Midland energy a1 - Answer to Seminar Case PDF

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Answer to Seminar Case...

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Midland Energy Resources, Inc. Capital Budgeting Within a Multi-Divisional Firm

Presenters in order: Ng Wenying Nguyen Huong Duong (Tony) Sim Siang Huat (Ronald) Oon Zhi Xiang (Wayne) Ong Sheng Yuan (Gabriel)

WHO ARE WE Janet Mortensen (SVP of Project Finance) of Midland Energy Resources, Inc., Advisor to CFO

WHAT IS THE OBJECTIVE OF THIS CASE Recommend WACC for Corporate & Divisions

Approach Step 1: Understand operational characteristics Step 2: Understand how WACC is used Step 3: Compute Corporate WACC Step 4: Assess appropriateness of single hurdle rate Step 5: Compute division’s WACC - E&P - R&M - Petrochemical

Step 1: Understand operational characteristics Midland Energy Resources, Inc. Year 2006: Op Rev: US$248.5B; Op Income: US$42.2B

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Exploration & Production

Refining & Marketing

Petrochemical

Rev: US$22.4B | Income: US$12.6B

Rev: US$203B | Income: US$4.0B

Rev: US$23.2B | Income: US$2.1B

Extracting Oil & Natural Gas Most profitable business Net margin highest amongst industry Production has been increasing Trends: • Rising global demand • Demand for non-traditional sources also increasing • Oil price at historical high prompting more investment  Higher capital spending

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Owns 40 refineries & distills oil Business with largest Revenue Revenue decreasing slightly Margins are low But still a Market leader due to tech advancement & vertical integration Trends: - Stiffer competition  Declining margins - Difficult to obtain approvals  little investment opportunities (low capital spending) - In longer term, global shortage in refining capacity

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Produces chemical products Smallest division Trends: - Facilities are old  Requires capital spending on replacement - Most investment will be outside US in the form of JV

Step 2: Understand how WACC is used

It is used in Asset appraisal, Capital budgeting, Performance assessment, M&A and Stock repurchasing decision making.

Step 3: Compute Corporate WACC

1

2

Step 3: Compute Corporate WACC 1

Weighted cost of debt

2

Weighted cost of equity

WACC

= weighted cost of debt + weighted cost of equity = 1.59% + 6.306% = 7.896 %

Step 4: Assess appropriateness of Single hurdle rate Evaluating Investment Opportunities

Which is the road most used by firms?

1. Single Corporate Hurdle Rate

2. Multiple Risk-adjusted discount rates 3. Specific Discount rates for individual projects

Step 4: Assess appropriateness of Single hurdle rate Allocating Capital Among a Firm’s Divisions: Hurdle rates versus budgets

Step 4: Assess appropriateness of Single hurdle rate Capital Budgeting Practices in Singapore - Singapore Management Review (2011)

• Survey questionnaires, 211 CEOs, 266 firms listed in SGX. • Exclude companies not registered in Singapore • Exclude companies registered in Singapore, head offices

overseas. • To improve response rate, 2 mailings were done at different timings.

Step 4: Assess appropriateness of Single hurdle rate Capital Budgeting Practices in Singapore - Singapore Management Review (2011)

54 Survey Responses • 4 Construction firms (7.4%) • 4 Hotels (7.4%) • 16 Manufacturing (29.6%) • 3 Property (5.6%)

• 3 Retail/ wholesale (5.5%) • 1 Finance (1.9%) • 23 firms in other or multiple lines of business (42.6%)

Step 4: Assess appropriateness of Single hurdle rate Capital Budgeting Practices in Singapore - Singapore Management Review (2011)

Extract:

Step 4: Assess appropriateness of Single hurdle rate The Engineering Economist Volume 48 No.4 - “Divisional Cost of Capital: A Study of its Use by Major US Firms” by Stanley Block

Step 4: Assess appropriateness of Single hurdle rate Business Horizons 2001 “The Trouble with Divisional Hurdle Rates” by Thode, Stephen F.

“All operating risk factors may be unique to each division so that the conglomerate firm may be viewed as a portfolio of individual divisions. Each division contributes to the overall business risk of the firm in the same way that individual securities contribute to the systematic risk of a portfolio of securities.”

Step 4: Assess appropriateness of Single hurdle rate Recommendation for Midland

Large projects, new products Central Investment Committee or Board of directors. Financing decisions for resources allocation among divisions

 Single corporate hurdle rate.

Investment decisions 1) Multiple risk-adjusted discount rates 2) Specific discount rates for individual projects

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

2. Refining & Marketing (R&M)

3. Petrochemical

Compute separate cost of capital WACC =Rd(D/V)(1-t) + Re(E/V) Exploration & Production

Marketing & Refining

Spread to Treasury

1.6%

1.8%

Debt / Value (Table 1)

46%

31%

Equity / Value

54%

69%

4.66%

4.66%

Tax rate calculated from Step 2

40%

40%

Equity Beta (exhibit 5)

1.15

1.2

5%

5%

10 year yield for Treasury Bonds

EMRP

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

1

2. Refining & Marketing (R&M)

For Exploration & Production Cost of debt, Rd(D/V)(1-t) = (Spread + Yield for Treasury Bonds) *(D/V) *(1-t) = (1.6%+4.66%) * 46% * (1-40%) =1.73%

Cost of equity, Re(E/V) = {Rf+β(EMRP)} * (E/V) = (4.66% + 1.15 * 5%) * 54% = 5.62% Cost for E&P = 1.73% + 5.62% = 7.35%

3. Petrochemical

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

2

2. Refining & Marketing (R&M)

For Refining & Marketing Cost of debt, Rd(D/V)(1-t) = (Spread + Yield for Treasury Bonds) *(D/V) *(1-t) = (1.8%+4.66%) * 31% * (1-40%) = 1.20%

Cost of equity, Re(E/V) = {Rf+β(EMRP)} * (E/V) = (4.66% + 1.2 * 5%) * 69% = 7.36% Cost for R&M = 1.20% + 7.36% = 8.56%

3. Petrochemical

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

2. Refining & Marketing (R&M)

3. Petrochemical

Why are cost of capital for Exploration & Production and Refining & Marketing Divisions different? •

Debt/Value: Exploration & Production has higher debt/value ratio (46% compared to 31% for Refining & Marketing). Possibly, because Exploration & Production has higher margin than Refining & Marketing. Hence, financial communities are more willing to lend money.

•

Rd: Spread over treasury is higher for Refining & Marketing than Exploration & Production. Reason is because Refining & Marketing has a lower credit rating (BBB) compared to Exploration & Production (A+)

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

2. Refining & Marketing (R&M)

WACCPetrochemicals = rd(D/V)(1-t) + re (E/V) where rd = cost of debt re = cost of equity D = Market value of debt E = Market value of equity V = Total assets of the company or division = D + E t = tax rate

3. Petrochemical

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

rd

2. Refining & Marketing (R&M)

3. Petrochemical

Cost of debt, rd = risk- free rate, rf + spread to Treasury for the Petrochemicals Division Since we are provided the 1 Year, 10 Year and 30 Year yields to maturity for US Treasury bonds, which one would be the most appropriate risk-free rate?

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

rf

2. Refining & Marketing (R&M)

3. Petrochemical

In determining the most appropriate risk-free rate to be used for the Petrochemicals Division, we will need to consider the useful life of the assets replaced during the asset replacement process. • The Petrochemicals Division is primarily involved in

manufacturing and research activities, where the assets involved have an medium-term useful life (Average 10 years) • They are also involved in capital spending projects such as replacement of

facilities which generate cash flows over a long period • Therefore, the 10-year rate shall be used.

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

rd

2. Refining & Marketing (R&M)

3. Petrochemical

Cost of debt, rd = risk- free rate, rf + spread to Treasury for the Petrochemicals = 4.66% (10-Year Treasury bond) + 1.35% = 6.01%

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

re

2. Refining & Marketing (R&M)

3. Petrochemical

Cost of equity, re = risk- free rate, rf (10-Year Treasury bond) + β(EMRP) Where β= equity beta for the Petrochemicals Division EMRP = equity market risk premium The key to calculating the cost of equity, re is to evaluate the equity beta of the Petrochemicals Division.

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

β

2. Refining & Marketing (R&M)

3. Petrochemical

In order to evaluate the equity beta of the Petrochemicals Division, we need to: • Obtain the unlevered beta of Midland Energy and the other 2 divisions, the E&P

Division and the R&M division. • The unlevered beta of Midland Energy Resources is the weighted average of the

unlevered beta of the three divisions

where w1= E&P earnings/ Total earnings w2= R&M earnings/ Total earnings w3= Petrochemicals earnings / Total earnings

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

β

2. Refining & Marketing (R&M)

3. Petrochemical

We need to use unlevered beta for the following reasons: • All the Divisions have never been publicly traded before, thus we need the

unlevered beta of these divisions to estimate the equity beta of the Petrochemicals Division • This will mean using the pure play method, which involves determining the

average unlevered beta of many similar companies in the same industry to use as a reference. This has been done in the case study for the E&Pindustry and the R&Mindustry.

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

β

2. Refining & Marketing (R&M)

3. Petrochemical

• Furthermore, as we are calculating the cost of equity, re, using unlevered

beta allows us to remove the impact of debt on the beta. • Lastly, once we obtain the unlevered beta of the Petrochemicals Division,

we will re-lever the beta to add back the financial risk as we have been provided with the debt-equity ratio of the Petrochemicals Division in the case study.

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

β

2. Refining & Marketing (R&M)

3. Petrochemical

• Obtain unlevered beta of Midland Energy, E & P Division and R & M

Division using Hamada’s Equation. • Calculate the weightage of the divisions, using total earnings of each

division as a ratio of Midland Energy’s total earnings. • Once the unlevered beta of the Petrochemicals Division has been

obtained, re-lever it using the debt equity ratio of the Petrochemicals Division

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

β re

2. Refining & Marketing (R&M)

3. Petrochemical

Equity βPetrochemicals = 0.6 *[1 + (1-0.4)* 0.667] = 0.840

Cost of equity, re , for the Petrochemicals Division = rf + β(EMRP) = 4.66% + 0.840 (5%) = 8.86%

Step 5: Compute Divisions’ WACC 1. Exploration & Production (E&P)

2. Refining & Marketing (R&M)

WACCPetrochemicals = rd(D/V)(1-t) + re (E/V) = 6.01% (0.4)(1-0.4) + 8.86% (0.6) = 6.76%

3. Petrochemical...