casestudy

FINM 7402 Corporate Finance

Tongxin L. 43048791

P1

Executive Summary: Midland Energy Resource, Inc. is an international It has a wide range of business about petrochemical, distillation and so on. The main business is selling fossil resources which are natural gas and fuel. This is also a main reason why Midland Company is a market leader in energy industry. Midland has three divisions which are Exploration & Production (E&P), Refining and Marketing and Petrochemicals divisions. E&P is the most profitable division and its net margin is the highest in the industry. Marketing division corporate has 40 refineries around the world. This division is stable and it is difficult to expand its business. Petrochemicals division is the smallest and growing division. it generates investment through joint ventures.

Calculation for Midland’s WACC For the calculating Midland’s corporate WACC, the formula should be applied that: 𝑟𝑑 = 𝑟𝑓 + 𝑆𝑝𝑟𝑒𝑎𝑑 In the above formula, there some assumption should be made. 

Corporate tax rate would be assumed at 40%.



𝛽𝐷 for A+ and AA- are 0. 𝛽𝐷 for BBB is 0.1. 𝑇𝑎𝑥

Form Exhibit 1, tax rate can be computed using 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒 = 𝐼𝑛𝑐𝑜𝑚𝑒 𝐵𝑒𝑓𝑜𝑟𝑒 𝑇𝑎𝑥𝑒𝑠 from 2004 to 2006 which are 41.40%, 39.21% and 38.58%. Tax rate would be assuming at 40%. Firm, E&P and Petrochemicals are A+ and AA- credit. This means that 𝛽𝐷 for A+ and AA-

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FINM 7402 Corporate Finance

Tongxin L. 43048791

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are 0, because of risk-free. Marketing division is BBB. 𝛽𝐷 for BBB should be 0.1 (Berk,2014). The original formula should be: 𝛽𝐸 = 𝛽𝐴 ∗ [1 + (1 − 𝑡) ∗

𝐷 𝐷 ] − 𝛽𝐷 (1 − 𝑡) ∗ 𝐸 𝐸

When 𝛽𝐷 is zero, the formula can be: 𝛽𝐸 = 𝛽𝐴 ∗ [1 + (1 − 𝑡) ∗

𝐷 ] 𝐸

Firstly, risk-free rate for this company should be 4.66%, because the company would choose a U.S. Treasury security with a similar maturity, which is mentioned in the given article. The company has begun to estimate cost of capital in 1980s. Furthermore, the business cycle for the energy resource industry should be 10 years, because the useful life for mining, fuel and gas industries. Therefore, the maturity for U.S. Treasury security is a 10 - year with yield of 4.66% which is close to the business maturity. For the spread to Treasury, the consolidated one should be 1.62%. Cost of Debt for Midland company should be computed at 6.28% (4.66% + 1.62%).

EMRP is appropriate at 5%, because the EMRP is estimated by giving less weight on the historical data. In Exhibit 6, there is presenting the historical data on average excess return based on U.S. stock and Treasury bond, which are about from 5.1 to 7.1 percent. Importantly, the most accurate market premium would be approximately 5 percent, which is from 1798 to 2006 with the lowest standard error at 1.2%. Exhibit 6 also illustrates that three researchers would survey different periods of market risk premium, which is around from 2.6 to 5.6 percent in 2001 and from 2 to 4.7 percent in 2006. It is

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Tongxin L. 43048791

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obvious that the ERMP is increasing as time series. The EMRP would be about 5 percent. Therefore, the EMRP should be around 5 percent. When cost of equity is calculated, CAMP can applied as shown: 𝑟𝑒 = 𝑟𝑓 + 𝛽 ∗ (𝐸𝑀𝑅𝑃) However, β of equity can be worked out, because the β presenting in Exhibit 5 is an unlevered β. The new levered β should be higher than the old one, to some extent, firm would bear more level of risk. Debt ratio is 59.30% in Exhibit 5. The debt ratio would change in 2007, which is 42.2% in 2007. Debt ratio should be 73% in 2007. The 𝛽𝐸 should apply debt ratio in 2007. The new levered β can be calculated as 𝛽𝐸 = 𝛽𝐴 ∗ [1 + (1 − 𝑡) ∗

𝐷 ] 𝐸

The 𝛽𝐴 equals 0.922(1.25/ (1+ (1-40%)*59.30%)). New 𝛽𝐸 should be 1.33 (0.922*(1 + (1-40%)*73%)). The cost of equity can be 11.31% (4.66%+ 1.33* 5%)

𝑊𝐴𝐶𝐶 = 𝑟𝑒 ∗

𝐸𝑞𝑢𝑖𝑡𝑦 𝐷𝑒𝑏𝑡 + 𝑟𝑑 ∗ ∗ (1 − 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

WACC can be applied calculated at 8.13%. (11.31 %*( 1-42.2%) +6.28 %*(1-40%)*42.2%).

Differentiation of Divisions Hurdle Rates 3

FINM 7402 Corporate Finance

Tongxin L. 43048791

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Midland cannot be applied a single corporate hurdle rate for evaluating investments in all divisions. There are several reasons to against that. 

Divisions have different targets. They run different performances to generate profit. It also has different profit margin, so the hurdle rate is not same.



The size of division also influences the rate, the corporate hurdle rate should be worked out by value weighted approach. A high rate may contribute less value weighted to the corporate rate, whereas, a low rate contributes more.



The world economy would affect divisions hurdle. For example, in Exploration & Production division, the hurdle rate will increase, because the fuel price will rise in early 2007. The information may not affect other divisions. Therefore, the hurdle rate should not be the same as the corporate rate.

Causes for E&P and R&M Cost of Capital in difference In term of calculating cost of capital in different divisions, this is the same formula as to compute the WACC of corporate.

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑟𝑒 ∗

𝐸𝑞𝑢𝑖𝑡𝑦 𝐷𝑒𝑏𝑡 + 𝑟𝑑 ∗ ∗ (1 − 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

However, cost of capital differs between divisions. There are three main factors to cause the differing. 

According to CAPM, β is one of main factors to compute different return on equity. β is a measurement of systematic risk. It implies that the higher β would 4

FINM 7402 Corporate Finance

Tongxin L. 43048791

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provide the higher return, but it also incurs the higher risk, so the divisions has different business fields and they would not be the same β. 

The spread is different from each other, which can be used in computing cost of debt. The debt which is offered by the company should be the higher default risk than Government Treasury. Thus, the corporate needs to provide a higher return in order to compensate to creditors. This causes that cost of debt are not the same figure.



Divisions also have different capital structures. This means that debt or equity does not occupy same percentage of the total assets in a division. For instance, Debt ratio (Debt/ Value) are 46% and 31% in E&P and Marketing division separately in 2007. The value of division also differs from others.



Corporate rate would be different. Different industries and countries may not pay the same tax rate, even though the given assumption assumes corporate rate at 40%. Domestic government may protect some specific businesses. These businesses would pay less tax or even no tax. For international, the divisions may have some subsidiaries in other countries. Governments would provide different tax rate to all companies. For example, the same business in U.S. may have 30%, but in Australia it may have 35% or 40% tax rate. That can make cost of capital in difference.

Calculation for E&P and R&M Divisions Cost of Capital

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FINM 7402 Corporate Finance

Tongxin L. 43048791

P1

To calculate cost of capital, some financial information about E&P and Marketing divisions is presented in Exhibit 5. There are some departments in each division and each department has its own ratio and β, which comes up the average ratio and β. the Debt ratio (Debt/ Value) for E&P and Marketing are 46.0% and 31.0% respectively, so D/E ratio should 85.2% and 44.9%. The β for E&P and Marketing are 1.15 and 1.20 separately. All divisions can be considered that they have the same maturity as the corporate, because the article does not mention the maturity of divisions. As a result, it still uses 𝑟𝑓 = 4.66%. The spread of Government Treasury can be found in Table 1 in each division. The spreads are 1.60% for E&P and 1.80% for Marketing. Cost of debt can be worked out 6.26% (4.66% + 1.60%) for E&P and 6.46% (4.66% +1.80%) for Marketing. βfor both divisions have the same method to calculate β𝐴 for each company and solve average β𝐴 at 0.933 with 𝛽𝐷 = 0 and 1.08 with 𝛽𝐷 = 0.1.

For Exploration & Production Division: β𝐸 = 0.933*(1+ (1-40%)*85.2%) =1.41 r𝐸 = 4.66% + 1.41 ∗ 5% = 11.71%

For Refining & Marketing Division: β𝐸 =1.08*(1+ (1-40%)*44.9%) - 0.1 (1-40%)*44.9% =1.34 r𝐸 = 4.66% + 1.34 ∗ 5% = 11.70%

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FINM 7402 Corporate Finance

Tongxin L. 43048791

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WACC for both divisions can be worked out using the mentioned formula. WACC are 8.05% for E&P (6.26%*0.6*46%+11.71%*54%) and 9.44% for marketing (6.46%*0.6*31%+11.70%*69%).

Calculation for Petrochemical Division Cost of Capital For Petrochemical division, the asset β𝑃𝑒𝑡 can be calculated using the following formula. 𝑎𝑠𝑠𝑒𝑡 β𝐹𝑖𝑟𝑚 = 𝑉𝑎𝑙𝑢𝑒 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑠𝑠𝑒𝑡 β𝐸&𝑃 + 𝑉𝑎𝑙𝑢𝑒 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑠𝑠𝑒𝑡 β 𝑀𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔 + 𝑉𝑎𝑙𝑢𝑒 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑠𝑠𝑒𝑡 β𝑃𝑒𝑡𝑟𝑜𝑐ℎ𝑒𝑚𝑖𝑐𝑎𝑙 The weigh for a firm should be 100% and the total value of three divisions should be the firm value. Thus, the total firm should be 262,379 million in 2006, which is shown in Exhibit 3. The weight of total value should be 53.4%, 35.8% and 10.8% in E&P, Marketing and Petrochemical separately. The asset β for E&P and Marketing divisions have been worked out at 0.933 and 1.06 respectively. As a result, asset β𝑃𝑒𝑡𝑟𝑜𝑐ℎ𝑒𝑚𝑖𝑐𝑎𝑙 equals 0.4102. Cost of equity can be easily computed β𝐸 = 0.4102 ∗ (1 + 0.6 ∗ 66.7%) = 0.574 r𝐸 = 4.66 + 0.574 ∗ 5% = 7.53% Spread can be found at 1.35% in Table 1. Risk-free is still the same as the firm one at 4.66%. Finally, cost of debt can be 6.01%.WACC for Petrochemical division should be 5.96% (6.01%*0.6*40% + 7.53%*60%).

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FINM 7402 Corporate Finance

Tongxin L. 43048791

P1

Summary In conclusion, Midland Energy Resources, Inc. is an international energy company. It should obtain a series of appropriate financial data, for example, cost of capital, cost of debt and equity. The purpose for this is that company would increase company value though investments and operating. Value from these activities should be at accurate figure, because company would know that the business runs in good condition or not. On the other hand, company may change the total amount of debt to achieve optimal company structure. For each division, company allows them to utilize their own cost of capital, because this will reflect accurate value of divisions. As noticed, divisions have different conditions and market. For E&P and Marketing, both businesses already mature. Especially, E&P is the most profit division in the firm. It implies that cost of capital would be lower than hurdle rate. However, cost of capital for Marketing would be higher than hurdle rate. For Petrochemical, this business is still expanding and also is a new business for company, so its cost still maintains at lower level and it also provides high opportunity to maximize its total value.

(Word counting: 1644)

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FINM 7402 Corporate Finance

Tongxin L. 43048791

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Reference Berk, J & DeMarzo, P, 2014, Corporate Finance, 3rd edn, Pearson Education Limited, England.

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