Review the Harvard Business School Case (Brief Case) – #4130, dated June 19, 2009 ( See Attached ) Consider the following in your analysis: The main goal for this case is for Janet Mortensen to append a sort of “user guide” in her 2007 calculations; If she did append a “user’s guide” what might be her guidance for different types of project analysis at Midland such as capital budgeting and financial accounting, performance assessments, M&A proposals, and stock repurchase decisions; how might the cost of capital numbers differ or guidance differ for division- level versus corporate-level decisions; what guidance might she provide with validating the components used to compute the WACC; how would you compute a cost of capital for the Petrochemical division; what ‘actual’ firm would you use now as a pure play for the Petrochemical division. Note:1- pages must be more than 1 page and less than 4 pages 2- Grading on Fact Sheet: Overview and Assumptions Appropriateness of T-bond maturity usedAppropriateness of equity risk premium usedAppropriateness of using firm-level WACC for divisionsApproach to defining division-level cost of capitalComputation of firm-level WACC Computation of division-level cost of capitalApproach used to compute cost of capital for PetroChemical DivisionUser Guide Reccomendation – capital project valuation, asset projects, performance evaluationFormat and Content standard 1″ marginssingle-spacing (text)double-spacing between paragraphsno paragraph indentation (left justified)size 12 font, Times New Roman, black textitalicized or bold font for section headings 3- Avoiding Plagiarism. 4- See attachment which is Information to compute WACC based upon different capital structures. 5- See attachment which some examples of factsheet.
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fin620_case2_midland.pdf
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4129
JUNE 19, 2009
TIMOTHY A. LUEHRMAN
JOEL L. HEILPRIN
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.
________________________________________________________________________________________________________________
HBS Professor Timothy A. Luehrman and Illinois Institute of Technology Adjunct Finance Professor Joel L. Heilprin prepared this case
specifically for the Harvard Business School Brief Case Collection. Though inspired by real events, the case does not represent a specific
situation at an existing company, and any resemblance to actual persons or entities is unintended. Cases are developed solely as the basis for
class discussion and are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.
Copyright © 2009 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized,
photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
This document is authorized for use only in FIN 620 by Pamela Queen at Morgan State University from January
2013 to July 2013.
4129 | Midland Energy Resources, Inc.: Cost of Capital
Midland’s Operations
Midland Energy Resources had been incorporated more than 120 years previously and in 2007
had more than 80,000 employees. Exhibits 1 and 2 present Midland’s most recent consolidated
financial statements. Exhibit 3 presents selected business segment data for the period 2004-06.
Exploration & Production
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
extracted approximately 2.10 million barrels of oil per day—a 6.3% increase over 2005 production—
and roughly 7.28 billion cubic feet of natural gas per day—an increase of slightly less than 1% over
2005. This represented $22.4 billion of revenue and after-tax earnings of $12.6 billion. E&P was
Midland’s most profitable business, and its net margin over the previous five years was among the
highest in the industry.
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 nontraditional sources such as deepwater drilling, heavy oil recovery, liquefied natural gas (LNG), and
arctic technology was expected to increase. Further, the geographic composition of output was
shifting, marked by increases from places such as the Middle East, Central Asia, Russia, and West
Africa.
With oil prices at historic highs in early 2007, Midland anticipated continued heavy investment in
acquisitions of promising properties, in development of its proved undeveloped reserves, and in
expanding production. In particular, continued high prices underlay plans to boost investment in
sophisticated extraction methods that extended the lives of older fields and marginal properties.
Capital spending in E&P was expected to exceed $8 billion in 2007 and 2008.
Refining and Marketing
Midland had ownership interests in 40 refineries around the world with distillation capacity of 5.0
million barrels a day. Measured by revenue, Midland’s refining and marketing business was the
company’s largest. Global revenue for 2006 was $203.0 billion—a slight decrease of approximately
1.8% over 2005. The division faced stiff competition, as its products were highly commoditized.
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
previous 20 years.
Though most of Midland’s refinery output was gasoline and was sold as fuel for automobiles, the
company also had manufacturing capacity to produce approximately 120,000 barrels of base-stock
lubricants per day. Midland believed its capacity was as technologically advanced as any in the
industry. Advanced technology and vertical integration combined to make Midland a market leader
in this business.
Midland projected capital spending in refining and marketing would remain stable, without
substantial growth in 2007-08. This reflected both the historical trends of low and shrinking margins
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.
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Midland Energy Resources, Inc.: Cost of Capital | 4129
Petrochemicals
Petrochemicals was Midland’s smallest division, but was a substantial business nonetheless.
Midland owned outright or had equity interests in 25 manufacturing facilities and five research
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
fuel and lubricant additives. In 2006, revenue and after-tax earnings were $23.2 billion and $2.1
billion, respectively.
Capital spending in petrochemicals was expected to grow in the near-term as several older
facilities were sold or retired and replaced by newer, more efficient capacity. Much of the new
investment would be undertaken by joint ventures outside the United States in which Midland’s
Petrochemicals Division owned a substantial minority interest.
Midland’s Financial and Investment Policies
Midland’s financial strategy in 2007 was founded on four pillars: (1) to fund significant overseas
growth; (2) to invest in value-creating projects across all divisions; (3) to optimize its capital structure;
and (4) to opportunistically repurchase undervalued shares.
Overseas Growth
The most easily exploited domestic resources had been put into production decades previously.
Consequently, overseas investments were the main engine of growth for most large U.S. producers,
and Midland was no exception. Midland usually invested in foreign projects alongside either a
foreign government or a local business as partner. Often, these investments had specialized financial
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.
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
abroad, Midland analyzed and evaluated them in U.S. dollars by converting foreign currency cash
flows to dollars and applying U.S. dollar discount rates. In 2006, Midland had earnings from equity
affiliates of approximately $4.75 billion. The majority of these earnings, 77.7%, came from non-US
investments.
Value-creating Investments
Midland used discounted cash flow methodologies to evaluate most prospective investments.
Midland’s DCF methods typically involved debt-free cash flows and a hurdle rate equal to or derived
from the WACC for the project or division. However, Midland’s interests in some overseas projects
were instead analyzed as streams of future equity cash flows and discounted at a rate based on the
cost of equity.
The performance of a business or division over a given historical period was measured in two
main ways. The first was performance against plan over 1- , 3- , and 5-year periods. The second was
based on “economic value added” (EVA), in which debt-free cash flows1 were reduced by a capital
1 For purposes of EVA calculations, the company defined debt-free cash flows as net operating profit after taxes (NOPAT),
which is EBIT(1-t).
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3
4129 | Midland Energy Resources, Inc.: Cost of Capital
charge, and expressed in dollars.2 The capital charge was computed as the WACC for the business or
division times the amount of capital it employed during the period.
Optimal Capital Structure
Midland optimized its capital structure in large part by prudently exploiting the borrowing
capacity inherent in its energy reserves and in long-lived productive assets such as refining facilities.
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
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
represented an opportunity to shield additional profits from taxes.
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
identifiable assets. Targets themselves tended to be “sticky,” but changes in the market value of
specific collateral, such as oil reserves, or the market capitalization of the company as a whole could
drive actual debt ratios away from corresponding targets.
Mortensen’s team did not set targets—they were set in consultations among division and
corporate executives and the board—but Mortensen did estimate a debt rating for each division
based on its target, and a corresponding spread over treasury bonds to estimate divisional and
corporate costs of debt.3 Mortensen’s preliminary estimates for 2007 are shown below in Table 1.
Table 1
Business Segment:
Consolidated
Exploration & Production
Refining & Marketing
Petrochemicals
Credit
Rating
A+
A+
BBB
AA-
Debt/ Spread to
Value Treasury
42.2%
1.62%
46.0%
31.0%
40.0%
1.60%
1.80%
1.35%
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
yields to maturity for U.S. Treasury bonds in January 2007.
Table 2
Maturity:
1-Year
10-Year
30-Year
Rate:
4.54%
4.66%
4.98%
Finally, although prudent use of Midland’s debt capacity was a primary determinant of capital
structure, other considerations played important roles as well. In particular, the strength of
2The basic EVA equation employed by Midland was EVA = NOPAT – (r
wacc
)(Invested Capital).
3 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.
4
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Midland Energy Resources, Inc.: Cost of Capital | 4129
Midland’s consolidated balance sheet and its access to global financial and commodity markets
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
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
information or unusual pricing relationships, was an additional reason that the actual capital
structure sometimes departed, temporarily, from planned targets.
Stock Repurchases
In the past, Midland had repurchased its own shares on occasion, and had stated that it would do
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
value of the enterprise and dividing the result by the number of shares outstanding. The
fundamental value of the consolidated enterprise was estimated using DCF analyses and a
comparison of the company’s trading multiples with those of its peers. When the stock price fell
below the stock’s intrinsic value, Midland considered repurchasing its shares. Small numbers of
shares could be purchased on the open market; larger blocks would be bought via self-tenders.
Midland had not repurchased shares in large numbers since 2002 and no large purchases were
anticipated by analysts in the near future, given the company’s high stock price. Nevertheless,
Midland executives pointed out that the mere fact that the stock price had risen did not mean the
shares were not undervalued – intrinsic value had clearly risen as well, and Midland remained
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.
Estimating the Cost of Capital
Mortensen’s primary calculations were based on the formula for WACC shown below.
In this expression, D and E are the market values of the debt and equity respectively, and V is the
firm’s or division’s enterprise value (V = D + E). Similarly, rd and re are the costs of debt and equity,
respectively, and t is the tax rate.
Cost of Debt
⎛E⎞
⎛D⎞
WACC = rd ⎜ ⎟(1 − t ) + re ⎜ ⎟
⎝V ⎠
⎝V ⎠
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
division’s cash flow from operations, the collateral value of the division’s assets, and overall credit
market conditions. For some of Midland’s operations, long-term expected cash flow and collateral
value were affected by political risk. This risk was most apparent, for example, in the exploration
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
production rights was significant. All else equal, such properties supported less borrowing than
might otherwise be expected.
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4129 | Midland Energy Resources, Inc.: Cost of Capital
Cost of Equity
To estimate the cost of equity, Mortensen used the Capital Asset Pricing Model (CAPM), shown
below, in which rf denotes the risk-free rate of return, β 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
diversified portfolio of risky assets is expected to exceed the risk-free return over a specific holding
period.
re = rf + β(EMRP)
Mortensen was aware that betas were measured, with error, from regressions of individual stock
returns on market returns. She and her team used betas published in commercially available
databases, rather than running their own regressions. Midland’s beta was 1.25, for example.
However, betas for Midland’s divisions were not observable, since the divisions did not have traded
shares of stock. To estimate betas for the divisions, Mortensen relied on published betas for publicly
traded companies she deemed comparable to each division’s business. A selection of these, along
with related financial data, is presented in Exhibit 5.
In 2006 Midland used an equity market risk premium of 5.0%, but higher EMRPs—6.0% to 6.5%—
had been used by Midland at various times in the past. Historical data on stock returns and bond
yields, such as those presented in Exhibit 6, supported the higher estimates of the EMRP. Other data,
such as the survey results shown in Exhibit 6, suggested lower figures. Midland adopted its current
estimate of 5.0% after a review of recent research and in consultation with its professional advisors—
primarily its bankers and auditors—as well as Wall Street analysts covering the industry.
6
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Midland Energy Resources, Inc.: Cost of Capital | 4129
Exhibit 1
Midland Income Statements, Years ended December 31 ($ in millions)
Operating Results:
Operating Revenues
Plus: Other Income
Total Revenue & Other Income
Less: Crude Oil & Product Purchases
Less: Production & Manufacturing
Less: Selling, General & Administrative
Less: Depreciation & Depletion
Less: Exploration Expense
Less: Sales-Based Taxes
Less: Other Taxes & Duties
Operating Income
Less: Interest Expense
Less: Other Non-Operating Expenses
Income Before Taxes
Less: Taxes
Net Income
2004
201,425
1,239
202,664
94,672
15,793
9,417
6,642
747
18,539
27,849
29,005
10,568
528
17,910
7,414
10,496
2005
249,246
2,817
252,062
125,949
18,237
9,793
6,972
656
20,905
28,257
41,294
8,028
543
32,723
12,830
19,893
2006
248,518
3,524
252,042
124,131
20,079
9,706
7,763
803
20,659
26,658
42,243
11,081
715
30,447
11,747
18,701
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4129 | Midland Energy Resources, Inc.: Cost of Capital
Exhibit 2
Midland Balance Sheets, at December 31 ($ in millions)
Assets:
Cash & Cash equivalents
Restricted Cash
Notes Receivable
Inventory
Prepaid Expenses
Total Current Assets
2005
16,707
3,131
18,689
6,338
2,218
47,083
2006
19,206
3,131
19,681
7,286
2,226
51,528
30,140
156,630
10,818
244,671
34,20 …
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