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Case Study Questions Midland Energy Resources, Inc: Cost of Capital

#10 The fact that 77.7% of Midlands earnings are generated abroad may put a question mark at the calculations done by Janet Mortensen. Why? How would you adjust the cost of capital calculated in Question 4 if we consider the overseas investment? Would it increase? Decrease? Or just stay the same? On what does your answer depend on?

#4

Janet Mortensen, senior vice president of project finance at Midland Energy Resources, is in the process of preparing her annual cost of capital estimates for Midland and each of its three divisions (oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals). These estimates are used in many analyses within Midland, including capital budgeting decisions, financial accounting, performance appraisals, M&A proposals, and stock repurchase decisions. There has been some disagreement in the past about specific inputs and assumptions used to arrive at the cost of capital estimate, so Mortensen needs to devote extra care in preparing the cost of capital estimates and justifying her assumptions.

Overview:

Company: Midland Energy Resources Inc

Vice President of Finance: Janet Mortensen

Objective: Preparing the annual cost of capital estimates for Midland and each of its three divisions

Divisions: Oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals.

Operations revenue: $248.5B

Operating income: $42.2B

Employees: more than 80,000

Initial Key Points:

o Divisions: January 2007, Global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals.

o Estimates of the cost of capital used for asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals and stock repurchase decisions.

o Estimates started in early 1980. However criticism of accuracy, assumptions and inputs.

o Mortensen trusted to take on estimate role since 2002.

o By 2007, she wondered if her calculations/estimates were actually appropriate for all applications and was considering appending a sort of "user's guide" to the 2007 set of calculations.

Divisions:

1) Exploration and Production (early stage of energy production, which includes searching and extracting oil and gas)

Most profitable business 2006

Extracted 2.10 million barrels of oil per day

Roughly 7.28 billion cubic feet of natural gas per day

Revenue of $22.4B

After tax earnings of $12.6B

Expected: Rising demand and economic growth for its products. Non-traditional sources expected to increase. Geographic composition of output shifting

Forecast: With oil prices at historic high, heavy investment in acquisitions of promising properties and expansion

Capital spending: Estimated to exceed $8B in 2007 and 2008

2) Refining and Marketing (production of heating, lubricating and fuel oils, as well as gasoline, diesel, jet fuel, propane, kerosene and other LPG products.

Company's largest division - belief in the company being technologically advanced and potential market leader

Margins declining steadily over the previous 20 years

Ownership interest in 40 refineries worldwide output of gas for automobiles

Distillation capacity of 5.0M barrels a day.

Global revenue in 2006: $203B

After tax earnings: $4B

Manufacturing capacity to produce approx. 120,000 barrels of base-stock lubricants per day.

Most of Midland refinery output was gasoline and sold as fuel for automobiles

Forecast: based on historic data and shrinking margins, company to remain stable without substantial growth in 2007-08.

Analyst estimate a global shortage of refining capacity eventually spurring investment in this segment

3) Petrochemicals

Smallest division

Owned and had equity interest in 25 manufacturing facilities and 5 research centers in 8 countries worldwide.

Revenue in 2006: $23.2B

After tax earnings: $2.1B

Forecast: Expected to grow in the near term as several older facilities were sold or retired and replaced by newer, more efficient capacity. New investments undertaken by joint ventures outside the US (Midlands Petrochemical Division owned a substantial minority interest.)

Midland's Financial and Investment Policies - 2007 Financial Strategy founded on 4 pillars

1) Overseas Growth:

Main source of growth for most large U.S. producers including Midland

Midland generally invest in foreign projects alongside foreign government or a local business as partner

In most cases, Midland acts as a lead developer of the project collecting a management fee or royalty.

Equity interest shared between Midland and foreign partner, with foreign partner generally receiving at least 50% plus a preferred return.

Despite investment located aboard, Midland converts foreign currency cash flows to dollars and applies US dollar discount rate.

In 2006, Midland had earnings from equity of approximately $4.75B

Majority of earnings, 77.7% came from non-US investments.

2) Value-creating Investments:

Midland uses discount cash flow method to evaluate prospective investments.

DCF involves debt free cash flow and a hurdle rate equal to or derived from the WACC for the project or division.

Performance of a business or division over a historical period was measured in two main ways:

o 1) Performance against plan over 1, 3, and 5 year periods

o 2) Based on economic value added (EVA) in which debt-free cash flows were reduced by a capital charge and expressed in dollars. Capital charge was computed as the WACC for the business or division times the amount of capital it employed ruing the period.

3) Optimal Capital Structure:

Optimizes its capital structure by exploiting the borrowing capacity inherent in its energy reserves and long-lived productive assets such as refining facilities.

Debt levels regularly reevaluated and long term targets set accordingly

Positive correlation between energy price level and Midland's stock prices

2007 oil prices and stock prices historic high which increased the company's borrowing capacity. Represented an opportunity to shield additional profits from taxes.

Each division as estimate target debt ratio (Table 1). Targets based on annual operating cash flow and collateral value of its identifiable assets.

Changes in market value of specific collateral affect debt ratios.

Company's debt rated A+ by Standard & Poor's.

Table 2 provides yields to maturity for US treasury bonds in January 2007

Debt capacity determinant of Midland's capital structure, however other considerations play a role such as the strength of the balance sheet and global financial and commodity markets

In comparison to competitors Midland was conservative - desire to manage certain risks

4) Stock Repurchases

Since 2002, Midland has not repurchases its own shares in large numbers, given the company's high stock price

But would consider repurchasing if an attractive opportunity arose and remained committed to repurchasing shares when they were undervalued..

Midland regularly estimates the intrinsic value of its shares by (fundamental value of the enterprise - market value of its debt)/results by the number of shares outstanding.

o Fundamental value of enterprise estimated by using DCF analyses and doing a "twin company comparison" of other peers

High stock prices does not indicate share not undervalued and intrinsic value had clearly risen

Estimated the Cost of Capital

Mortensen primary calculates based on the formula for WACC (with tax)

V = D+E, D = debt, E = equity, r_d = cost of debt, r_e = cost of equity

Cost of Debt

Cost of debt computed for each division by adding a premium or spread over US

Premium or spread dependent on several factors including Operations CF, Collateral Value of the Division's Assets and overall credit market conditions

Some of Operation Long Term expected CF and collateral value affect by political risk. Significant affect in E&P division.

Cost of Equity

CAPM used -

Betas are measured with errors, from regressions of individual stock returns on market returns.

Mortensen and team used betas published from public databases

Beta_Midland = 1.25 (procyclical)

Beta divisions based on "twin or comparable public companies" - Exhibit 5

In 2006: MRP = 5%, based on research and professional advisors

Previously: MRP = 6.0% to 6.5%

Exhibit 6 showcases historical stock returns and bond yields data