Think of yourself as a consultant working for Midland Energy. This is the summary you send to the Board of Directors. Within the brief introductory paragraph answer the question in the introduction of your summary. The rest of the paper is your logic and evidence to support your conclusion. Brevity is always important in business. Make sure the Excel file is labelled for data to be easily found. You would not want your client to struggle to find where items are in the Excel file. The below questions will help to derive your answer and should be integrated into your discussion. To guide your analyses, you may want to answer the following questions within your report: 1. How are Mortensen's estimates of Midland's cost of capital used? How, if at all, should these anticipated uses affect the calculations? 2. Calculate Midland's corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations. Is Midland's choice of EMRP (Equity Market Risk Premium) appropriate? If not, what recommendations would you make and why? 3. Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why or why not? 4. Compute a separate cost of capital for the E&P and Marketing & Refining divisions. What causes them to differ from one another? 5. How would you compute a cost of capital for the Petrochemical division?

Midland Energy Resources, Inc.: Cost of Capital In late January 2007, Janet Mortensen, senior vice president of project finance for Midland Energy Resources, was preparing her annual cost of capital estimates for Midland and each of its three divisions. Midland was a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. On a consolidated basis, the firm had 2006 operating revenue and operating income of $248.5 billion and $42.2 billion, respectively. Estimates of the cost of capital were used in many analyses within Midland, including asset appraisals for both capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions. Some of these analyses were performed at the division or business unit level, while others were executed at the corporate level. Midland's corporate treasury staff had begun preparing annual cost of capital estimates for the corporation and each division in the early 1980s. The estimates produced by treasury were often criticized, and Midland's division presidents and controllers sometimes challenged specific assumptions and inputs. In 2002, Mortensen, then a senior analyst reporting to the CFO, was asked to estimate Midland's cost of capital in connection with a large proposed share repurchase. Six months later she was asked to calculate corporate and divisional costs of capital that the executive and compensation committees of the board could incorporate in planned performance evaluations. Since then, Mortensen had undertaken a similar exercise each year and her estimates had become widely circulated de facto standards in many analyses throughout the company, even ones in which they were not formally required. By 2007 Mortensen was aware that her calculations had become influential and she devoted ever more time and care to their preparation. Lately she wondered whether they were actually appropriate for all applications and she was considering appending a sort of "user's guide" to the 2007 set of calculations.Midland's Operations Petrochemicals Midland Energy Resources had been incorporated more than 120 years previously and in 2007 Petrochemicals was Midland's smallest division, but was a substantial business nonetheless. had more than 80,000 employees. Exhibits 1 and 2 present Midland's most recent consolidated Midland owned outright or had equity interests in 25 manufacturing facilities and five research financial statements. Exhibit 3 presents selected business segment data for the period 2004-06. centers in eight countries around the world. The company's chemical products included polyethylene, polypropylene, styrene and polystyrene as well as olefins, 1-hexene, aromatics, and Exploration & Production fuel and lubricant additives. In 2006, revenue and after-tax earnings were $23.2 billion and $2.1 billion, respectively. Midland engaged in all phases of exploration, development, and production, though the last of these, production, dominated the E&P division's reported operating results. During 2006, Midland Capital spending in petrochemicals was expected to grow in the near-term as several older extracted approximately 2.10 million barrels of oil per day-a 6.3% increase over 2005 production- facilities were sold or retired and replaced by newer, more efficient capacity. Much of the new and roughly 7.28 billion cubic feet of natural gas per day-an increase of slightly less than 1% over investment would be undertaken by joint ventures outside the United States in which Midland's 2005. This represented $22.4 billion of revenue and after-tax earnings of $12.6 billion. E&P was Petrochemicals Division owned a substantial minority interest. Midland's most profitable business, and its net margin over the previous five years was among the highest in the industry. Midland's Financial and Investment Policies Midland expected continued global population and economic growth to result in rising demand for its products for the foreseeable future. Nevertheless, the fraction of production coming from non- Midland's financial strategy in 2007 was founded on four pillars: (1) to fund significant overseas traditional sources such as deepwater drilling, heavy oil recovery, liquefied natural gas (LNG), and growth; (2) to invest in value-creating projects across all divisions; (3) to optimize its capital structure; arctic technology was expected to increase. Further, the geographic composition of output was and (4) to opportunistically repurchase undervalued shares. shifting, marked by increases from places such as the Middle East, Central Asia, Russia, and West Africa. Overseas Growth With oil prices at historic highs in early 2007, Midland anticipated continued heavy investment in The most easily exploited domestic resources had been put into production decades previously. acquisitions of promising properties, in development of its proved undeveloped reserves, and in Consequently, overseas investments were the main engine of growth for most large U.S. producers, expanding production. In particular, continued high prices underlay plans to boost investment in and Midland was no exception. Midland usually invested in foreign projects alongside either a sophisticated extraction methods that extended the lives of older fields and marginal properties. foreign government or a local business as partner. Often, these investments had specialized financial Capital spending in E&P was expected to exceed $8 billion in 2007 and 2008. and contractual arrangements similar in many respects to project financing. In most cases, Midland acted as the lead developer of the project, for which it collected a management fee or royalty. Refining and Marketing Midland and its foreign partner shared the equity interest, with the foreign partner generally receiving at least 50% plus a preferred return. Despite the fact that the investments were located Midland had ownership interests in 40 refineries around the world with distillation capacity of 5.0 abroad, Midland analyzed and evaluated them in U.S. dollars by converting foreign currency cash million barrels a day. Measured by revenue, Midland's refining and marketing business was the flows to dollars and applying U.S. dollar discount rates. In 2006, Midland had earnings from equity company's largest. Global revenue for 2006 was $203.0 billion-a slight decrease of approximately affiliates of approximately $4.75 billion. The majority of these earnings, 77.7%, came from non-US 1.8% over 2005. The division faced stiff competition, as its products were highly commoditized. investments. After-tax earnings for refining and marketing totaled only $4.0 billion. The relatively small margin was consistent with a long-term trend in the industry; margins had declined steadily over the Value-creating Investments previous 20 years. Midland used discounted cash flow methodologies to evaluate most prospective investments. Though most of Midland's refinery output was gasoline and was sold as fuel for automobiles, the Midland's DCF methods typically involved debt-free cash flows and a hurdle rate equal to or derived company also had manufacturing capacity to produce approximately 120,000 barrels of base-stock from the WACC for the project or division. However, Midland's interests in some overseas projects lubricants per day. Midland believed its capacity was as technologically advanced as any in the were instead analyzed as streams of future equity cash flows and discounted at a rate based on the industry. Advanced technology and vertical integration combined to make Midland a market leader cost of equity. in this business. The performance of a business or division over a given historical period was measured in two Midland projected capital spending in refining and marketing would remain stable, without main ways. The first was performance against plan over 1- , 3-, and 5-year periods. The second was substantial growth in 2007-08. This reflected both the historical trends of low and shrinking margins based on "economic value added" (EVA), in which debt-free cash flows were reduced by a capital and the difficulty of obtaining the myriad approvals necessary to expand or to build and operate a new refinery. However, most analysts projected a longer-term global shortage of refining capacity that would eventually spur investment in this segment. For purposes of EVA calculations, the company defined debt-free cash flows as net operating profit after taxes (NOPAT), which is EBIT(1-t).charge, and expressed in dollars." The capital charge was computed as the WACC for the business or Midland's consolidated balance sheet and its access to global financial and commodity markets division times the amount of capital it employed during the period. sometimes presented attractive opportunities to trade securities and commodities. Midland was conservative compared to some of its large competitors, but it did have a group of traders in-house Optimal Capital Structure who actively managed currency, interest rate, and commodity risks within a set of guidelines approved by the board. The desire to manage certain risks, or to take advantage of private Midland optimized its capital structure in large part by prudently exploiting the borrowing information or unusual pricing relationships, was an additional reason that the actual capital capacity inherent in its energy reserves and in long-lived productive assets such as refining facilities. structure sometimes departed, temporarily, from planned targets. Debt levels were regularly reevaluated and long-term targets set accordingly. In particular, changes in energy price levels were correlated with changes in Midland's stock price, and necessitated regular Stock Repurchases reassessments of optimal borrowing. In 2007 both oil prices and Midland's stock price were at historic highs, which-all else equal-increased the company's borrowing capacity. This in turn In the past, Midland had repurchased its own shares on occasion, and had stated that it would do represented an opportunity to shield additional profits from taxes. so again whenever attractive opportunities arose. Consequently, the company regularly estimated the intrinsic value of its shares by subtracting the market value of its debt from the fundamental Each of Midland's divisions had its own target debt ratio. Targets were set based on value of the enterprise and dividing the result by the number of shares outstanding. The considerations involving each division's annual operating cash flow and the collateral value of its fundamental value of the consolidated enterprise was estimated using DCF analyses and a identifiable assets. Targets themselves tended to be "sticky," but changes in the market value of comparison of the company's trading multiples with those of its peers. When the stock price fell specific collateral, such as oil reserves, or the market capitalization of the company as a whole could below the stock's intrinsic value, Midland considered repurchasing its shares. Small numbers of drive actual debt ratios away from corresponding targets. shares could be purchased on the open market; larger blocks would be bought via self-tenders. Mortensen's team did not set targets-they were set in consultations among division and Midland had not repurchased shares in large numbers since 2002 and no large purchases were corporate executives and the board-but Mortensen did estimate a debt rating for each division anticipated by analysts in the near future, given the company's high stock price. Nevertheless, based on its target, and a corresponding spread over treasury bonds to estimate divisional and Midland executives pointed out that the mere fact that the stock price had risen did not mean the corporate costs of debt." Mortensen's preliminary estimates for 2007 are shown below in Table 1. shares were not undervalued - intrinsic value had clearly risen as well, and Midland remained Table 1 committed to repurchasing shares when they were undervalued. Exhibit 4 shows Midland's historical stock prices, dividends per share, and selected financial data for the period 2001-06. Credit Debt/ Spread to Business Segment: Rating Value Treasury Consolidate A+ 42.2% 1.62% Estimating the Cost of Capital Mortensen's primary calculations were based on the formula for WACC shown below. Exploration & Production A+ 46.0% 1.60% Refining & Marketing BBB 31.0% 1.80% In this expression, D and E are the market values of the debt and equity respectively, and V is the Petrochemicals AA- 40.0% 1.35% firm's or division's enterprise value (V = D + E). Similarly, r, and r, are the costs of debt and equity, respectively, and t is the tax rate. Note: Debt/Value is based on market values. At December 31, 2006, the company's debt was rated A+ by Standard & Poor's. Table 2 gives (B)a-D)+. (8) yields to maturity for U.S. Treasury bonds in January 2007. Cost of Debt Table 2 Mortensen computed the cost of debt for each division by adding a premium, or spread, over U.S. Treasury securities of a similar maturity. The spread depended on a variety of factors, including the Maturity: Rate: division's cash flow from operations, the collateral value of the division's assets, and overall credit 1-Year 4.54% market conditions. For some of Midland's operations, long-term expected cash flow and collateral 10-Year 4.66% value were affected by political risk. This risk was most apparent, for example, in the exploration 30-Year 4.98% and production division. A significant fraction of E&P's productive assets and proven reserves were located in politically volatile countries in which the risk of nationalization or a forced renegotiation of Finally, although prudent use of Midland's debt capacity was a primary determinant of capital production rights was significant. All else equal, such properties supported less borrowing than structure, other considerations played important roles as well. In particular, the strength of might otherwise be expected. The basic EVA equation employed by Midland was EVA = NOPAT -(r._XInvested Capital). The spread to Treasury refers to the amount the borrower will have to pay in interest cost above U.S. Treasury securities of a similar maturity.Cost of Equity Exhibit 1 Midland Income Statements, Years ended December 31 ($ in millions) To estimate the cost of equity, Mortensen used the Capital Asset Pricing Model (CAPM), shown below, in which r, denotes the risk-free rate of return, B is a measure of systematic risk, and EMRP denotes the equity market risk premium, that is, the amount by which the return on a broadly Operating Results: 2004 2005 2006 diversified portfolio of risky assets is expected to exceed the risk-free return over a specific holding Operating Revenues 201,425 249,246 248,518 period. Plus: Other Income 1,239 2,817 3,524 Total Revenue & Other Income 202,664 252,062 252,042 I, = 1, + B(EMRP) Less: Crude Oil & Product Purchases 94,672 125,949 124,131 Mortensen was aware that betas were measured, with error, from regressions of individual stock Less: Production & Manufacturing 15,793 18,237 20,079 returns on market returns. She and her team used betas published in commercially available Less: Selling, General & Administrative 9,417 9,793 9,706 databases, rather than running their own regressions. Midland's beta was 1.25, for example. Less: Depreciation & Depletion 6,642 6,972 7,763 However, betas for Midland's divisions were not observable, since the divisions did not have traded Less: Exploration Expense 747 56 803 shares of stock. To estimate betas for the divisions, Mortensen relied on published betas for publicly Less: Sales-Based Taxes 18,539 20,905 20,659 traded companies she deemed comparable to each division's business. A selection of these, along Less: Other Taxes & Duties 27,849 28,257 26.658 with related financial data, is presented in Exhibit 5. Operating Income 29,005 41,294 42,243 In 2006 Midland used an equity market risk premium of 5.0%, but higher EMRPs-6.0% to 6.5%- Less: Interest Expense 10,568 8,028 11,081 had been used by Midland at various times in the past. Historical data on stock returns and bond Less: Other Non-Operating Expenses 528 543 715 yields, such as those presented in Exhibit 6, supported the higher estimates of the EMRP. Other data, Income Before Taxes 17,910 32,723 30,447 such as the survey results shown in Exhibit 6, suggested lower figures. Midland adopted its current Less: Taxes 7,414 12,830 11,747 estimate of 5.0% after a review of recent research and in consultation with its professional advisors- Net Income 10,496 19,893 18,701 primarily its bankers and auditors-as well as Wall Street analysts covering the industry