Midlands Case Final

8/11/2019 Midlands Case Final

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Midlands Energy Resources

Midland Energy Resources is a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M) and petrochemicals. The company had been incorporatedmore than 120 years previously and in 2007 had more than 80000 employees. On a consolidated basis, the firmhad 2006 operating revenue and operating income of $248.5 billion and $42.2 billion, respectively. E&P isMidlands most profitable business. However measured by revenu e its refining and marketing business is itslargest. Petrochemicals is midlands smallest division.

Midland must calculate an appropriate cost of capital that will help them achieve an optimal capital structure.

Assumptions in our model:

The Cost of Debt assumption: The ratio of D/D+E is calculated for each of the companies. This ratio is compared withthe debt/value ratio given in Table 1 of the case. The D value corresponding to the credit ratings have been calculatedfrom the article Risk in capital structure arbitrage mentioned during class discussions. For Exploration & Productiondivision, as all the comparable firms have a debt/value ratio less than or equal to 46%, we have assumed AAA rating foreach one of them (This implies D =0).

The Risk free rate Assumption: We take 4.98% as the risk free rate of return based on returns for Treasury bond for 30years and 5% as the equity market risk premium. Because the period from 1798-2006 has the least standard error we aregoing with the approximation of equity market risk premium of 5%.

Exploration & Production (E&P)

E&P is Midlands most profitable business with net margin over the previous five years among the highest inthe industry. It produces 67% of the companys net income. Midland must calculate an appropriate cost ofcapital that will help them achieve an optimal capital structure. Capital Spending in E&P was expected toexceed $8billion in 2007 and 2008

Using the data that we have for comparable companies in this sector, we need to calculate the unlevered cost ofcapital for this division of Midland.

Based on the D values we can calculate the unlevered separately for each similar company as per the formula

u = (E)/(D+E)x E + (D)/(D+E)x D

Which gives U. From each individual U we calculate the weighted W from the given firms by weighing the assets of thefirms.

Where Assets = (Market value + Net Debt) and w = ( U x Individual Assets)/ (Total Assets)

The final W = 0.59

Now, we can apply CAPM and calculate the unlevered cost of capital using the formula

r U = r f + [E(r m)-r f ] W . Therefore r u = 4.98% + (0.59x5%) = 7.94% where 4.98% is the risk free rate of return.Hence, the unlevered beta for Exploration and Production division is 0.59 and the rate of return is 7.94%.

Refining & Marketing (R&M)

In terms of revenue, Midland's refining and marketing business was the company's largest. However, its products were highly commoditized resulting in stiff competition. After tax earnings totaled only $4million.Midland was the market leader in this business due to its advanced technology and vertical integration.

Using the same model as the Refining and Production division, the unlevered beta for Exploration andProduction division is 1.116 and the rate of return is 10.56%.


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Petrochemicals

Petrochemicals is Midland's smallest division but capital spending in petrochemicals was expected to grow inthe near-term as several older facilities were sold or retired and replaced by more efficient capacity. Revenueand After tax earnings in 2006 were $23.2 billion and $2.1 billion respectively

As we already have the unlevered beta for the Exploration and Refining divisions, we can use this data alongwith the unlevered beta of the whole company, to find out the unlevered beta for the petrochemicals division

using the formula:

( ) (

) (

) The detailed workings of the same have been shown in exhibit 3.

The unlevered beta for Petrochemical division is 0.453 and the rate of return is 7.24%.

Verdict:

The rate of returns for the Petrochemical division is the lowest at 7.24%, while it is maximum for the Refiningand Marketing division at 10.56%.

A note on Hurdle Rate

For our evaluation of Midlands, instead of using one fixed rate of return (hurdle rate) for the whole company,we have used a separate hurdle rate for each division. This has been done because the performance of thedivisions will vary since Midland is a large enterprise. Hence different risk factors are present in differentdivisions and there are different risk premiums. This is so because these divisions operate in different industriesand have a different market risk associated with them. So hurdle rates for these divisions should be calculatedseparately based on the market risk of the division.

If a single hurdle rate is used all along, these problems can affect the value assessment of Midlands:

i) Midlands will allocate resources/investments improperly among the three divisions. It will investrelatively more in poorly performing divisions resulting in wastage of assets. Similarly it will notinvest enough in divisions which are earning more profits.Eg: If we find the single hurdle rate for the company: r U = 4.98% + (0.764x5%) = 8.8%In such a case if we straight away use 8.8% for all departments, the company will overstate the riskas well as returns for Exploration & Production as well as Petrochemical Divisions. Thus, we willnot invest much in these relatively lower risk departments, and hence, the overall volatility of thereturns for Midlands will increase, making the stock more risky.

ii) This decision will adversely affect the performance of the different divisions and hence the companyas a whole. Hence its brand equity will decrease and stock prices will also fall. Overall value of thefirm will be overstated by using one higher rate of return the risk premium will increase.


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Exhibits:

Exhibit 1: Comparable companies showing debt beta and unlevered beta for Exploration andProduction sector.

Equity NetEquit

y LTM LTM Exploration&

Production:Ratin

gD/D+

E

Market

Value Debt D/E BetaRevenu

eEarning

sDebtbeta

Unlevered beta

JacksonEnergy, Inc. AAA 10% 57,931 6,480

11.2% 0.89 18,512 4,981 0 0.790

Wide PalinPetroleum AAA 46% 46,089

39,375

85.4% 1.21 17,827 8,495 0 0.176

CorsicanaEnergyCorp. AAA 13% 42,263 6,442

15.2% 1.11 14,505 4,467 0 0.941

WorthingtonPetroleum AAA 32% 27,591

13,098

47.5% 1.39 12,820 3,506 0 0.730

Exhibit 2: Comparable companies showing debt beta and unlevered beta for Refining and Marketingsector.

Equity Net Equity LTM LTM

Refining &

Marketing:

Ratin

g

D/D+

E

Marke

t Value Debt D/E Beta

Revenu

e

Earning

s

Debt

beta

Unlevere

d betaBexarEnergy, Inc. AAA 9% 60,356 6,200

10.3% 1.70 160,708 9,560 0 1.542

Kirk Corp. AAA 16% 15,567 3,01719.4

% 0.94 67,751 1,713 0 0.787White PointEnergy AAA 17% 9,204 1,925

20.9% 1.78 31,682 1,402 0 1.472

PetrarchFuelServices AAA -14% 2,460 (296)

-12.0

% 0.24 18,874 112 0 0.273Arkana

PetroleumCorp. A 24% 18,363 5,931 32.3% 1.25 49,117 3,353 0.05 0.957BeaumontEnergy, Inc. AAA 17% 32,662 6,743

20.6% 1.04 59,989 1,467 0 0.862

DameronFuelServices BBB 33% 48,796

24,525

50.3% 1.42 58,750 4,646 0.10 0.978

Exhibit 3: Calculation of Unlevered Beta and Rate of Return for Petrochemical Division of Midlands.


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Enterprise value = Equity + Debt Cash

Where = Unlevered beta for MidlandsE = Shareholders equity D = Long term debts

Equity betaEquity (inmill $) Debt beta

Total debt (inmill $)

D+E-cash(in mill $)

Unlevered betafor Company

1.25 97280 0 81078 159152 0.764049462

The debt beta has been assumed as 0, because, the companys credit rating is A+.

Now, to find the Unlevered Beta for Petrochemical Division:

Company Asset Value (in mill. $)E & P (A1) 140100R & M (A2) 93829Petro (A3) 28450

Now: Where 0.764049462, 0.59 and 1.116

From this we find, 0.453

r U = r f + [E(r m)-r f ] A3

Where 4.98% is the risk free rate of return for Treasury bond for 30 years and 5% is the equity market risk premium.

r U = 4.98%+(0.3x5%) = 7.24%

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Midlands Case Final