This document provides background information on Midland Energy Resources, a global energy company with three business segments: oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. It then discusses the weighted average cost of capital (WACC) for the overall firm and each division. The WACC is 8.13% for the overall firm, 8.06% for E&P, 9.02% for R&M, and 6.14% for petrochemicals. Using a single WACC for the entire firm could lead to incorrect investment decisions, so the divisional WACCs should be used instead to identify the best opportunities.

1. MIDLAND ENERGY RESOURCES,
INC.
DONALD L PALMA
FINC 430.01

2. BACKGROUND
• GLOBAL ENEREGY COMPANY
• WENT PUBLIC AROUND 1886
• 2006 OPERATIONAL REVENUE: $203B
• 2006 OPERATIONAL INCOME:42.2B
• THREE SEGMENTS:
• OIL & GAS EXPLORATION AND PRODUCTION (E&P)
• REFINING AND MARKETING (R&M)
• PETROCHEMICALS

3. EXPLORATION & PRODUCTION (E&P)
• REVENUE: $22.4B
• AFTER TAX INCOME: $12.6B
• MOST PROFITABLE
• NET MARGIN AMONG HIGHEST IN THE INDUSTRY
• RISING GLOBAL DEMAND = PRODUCTION INCREASING
• HISTORICALLY HIGH OIL PRICES = MORE INVESTMENTS

4. REFINING & MARKETING (R&M)
• REVENUE: $203B
• AFTER TAX INCOME: $4.08B
• OVER 40 REFINERIES WORLDWIDE
• FIRM’S LARGEST REVENUE
• REVENUE IS DECREASING
• TOUGH COMPETITION = VERY LOW MARGINS
• LONG-TERM = REFINING CAPACITY DECLINING

5. PETROCHEMICAL
• REVENUE: $23.2B
• AFTER TAX INCOME: $2.1B
• PRODUCES DIFFERENT CHEMICALS AND LUBRICANTS
• SMALLEST DIVISION
• MOST INVESTMENTS OUTSIDE OF U.S. IN JOINT VENTURES

6. FINANCIAL AND INVESTMENT POLICIES
• GROW OVERSEAS:
• CONVERT FOREIGN CASH FLOWS
• INVEST IN VALUE-CREATING PROJECTS:
• PROJECT’S DISCOUNT CASH FLOWS
• OPTIMAL CAPITAL STRUCTURE:
• EVALUATE BORROWING
• REPURCHASE UNDERVALUED SHARES:
• VALUE COMPANY USING DCF AND APPROPRIATE DISCOUNT RATE

7. CURRENT SITUATION
• JANET MORTENSEN: SENIOR VP OF PROJECT FINANCE
• COST OF CAPITAL ANALYISIS:
• ASSETS APPRAISALS
• M&A PROPOSALS
• PERFORMANCE ASSESSMENTS
• FINANCIAL ACCOUNTING
• TASK: DETERMINE FIRM WACC & DIVISIONS WACC
• WHICH WACC SHOULD BE USED
• WHERE SHOULD THEY INVEST?

8. WACC
• WEIGHTED AVERAGE COST OF CAPITAL
• COST TO BORROW MONEY
• WEIGHTS ARE ON EACH FINANCING SOURCE
• USED TO FIND DISCOUNT RATE FOR A PROJECT
• COST OF FINANCING CAPITAL
• USED TO FIND DISCOUNT RATE IN DCF VALUATION MODEL

9. WACC FORMULA
• rd *(D/V)*(1-t)+re*(E/V)
• rd=COST OF DEBT (INTEREST EXPENSE)
• (D/V)=PERCENT OF FINANCING THAT IS DEBT
• (1-t)= INTEREST TAX SHIELD
• re =COST OF EQUITY (CAPITAL ASSET PRICING MODEL)
• CAPM= r +β*(EMRP) (EQUITY MARKET RISK PREMIUM)
• (E/V)= PERCENT OF FINANCING THAT IS EQUITY

10. BETA UNLEVERING/ASSET BETA
• UNLEVER THE BETA OF FIRM AND DIVISIONS
• REMOVES DEBT FROM COMPARISON OF RISK TO MARKET
• βU= βL /(1+(1-t)*D/E)
• βUMIDLAND=1.25(1+(1-39.7%)*59.3%)=.922
• βUE&P=.933
• βUR&M=1.049

11. TARGET EQUITY BETA
• USE THE D/E FROM THE (E/V)/(D/V)
• E/V=.578; D/V=.422; V=1 : SO D/E=.73
• βE= βu*(1+(1-t)*(D/E)
• βE=.922*(1+(1-39.7%)*.73)
• βEMIDLAND=1.33
• ΒEE&P=1.41
• βER&M=1.33

12. FIRM WIDE WACC INPUT: RD
• COST OF DEBT: 6.28%
• 1.62% = INTEREST RATE ON CURRENT DEBT: SPREAD TO TREASURY
• 4.66% = 10 YEAR ON US TREASURY BONDS
FIRM WIDE WACC INPUT: RE
• COST OF EQUITY: 11.30%
• r +β(EMRP)
• r = 4.66%: 10 YEAR ON US TREASURY BONDS
• β= 1.33
• EMRP=5%: EQUITY MARKET RISK PREMIUM
EQUITY MARKET RISK PREMIUM
• EXPECTED RETURN OF A BROAD PORTFOLIO OVER RISK-FREE RETURN
• WALL STREET ANALYST, ADVISORS: BANKERS & AUDITORS AGREED ON 5%

13. VALUES USED FOR COST OF DEBT

14. FIRM WIDE WACC INPUT: TAX
• TAX RATE: 39.7%
• AVERAGE OF 2004, 2005, 2006 TAX
RATE
• TAX RATE= INCOME TAX/INCOME
BEFORE TAXES

15. FIRM WIDE WACC
• rd *(D/V)*(1-t)+re*(E/V)
• 6.28%*42.2%*(1-.397)+(4.66%+(1.33%*5%)*57.8%) =
• 0.08127969
•8.13%

16. E&P, R&M, AND PETROCHEMICALS WACC

17. DIVISION BETAS

18. E&P AND R&M WACC
• E&P
• rd *(D/V)*(1-t)+re*(E/V)
• (.016+.0466)*46%*(1-.397) +(4.66%+(1.41*.05))*54%=
• 0.080622845
• 8.06%
• R&M
• rd *(D/V)*(1-t)+re*(E/V)
• (.018+.0466)*31%*(1-.397) +(4.66%+(1.33*.05))*69%=
• 0.090215226
•9.02%

19. E&P, R&M, AND PETROCHEMICALS WACC INPUTS
E&P R&M PETROCHEM
SPREAD TO
TREASURY
1.6% 1.8% 1.35%
10 YR RISK FREE 4.66% 4.66% 4.66%
(D/V) 46% 31% 40%
TAX RATE 39.7% 39.7% 39.7%
(E/V)=(1-D/V) 54% 69% 60%
DIVISION BETA 1.41 1.33 βPETROCHEMICAL
EMRP 5% 5% 5%

20. PETROCHEMICAL ΒETA
• βMIDLAND=βE&P*(E&P ASSET WEIGHT)+ βR&M *(R&M ASSET WEIGHT)+
βpetrochemical *(PETROCHEMICAL ASSET WEIGHT))
• .92=.93(.53)+1.05(.36)+βPETROCHEMICAL(.11)
• ASSET βPETROCHEMICAL = 0.452
• TARGET EQUITY βPETROCHEMICAL = ASSET βPETROCHEMICAL(1+(1-t)*D/E)
• = 0.452*(1+(1-.397)*.667)
• = 0.633

21. PETROCHEMICAL WACC
• rd *(D/V)*(1-t)+re*(E/V)
• .601*40%*(1-.397)+.783*60%
• 0.061445102
• 6.14%

22. MIDLAND ENERGY RESOURCES WACC’S
• WHOLE FIRM: 8.13%
• E&P: 8.06%
• R&M: 9.02%
• PETROCHEMICAL: 6.14%

23. • USING A SINGLE WACC CAN CAUSE TWO PROBLEMS:
• TYPE 1 ERROR: INVEST IN PROJECT THAT SEEMS TO HAVE
POSITIVE NPV BUT ACTUALLY ARE NEGATOIVE BEAUSE NPV
IS TOO LOW
• TYPE 2 ERRORS: REJECT A GOOD PROJECT BECAUSE WACC IS
TOO HIGH
• PETROCHEMICAL’S LOW WACC REPRESENTS A GROWTH
OPPORTUNITY
• E&P LOWER COC MAY BE BETTER USE OF LEVERAGE