Midland Energy Resources is a global energy company with operations in three divisions: oil and gas, exploration and production, and refining and marketing. The company has been incorporated for more than 120 years and in 2007 had more than 80,000 employees. Janet Mortensen is a senior vice president of project finance for Midland Energy Resources. In 2002, Mortensen, then a senior analyst reporting to the CFO, was asked to estimate Midland’s cost of capital with regards to a proposal in share repurchases. Six months later, she was asked to calculate corporate and divisional cost of capital that the executive and compensation committees of the board could incorporate in planned performance evaluations.
Her research, hard work and commitment, coupled with her expertise had such an influential factor upon the company’s research that she was considering creating a user’s guide for future company evaluations. Mortensen had a significant impact on the 3 divisions of Midland Energy Resources. The financial strategy in 2007 was founded upon 4 pillars: (1) to fund significant overseas growth, (2) to invest in value-creating projects across all three divisions, (3) to optimize its capital structure, and (4) to opportunistically repurchase undervalued shares. In order for Janet to add value to the company through the four pillars, she used the concepts of cost of capital, WACC and CAPM in her research.
The cost of capital is the cost of the company’s funds, both debt and equity. It is a financial metric used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. For an investment to be worth taking, the expected return on capital must be greater than the cost of capital. In order to calculate such a metric, you must calculate a company’s securities which typically include both debt and equity. The cost of debt is relatively straight forward. It is just the rate of interest being paid. The interest rate paid by the company can be distinguished as the risk-free rate plus a risk component (risk premium). The cost of equity however is a bit more intricate.
Because the cost of equity is broadly defined as the risk-weighted projected return required by investors, the return is largely unknown, hence the calculation is equated by using a formula known as CAPM (Capital Asset Pricing Model). There are many different takes on using the Capital Asset Pricing model and the argument for calculating the cost of equity is quite contentious (I will revisit CAPM formula in more detail later on). Once the cost of debt and equity has been determined, the blend of the two quantitative values can be used to calculate the WACC (Weighted Average Cost of Capital). The WACC is a useful metric because it measures a firm’s cost of capital. It is used in discounting cash flows for calculation of NPV and other valuations for investment analysis.
Mortensen’s estimates are used for asset appraisals for capital budgeting and financial accounting, performance assessment, M&A proposals, and stock repurchases decisions. Mortensen primarily calculated the WACC at the corporate level as well as for each of the 3 divisions. The calculation of the WACC for the 3 division levels can vary based on different levels of evaluated risk. For example, the M&A proposal’s cost of capital may need to be adjusted by including a higher risk premium as oppose to appraisals of long-lived assets with cash inflows and outflows that may be of lower risk.
In order to calculate the WACC for Midland Energy Resources, we first must calculate the WACC for each individual division. WACC formula is as follows:
WACC = rd*(D/V)*(1-t)+re*(E/V)
rd = Cost of debt
re = Cost of equity
D = Market value of debt
E = Market value of equity
V = D+E
t= Tax rate
In order to solve for the WACC, we first must calculate the cost of debt (rd) and the cost of equity (re). According to Mortensen, she computed the debt for each division by adding a premium to the U.S. Treasury securities of similar maturity (Table 1 & 2). Please see below.
Business Segment| Credit Rating| Debt/Value| Spread to Treasury| Consolidated| A+| 42.2%| 1.62%|
E&P| A+| 46.0%| 1.60%|
R&M| BBB| 31.0%| 1.80%|
Petrochemicals| AA-| 40.0%| 1.35%|
When determining the cost of debt, one has to keep in mind that different maturity duration comes into factor. Because E&P and R&M divisions’ and Midland as a whole company take on longer projects, the 30 year maturity rate was used. The petrochemicals however take on a much shorter duration of projects hence why only 1 year maturity duration was used. From table 1 we were able to calculate the cost of debt for all 3 divisions along with the consolidated Midland company cost of debt.
Cost of Debt:
Midland (Consolidated)| 4.98%+1.62%=6.60%|
The second unknown variable in the WACC equation is the cost of equity (re). The equation for cost of equity is as follows.
re = rf + Beta (EMRP)
rf = Interest rate available on the risk-free bond
EMRP = Market risk premium (rm – rf)
rm = return required to attract investors to hold the broad market portfolio of risky assets. Beta = Relative risk of the particular asset
Given the cost of equity formula, we need to calculate the cost of equity for each of the 3 divisions and the consolidated Midland company cost of equity. The cost of equity formula is based on a methodology called Capital Asset Pricing Model (CAPM). Because the CAPM equation depends on several variables such as the risk free interest rate and the Beta value, there has been a lot of speculation with financial advisors on the accuracy and optimal values of each variable. After researching with several advisors’ from sophisticated financial institutions, we concluded that applying CAPM will be in favour of different approaches and practical implications dictated by the current situation given.
The best current practice of CAPM includes that the betas are drawn substantially from published sources, where betas are using a long interval of equity returns. The risk-free rate should match the tenor of the cash flows being valued. The equity market risk premium is an elusive value to calculate so the conventional value company’s use is a premium of 6.0% or lower, in this case Mortensen used an equity market risk premium of 5.0%.
In order to calculate the Beta for the 3 divisions, we used the formula given below.
Asset_b = Equity_b / [1+(1-t)*(D/E)]
Because each division have different risk values and carry different weight around the company, beta values cannot be assumed. The following table summarizes the calculated beta values.
Cost of Equity:
Table 3 Beta Values
Division| Equity Beta Value|
Midland (Consolidated)| 1.25|
Equity Beta for Midland (Consolidated) = 1.25
Equity Beta for E&P = 0.93*[1+ (1-39.73%)*85.19%], where 0.93 = 1.15 / [1+(1-0.3945)*(0.398)]
Equity Beta for R&M = 1.05*[1+ (1-39.73%)*44.93%], where 1.05 = 1.2 / [1+(1-0.3945)*(0.203)]
1.15 and 1.2 values were given in Exhibit 5 as Equity Beta. The reason why we had to use the equation twice was because each division weighted differently amongst the company as a whole. The E&P division had a D/E value of 39.8% while the R&M division had a D/E value of only 20.3%. These weights had to be considered when determining the Beta values. Finally in order to calculate the Equity Beta for Petrochemicals, given that no Beta value was provided in Exhibit 5, we used a weighted average equation of the 3 divisions to determine its value. The Equation is as follows.
Beta Midland = (W1 * Beta E&P) + (W2 * Beta R&M) + (W3 * Beta Petrochemical)
Beta Midland = 1.25
Beta E&P = 1.41
Beta R&M = 1.33
W1, W2, W3 = total assets of a division divided by Midland’s total assets (Using Exhibit 3)
Exhibit 3 Table of Weighted Average
Division| 2004| 2005| 2006| Average| Weight|
Midland| 157,497| 244,671| 262,378| 221,515.33| 1|
E&P (W1)| 76,866| 125,042| 140,100| 114,002.67| 114,002.67/221,515.33 = 0.51| R&M (W2)| 60,688| 91,629| 93,829| 82,048.67| 82,048.67/221,515.33 = 0.37| Petro (W3)| 19,943| 28,000| 28,450| 25,464.33| 25464.33/221,515.33 = 0.12|
Therefore the Equity Beta for Petrochemical can be solved using the formula above.
1.25 = (0.51*1.41) + (0.37*1.33) + (0.12*Beta Petrochemical)
Solving for Beta Petrochemical, we get:
Beta Petrochemical = 0.32
The last unknown variable we need is the EMRP in the Cost of equity formula. According to Mortensen, Midland adopted its current estimate of 5% after a review of recent research and in consultation with its professional advisors as well as Wall Street analysts covering the industry. This information is also provided by Exhibit 6 in the following table below.
Exhibit 6 Equity Market Risk Premium Table
Period| Average excess return US Equity – Treasury Bonds| Standard Error| 1987-2006| 6.4%| 3.7%|
1967-2006| 4.8%| 2.6%|
1926-2006| 7.1%| 2.2%|
1900-2006| 6.8%| 1.9%|
1872-2006| 5.9%| 1.6%|
1798-2006| 5.1%| 1.2%|
Referring to the cost of equity formula again,
re = rf + Beta (EMRP)
The results for the Cost of Equity are seen in the table below.
Table 4 Cost of Equity Final Results
Division| Cost of Equity (re)|
Midland (Consolidated)| 4.98%+5%*1.25 = 11.23%|
E&P| 4.98%+5%*1.41 = 12.03%|
R&M| 4.98%+5%*1.33 = 11.63%|
Petrochemicals| 4.54%+5%*0.32 = 6.14%|
Once the cost of debt and cost of equity are calculated, we can finally determine the WACC for each division and for Midland Energy Resources.
WACC = rd*(D/V)*(1-t)+re*(E/V)
The interest free rate is 39.45% calculated from Exhibit 1, the D/V ratio is given in Table 1, and the cost of debt (rd) and cost of equity (re) have been calculated earlier. We now have all the ingredients to calculate the WACC. Below is the table of results for the WACC calculation.
Table 5 WACC
Division| WACC (Weighted Average Cost of Capital)|
Midland (Consolidated)| 0.066*(0.422)*(0.6055)+0.1123*(1-0.422)=0.08177, 8.177%| E&P| 0.0658*(0.46)*(0.6055)+0.1203*(1-0.46)=0.08328, 8.328%| R&M| 0.0678*(0.31)*(0.6055)+0.1163*(1-0.31)=0.092973, 9.2973%| Petrochemical| 0.058*(0.4)*(0.6055)+0.0614(1-0.4)=0.05088, 5.088%|
As you can see from the calculated results, the cost of capital will differ for the three divisions because of the different nature of each division. Being that each division operates in a different industry, they get exposed to different levels of risk, beta values, and ultimately receive different credit ratings. All these different factors contribute to the varying cost of capital of each division.
Further Analysis & Conclusion
Mortensen’s calculation and estimates were influential in assessing Midland Energy Resource’s financial stability. Her research included performance assessments, mergers and acquisition proposals, stock repurchases, asset appraisals, and financial accounting. Mortensen’s methodology was sound however there were some assumptions she made throughout her research. On her path to calculating corporate WACC, Mortensen computed the cost of debt for each division by adding a premium over U.S. Treasury securities of a similar maturity. For Exploration and Production (E&P), Refining and Marketing (R&M), as well as Midland (consolidated) corporation, she used a 30 year maturity treasury bond because she hypothesized those divisions take on longer project duration. Petrochemicals on the other hand were only allotted maturation of 1 year treasury bonds because it was more of a short term project.
A second assumption Mortensen used throughout her research and calculation was the tax rate of 39.45% which remained constant throughout all 3 divisions and Midland Energy Resource Corporation as a whole. She also used a fixed ERMP of 5%, a value she inherited by Midland after a recent research and consultation with professional advisors. The final point of Mortensen’s analysis should be focused on the different hurdle rates she used when calculating the WACC in the 3 different divisions. Exhibit 5 directly showed the Equity Beta, which represents a risk metric, of all 3 divisions. As the risk profiles are different for the 3 divisions, the hurdle rate for each division should also be different.
Midland should not use a single corporate hurdle rate because doing so will severely skew the results which can lead to poor investment strategies. For example, a corporate WACC should be used across the entire board when purchasing new computers for all employees. However a divisional WACC, Exploration & Production, should be used when drilling for a new project in the Pacific Ocean. Mortensen clearly had a very intricate thought out process in calculating the cost of capital for Midland Energy Resources. She did a great job in differentiating the equity beta value for all 3 divisions as well as Midland Energy Resource as a whole entity. Her analysis provided a full coverage, accurate assessment of division and corporate value.