance maturity depending on the division. For Exploration and Production (E&P), Refining and Marketing (R&M), as well as Midland as a corporation, Mortensen used a 30 year maturity TBond assumption as those divisions tended to focus on longer term projects. She decided on a 1 year T-Bond maturity assumption for Petrochemicals as they tended to focus on shorter term projects. some other assumption was that the tax rate (39. 73%) remained constant throughout the case as well as an EMRP of 5%.The EMRP was based on screening 6 of the case which examined TBonds during a certain period of time and with a certain standard of error. With a very low standard of error (based on the chart) and advisors, bankers, and investors covering the industry agreeing with 5% as an estimate, I study the estimate to be appropriate. Analysts on the industry, bankers, and investors tend to have a broader look on companies within an industry as a whole. Lastly, Midland should not use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions because each division is different.Midland is too large of a corporation, with different divisions, each containing its own unique set of risks. Due to the fact that the risk for each division will be different, I intend the corporate hurdle rates for those divisions should also be different to theorize a more accurate corporate assessment. I take Mortensen did a great job with the information she was presented with in the case and I believe Midland Energy will continue to be a cock-a-hoop company within the industry. Midland Energy Case Analysis Managerial Finance 7