Midland Energy Resources

Abstract

Cost of Capital

Midland Energy Resources has its operations divided amongst three separate divisions. The divisions have different functions and need separate discount rate to evaluate its projects. The cost of capital is very critical in Midland as it used for many diverse purposes. Therefore, it is important to calculate an accurate cost of capital. The Weighted Average Cost of Capital is used to discount Midland s cash flows. Cost of debt is comparatively easier to calculate using a bond yield plus risk premium approach. The cost of equity is calculated using the Capital Asset Pricing Model (CAPM). In CAPM, the calculation of beta requires significant judgment. Industry data is used to calculate the beta, but such data is not available for one of the divisions where an alternative method is applied. There is also some controversy in using the market risk premium: the historical risk premium for US stocks significantly differs from the risk premium used in the industry. By making certain assumptions about these variables, four separate costs of capital are estimated for Midland and its three divisions.

Introduction
Midland Energy Resources, Inc is an energy company with global operations. It provides a broad range of products and services including oil and gas exploration and production, refining and marketing, and petrochemicals. Janet Mortensen, the senior vice president of project finance, has a responsibility to determine the weighted average cost of capital (WACC) for the overall company as well as its divisions. The cost of capital is not only used in the annual capital budgeting process but also utilized for performance evaluation, share repurchases, and economic value added calculations. Calculating the cost of capital, however, is not easy cost of capital. many variables have to be critically evaluated when determining the

Cost of Debt
The cost of debt is the marginal rate at which the company might be able to borrow additional capital. It is usually calculated as the yield to maturity on the future debt payments the rate that equates the

present value of debt payments to the current market value of debt. In case, the market value of debt cannot be reliably estimated, company s often use the debt ratings (given by rating agencies) to estimate the cost of debt. The ratings estimates are indeed provided in the case of Midland, but the company prefers to use a more intricate method of calculating debt. In simple terms the method is called the bond yield plus risk premium approach. The riskfree yield on a treasury security is adjusted for a risk premium to arrive at an appropriate cost of debt. The risk premium is usually based on the debt ratings of the company, but Midland calculates it in a more complex way. However, Midland does take debt rating into account when calculating the risk premium and there is no reason to dispute the accuracy of Midland s calculations.

The case study provides US Treasury bond yields for three different time horizons: 1-year, 10-year, and 30-year. The time horizon the relevant Treasury bond yield should match the time horizon for the debt. Since, debt is long-term in nature, the 1-year t-bond yield is not appropriate. 30 years seem to be too long a period and the average debt of the company is not likely to last that long. Therefore, 10-year seems to be a more appropriate time horizon for selecting t-bond yield. Therefore, the 10-year t-bond yield of 4.66% is added to the relevant risk premiums to calculate the cost of debt for Midland as well as each of its operating divisions.

Cost of Equity
The calculation of cost of equity is much more subjective and complex than the calculation of cost of debt. Many approaches have been suggested to calculate the cost of equity. One such approach is the Capital Asset Pricing Model (CAPM):

Re = Rf + x EMRP

In the CAPM equation, Rf stands for the risk-free rate of return,

is a measure of sensitivity of stock

with the market (systematic risk), and EMRP represents the equity market risk premium.

Riskfree Rate The 10-year US Treasury bond rate is used to represent the riskfree rate. The rationale for using the rate as a proxy for riskfree rate is already presented in the section on cost of debt and it remains the same for cost of equity. Although it can be argued that the 30-year t-bond rate serves as a more conservative measure; and it may be more appropriate as equities have no maturity dates. However, the 10-year tbond rate has been retained for consistency across calculations.

Beta Beta is a measure of the sensitivity of a stock s returns to market returns. Technically, it is measured as a covariance of stock returns with market returns divided by the variance of stock. However, an alternative approach, as used by Midland, is to calculate beta by looking at outside sources like competitors betas and analysts reports. Midland calculates has come up with a company beta of 1.25 using outside information and there is no reason to dispute its accuracy. However, the betas for the internal divisions of Midland are hard to calculate. A number of competitor betas for Exploration & Production and Refining & Marketing divisions have been provided. An average of the betas for competitors has been assumed to as the appropriate betas for the respective two division of Midland. However, in the case of Refining & Marketing, the Petrarch Fuel Services has been omitted when calculating the average beta. Petrarch Fuel Services does not appear to be similar to Midland. Apart from its unusual leverage and beta, the company has very low long-term revenue and earnings. It is considered that the company may significantly differ from Midland in terms of size and operations.

A major hurdle arises in estimating the beta for the Petrochemicals division. There are no comparable Petrochemicals firms within the industry. Therefore, the industry average cannot be used to calculate the relevant beta. Similarly, historical data for Midland is not available as stock returns cannot be bifurcated between the different divisions. A possible approach is to distribute the overall beta of Midland among the three divisions, on the basis of weighted asset values. It can be assumed the overall beta of Midland is the asset weighted average of the betas of the individual divisions:

WExploration x

Exploration +

WRefining x

Refining

+ WPetrochemicals x

Petrochemicals

= WMidland x

Midland

Based on the asset weights for the year end 2006 and the betas obtained from industry data, we find the missing beta for Petrochemicals to be 1.40. The technique of obtaining the beta for the Petrochemicals is not very robust. It is strictly based on the assertion that the asset weighted average betas of each division constitute the overall beta of the company. This may not be a very far-off contention if the betas of other division and the company beta are accurately calculated. However, the fact is that the estimates of the other betas are also speculative in nature. This makes the beta estimate for the Petrochemicals division highly subjective. Nevertheless, it appears to be the only way to calculate the beta with the available to information, and we have no choice but the employ it in the calculations.

Equity Market Risk Premium The Equity Market Risk Premium (EMRP) is the risk premium awarded for taking systematic risk. Systematic risk is the risk of the overall market. The premium is usually measured as the difference between market return and riskfree return. In this case study, the US Treasury bond returns have been taken as a measure of riskfree return. However, the riskfree return can be taken to be some other return as well. For instance, the 3-month US treasury bills interest serves as a good measure of the short-term riskfree return. The market return for US can be calculated by using a national level stock index like the S&P500. Although the S&P500 contain only the 500 biggest companies out of thousands of

publicly traded US companies, studies on indicate that most of the unsystematic risk can be diversified away with a portfolio of 30 uncorrelated stocks. Therefore, it can be stated that the S&P500 returns will serve as a reliable indicator of market return.

Exhibit 6 of the case study provides the historical data on Equity Market Risk Premium for US stocks. The amount of the premium differs, depending on the time horizon selected. The lowest value for Equity Market Risk Premium is 4.8% for the period between 1967 and 2006. The EMRP increases drastically if a larger or a smaller time horizon is used. Therefore, using historical data, 4.8% can be seen as the most conservative estimate of Equity Market Risk Premium. By this standard, Midland s EMRP of 5% is quite conservative. However, the survey results about Equity Market Risk Premium, provided in Exhibit 6, paint an altogether different story. The surveys from academics, pension fund managers, and other US companies suggest that they use a much smaller estimate for Equity Market Risk Premium. The consensus lies on an EMRP between 3% and 4%.

It is believed that the EMRP of 5%, used by Midland, is appropriate. The historical data suggests that the 5% figure is slightly conservative, while surveys suggest that other stakeholders use an even lower EMRP. The only credible alternative would be to use an even lower EMRP in order to comply with industry standards. However, prudence suggests that this may not be a wise step as it might understate the cost of capital for Midland. An understated cost of capital can make unsuitable projects to appear more profitable than they actually are. The company might even start to accept projects that are destroying value, but appear to have a positive Economic Value Added (EVA) because the cost of capital used is too low. Moreover, there is no historical evidence to suggest that the EMRP can be lower than 4.8% - the lowest observed value. Therefore, it will be sensible for Midland to persist with the 5% Equity Market Risk Premium.

Cost of Capital
A reliable indicator the cost of capital for Midland is the Weighted Average Cost of Capital (WACC). Midland uses considerable amount of leverage in its capital structure and, therefore, it makes sense to calculate its cost of capital as a weighted average of its debt and equity. The weights are calculated using the market values of debt and equity. The formula for calculating Weighted Average Cost of Capital is:

WACC =

x Rd x (1 t) +

x Re

In the equation above,

and

represent the weights of debt and equity respectively, Rdx(1 t)

represent the after tax return on debt, and Re represent the return on equity.

The ratio of the market value of debt to value - for Midland and its three divisions - has been provided in the case study. The ratio of equity to value equals one minus the ratio of debt to value since debt and equity are the only two sources of capital for Midland. The return on debt and the return on equity have been calculated using the assumptions made and the method outlined. However, there is no information available on the applicable tax rate. The tax rate for US corporations is usually 40%. We have assumed that there are no tax-holidays applicable to Midland, and there are no permanent differences in accounting income and tax income. These assumptions imply that the effective tax rate is assumed to be equal to the statutory tax rate of 40%.

Using this information, we can calculate the cost of capital for Midland and each of three divisions. Since, we now have a separate cost of capital for each of Midland s divisions; the projects for each of the divisions can be evaluated more accurately. However, the accuracy of the calculations is not fully guaranteed. The accuracy is vastly dependant on the calculations performed in this analysis. Especially, the betas calculated are highly subjective and can vary accordingly. For instance, if we had not excluded the beta for Petrarch Fuel Services from our calculations, the beta for Refining & Marketing would have

dropped to 1.20 from 1.36; and the beta for Petrochemicals would have risen to 1.91 from 1.40. In such a scenario, the cost of capital for Petrochemicals would have been much higher than its current level; the cost of capital for Refining & Marketing would have been considerably lower. Regardless of the subjectivity associated with the assumptions, we persist that the chosen assumptions are closest to reality and provide the most reliable estimate of the cost of capital for Midland and its divisions.