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- 1. Case 3: Midland Team 3 – Christie Apodaca, Mit Bhatt, Tagan Blake Background Midland is a global energy company with operating divisions in oil and gas exploration and production (E&P),refining and marketing (R&M),and petrochemicals. Exploration and production is involvedin oil and gas exploration, development and production and is Midland’s most profitable business. With revenue of $22.4 billion and NOPATof 12.6 billion, E&P’s net margin is one of the highest in the industry. The Refining and Marketing division is involvedwith refining oil & gas for the automotive gasoline market. R&M is Midland’s largest business measured by revenue of $203 billion, however, due to it’s heavy commoditization,after tax earnings yield only $4 billion. The Petrochemicalsdivision produces chemical products such as polyethylene, polypropylene,and lubricant additives. Petrochemicals is Midland’s smallest division with revenue of $23.2 billion and net profitof $2.1 billion. Industry trends impacted divisions individually. For instance, with oil prices on the rise in 2007, opportunities in E&P lend themselves to more attractivecapital investments. E&P anticipates to exceed $8 billion in capital spending by 2008--projects that include new property purchases, production expansion, and extraction technology improvements. In contrast, within the R&M sector, despite high prices, gasoline is highly commoditized resulting in their razor thin margins. With R&M’s decline in margin forover 20 years, investing in new refineries or expanding existing ones has proven difficultto justify. Lastly, in the Petrochemicaldivision growth is projected in the future and therefore older facilities will be divested or sold and replaced by newer, withmore efficientcapacity. Cost of Capital Mortensen’s estimates of Midland’s cost of capital are used for internal analysis, asset appraisals for capital budgeting and financial accounting, assessing performance, mergers and acquisitions, and stockrepurchase decisions. The appropriate WACC - enterprise versus divisional - varies among these uses. M&A, performance assessment, and projectinvestment decisions should all use divisional cost of capital since these decisions reflectdivision-specific performance relative to the market. However,a major M&A affectingmultiple divisions might use the corporate WACC. Likewise, a share repurchase and an accounting calculationaffectthe overall corporate balance sheet and so should use the corporate WACC. When applying cost of capital to a particular division, debt is computed forby incorporating a division-specific premium overUS Treasury securities with like maturity. This spread to treasure premium is affectedby division operating cash flows,asset values, and and market credit conditions. Midland may wish to adjust its debt cost of capital estimate depending on the timeframe being examined. For example, short term projects and compensation measures may use
- 2. a short-term cost-of debt based on shorter Treasury maturities. Based on such distinctions, Midland should publish its WACC calculations internally together withguidelines for use to help ensure users are properly applying the correctrate. Midland’s Enterprise Weighted Average Cost of Capital Midland’s corporate weighted average cost of capital (WACC) is determined by incorporating all business segments and applying the followingformula: 𝑊𝐴𝐶𝐶 = 𝑟_𝑑𝑒𝑏𝑡 (1 − 𝜏)𝐷/𝑉 + 𝑟_𝑒𝑞𝑢𝑖𝑡𝑦 𝐸/𝑉 Debt Costof Capital First weconsider the debt side of the equation. Although we observe from Table 1 of the case that Midland’s three different business segments have varied credit ratings, we also observe that Midland’s consolidated business units have been rated A+ by Standard & Poor. This is reasonable given the Exploration & Productiondivision’s extraordinary profitability and its A+ rating and the even higher credit rating of the Petrochemicals division (AA-). With a spread to treasury of 1.62% we add the 10-year yield to maturity rate forU.S. Treasury bonds (4.66% per Case Table 2) to obtain a cost of debt of 6.28%. Case Table 1 also gives us Midland’s consolidated debt to value ratio of 42.2%. Our final debt variable, tax rate, is calculated by dividing 2006 taxes by income before taxes. This calculation determines a 38.58% tax rate. Equity Cost of Capital Our rate of equity is determined by the Capital Asset Pricing Model (CAPM). This model estimates the opportunity cost of capital based on a risk-adjusted equity market risk premium (EMRP): 𝑟_𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑖𝑠𝑘− 𝐹𝑟𝑒𝑒 𝑅𝑎𝑡𝑒 + 𝛽_(𝑒𝑞𝑢𝑖𝑡𝑦 ) × 𝐸𝑀𝑅𝑃 Where the EMRP represents the rate of return expected to exceed the risk-free return over a specified period. For the risk-free market rate of return, we used the 10-year U.S. Treasury bond interest rate: 4.66%. Midland’s previously calculatedcorporate beta and EMRP are 1.25 and 5.00% respectively. Considering Exhibit 6A and B values weare confident that Midland’s use of a 5.00% EMRP is appropriate. The 5.00% reflects a balance between forward-lookingEMRP values in Exhibit 6B, averaging about 3.3%, and the recent investment experience of the last 20 years (Exhibit 6A), which provided excess yields of 6.4%. From Exhibit 6A, the long range average (1798 to 2006) presents a 5.1% excess return along withthe smallest standard error, and is in line with Midland’s estimate.
- 3. With Exhibit 6B, expert opinion surveys likely provide higher weight to short-term expectations, whichcan experience more fluctuations. For instance, monetary policy and business cyclecan drive excess return rates down in the short-term. Such low rates may not be appropriate for a longer term investment forecast. For further confirmation, we also calculated EMRP using Historical Average Realized Return. Here we averaged historic differencebetween returns on equity market index and returns on government debt. We used S&P 500 index from 1928-2006 and calculated premium using arithmetic average approach, which came out to be 6.57%. We compared ranges of the past 50 years and 10 years in order to incorporate new market realities. EMRP forthe last 50 years and 10 years came out to be 5.13% and 3.54% respectively as shown in Table 1 below. Table1:ERMP Calculation using Historical Average Realized Return Range S&P 500 Return Average (A) 10-year T. Bond Average (B) EMRP Arithmetic Average (A-B) Std. Error 1928-2006 11.77% 5.20% 6.57% 2.33% 1957-2006 11.82% 6.68% 5.13% 2.51% 1997-2006 9.90% 6.37% 3.54% 7.30% Data obtained from: http://pages.stern.nyu.edu/~adamodar/ One limitation of historical average realized return approach is that it does not always take into accountnew market realities. Due to this factwe decided to calculate implied risk premium that takes a forwardlooking approach using stockprices and expected cash flow in the future. For this we utilized online tools provided by NYU’sProfessor Damodaran. Table 2 presents our calculation inputs while Table 3 presents resulting figures. The implied risk premium for the next 5 years was determined to be 5.01%, also in line with Midland’s estimation. Table2:Inputs to calculate implied risk premium Implied Risk Premium Calculator Enter current level of index 1418.3 Cash yield on index (Calculated number) 4.90% Enter expected growth rate in earnings for next 5 years for market 4.16% Enter current long term bond rate 4.70% Enter risk premium 5.00% Enter expected growth rate in the long term = 4.70% Dividends and Buybacks (10-year average) 69.46 Data obtained from: http://pages.stern.nyu.edu/~adamodar/
- 4. Table3:Calculation of implied risk premium using Solver function Implied Risk Premium Implied Risk Premium in current level of Index = 5.01% 1 2 3 4 5 Expected Dividends = $72.35 $75.36 $78.49 $81.76 $85.16 Expected Terminal Value = $1,780.39 Present Value = $65.95 $62.61 $59.45 $56.44 $1,173.86 Intrinsic Value of Index = $1,418.30 Data obtained from: http://pages.stern.nyu.edu/~adamodar/ Based on these various approaches, we confirmed it was appropriate to maintain Midland’s calculated EMRP of 5.00%. Given these variables the rate of equity is calculatedto be 10.91%. Completing the equity side of the equation we determine an equity to value ratio to be one minus the debt to value ratio. Given wedetermine earlier a debt to value ratio of 42.2%, our equity to value ratio is 57.8%. This ratio is also confirmedby utilizing Midland’s actual equity market value and solving forvalue using debt with the debt to value ratio. With all variables input Midland’s corporate WACC is determined to be 7.93%. Table4:Midland’s Enterprise Costs of Capital Debt cost of capital (rdebt) 6.28% Equity cost of capital (requity ) 10.91% Weighted-average cost of capital 7.93% Divisional Hurdle Rate We advise Midland to use a corporate hurdle rate together with individualized divisional hurdle rates. For investments that support the wholebusiness, such as a M&A impacting all divisions or an operational investment that supports the overallenterprise, utilizing the corporate WACC of 7.93% as their hurdle rate is the appropriate. However,when faced with division-specific investment decisions, divisional hurdle rates allows Midland to be more realistic in their evaluations. Divisional hurdle rates can help prevent Midland from skewing its risk profile over time due to an inflated NPVof higher risk projects. Utilizing a single hurdle rate across different divisions and investment decisions wouldbias investment toward riskier divisions and increase the systemic (market-correlated) risk of the company over time. With individualized divisional hurdle rates, alignment of Midland’s overall risk level is advised to maintain their target risk profile. Distinct divisional hurdle rates also allows formore
- 5. accurate benchmarking against peers and thus are more appropriate to assess divisional investments and compensation. Midland’s Divisional WACCs The divisional WACCs are calculated in the same way as the corporate WACC. The debt cost of capital uses the synthetic credit rating to determine the risk spread over the risk-free rate (4.66%). The equity cost of capital utilizes the same EMRP (5.00%) and risk-free rate, however,requires an estimate of a distinct divisional beta. Finally, we need an allocationof debt and enterprise value to the divisions to determine the debt to value ratio. Thus, to determine the divisional WACCs, we need to determine three inputs: the risk spread to Treasuries, the divisional beta, and the debt to value ratio. We determine the allocation of debt tothe various divisions by their three year average investment share, since debt is primarily used to fund investment. The allocation of enterprise value to each division is based on the division’s three year average net income contribution share. Based on this approach, the debt to value ratio fordivisions were calculated and are shown in Table 5 below. E&P’s debt to value ratio of 49.80% reflects its higher contribution to Midland’s leverage. Table5:Divisional Debt to Value Ratios Division Debt to Value Ratio Exploration & Production 49.80% Refining & Marketing 33.62% Petrochemicals 14.60% Exploration & Production WACC Per Case Table 1, Exploration& Production’s synthetic credit rating is A+, corresponding to a risk spread of 1.60%. Therefore, the E&P debt cost of capital is 6.26% whichis slightly lower than the enterprise rate. Divisional beta forE&P is calculated from peer data in Exhibit 5 where betas of the four peers range from 0.89 to 1.39. Given the small sample size, we determine to use a median value of 1.16 for use as E&P’s beta. Given corresponding inputs, E&P’s equity cost of capital is 10.46%, lower than the enterprise rate. Finally, divisional WACC forE&P,including the interest-tax shield adjustment is calculated below. We note that E&P’sWACC of 7.17% is a lowerrate than the corporate WACC of 7.93%. 𝑊𝐴𝐶𝐶 = 𝑟_𝑑𝑒𝑏𝑡 (1 − 𝜏)𝐷/𝑉 + 𝑟_𝑒𝑞𝑢𝑖𝑡𝑦 𝐸/𝑉 WACCE&P = 6.26% x (1 - 38.58%) x 49.80% + 10.46% x (1 - 49.80%) = 7.17%.
- 6. Table6:Exploration & Production’sCosts of Capital Debt cost of capital (rdebt) 6.26% Equity cost of capital (requity ) 10.46% Weighted-average cost of capital 7.17% Refining & Marketing WACC The WACC calculationfor the Refining & Marketing division followsthe same approach. The debt risk spread in this case is 1.80%, reflecting the division’s lowersynthetic credit rating of BBB. This gives a cost of debt of 6.46%, excluding tax effects. For bata, again, we used the median of peer companies to calculatea bottom-up beta thereby diminishing the effectsof the heavy outliers. Based on the sample size of seven, the median beta is 1.25 whichmatches Midland’s corporate beta. Utilizing this beta, the equity costof capital, just as the corporate equity costof capital, is 10.91%. Based on the debt to value ratio of 33.62% calculated above,the WACCM&R calculation is as follows. We note that the resulting marketing and refining WACC of 8.58% is greater than the corporate WACC of 7.93%. WACCE&P = 6.46% x (1 - 38.58%) x 33.62% + 10.91% x (1 - 33.62%) = 8.58%. Table7:Refining & Marketing Costs of Capital Debt cost of capital (rdebt) 6.46% Equity cost of capital (requity ) 10.91% Weighted-average cost of capital 8.58% Petrochemical WACC There are twooptions to obtain the Petrochemicaldivision’s WACC: 1. Use the factthat the enterprise WACC is the weighted average of the divisions’ WACCs. Since we have the enterprise, Exploration & Production, and Refining & Marketing WACCs, we can infer the Petrochemical division’s WACC. 2. Use a bottom-up estimate using a group of peer companies. To infer betapetrochemical, weuse the followingequation to solve for betapetrochemical. 𝛽_𝑀𝑖𝑑𝑙𝑎𝑛𝑑 = ∑_𝑖 𝑥_𝑖 𝛽_𝑖 ∀𝑖 ∈ 𝑑𝑖𝑣𝑖𝑠𝑖𝑜𝑛𝑠, 𝑤ℎ𝑒𝑟𝑒 𝑥_𝑖 = 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑖^′ 𝑠 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 As discussed in the previous section, we used the three year average net income contribution of each division to determine the relative proportions of enterprise value for each. These values are shown in Table 8 below.
- 7. Table8:Enterprise Value Allocation by Division Division Share of Enterprise Value Exploration & Production 66.59% Refining & Marketing 21.90% Petrochemicals 11.51% betapetrochemical = x-1petrochemicals x (xMidland∙betaMidland - xE&P∙ betaE&P - xR&M∙ betaR&M) betapetrochemical = (232,031 x 0.1151)-1 x 232,031(1.25 - 0.6659 x 1.16 - 0.2190 x 1.25) Betapetrochemical = 1.78 This first approach suggests a relatively high beta of 1.78. For the second option, we can use the same approach as we used forthe Exploration & Production and Refining and Marketing WACCs. The cost of debt is available using the synthetic credit rating. Per Table 1 in the Case, the synthetic credit rating is AA-. According to Table 1 in the Case, this corresponds to an interest rate spread of 1.35%. Based on the risk-free rate of 4.66, this corresponds to a cost of debt of 6.01%. The cost of equity uses the CAPM-based approach. The EMRP is the same:5.00%. Likewise,the risk- free rate of return is same: 4.66%. All that remains is to obtain an estimate of the Petrochemical division’s beta using the bottom-up approach. We evaluated the five peers in Table 9 to obtain an estimate of betapetrochemicals. These peers were selected fortheir size, concentration in chemicals and petrochemicals, and high international exposure. Since historical betas were not available, we used Morningstar’s current betas (April 2016) and calculated an unlevered beta foreach firm as follows: betaunlevered = betalevered / (1 + (1 - �) x D/E)1 Table 9: Peer Petrochemical Companies2 Company Revenue (2007 $M) Credit Rating (S&P) Debt to Equity Ratio Effective Tax Rate Levered Beta* Unlevered Beta BASF 57,951 A 0.36 0.38 1.19 0.97 Dow Chemical 53,513 BBB 0.39 0.29 1.31 1.03 Dupont 29,378 A- 0.55 0.20 1.85 1.28 1 Assumes debt has a beta equal to zero. 2 Note that we used current data which is not necessarily directly comparable with 2007 data but was more easily available.
- 8. Mitsui Chemicals 15,208 A 0.54 0.32 -0.13 -0.10 Sumitomo Chemical 16,126 A- 0.51 0.36 0.57 0.43 Median - - - - 1.19 0.97 *Morningstar April 2016 Based on the average of the unlevered betas, weobtained a median beta of 0.97 for the Petrochemicaldivision, much lowerthan the implied beta of 1.78 from the first method. Finally, it is possible to estimate the equity cost of capital using CAPM and both betas: Equity Cost of Capital = Risk-Free Rate + Betaequity x EMRP 1st approach: 4.66% + 1.78 x 5.00% = 13.56% 2nd approach: 4.66% + 0.97 x 5.00% = 9.51% Using the first approach and a debt to value ratio of 14.60%, the WACC is 12.12%. Using the second approach, the WACC would be 8.66%. While the first approach has the advantage of internal consistency, the second approach has the advantage of a more realistic assessment of the beta using the bottom-up estimation approach. Therefore, the lower 8.66% WACC for the Petrochemicals division is our preferred value. Based on the 0.97 beta calculated forthe Petrochemicalsdivision, we can also propose a revised enterprise beta and WACC. betaenterprise = x1(beta1) + x2(beta2) + x3(beta3) = 0.6659 x 1.16 + 0.2190 x 1.25 + 0.1151 x 0.97 = 1.16 This implies a recalculated cost of equity of 10.45% and a revised WACCenterprise of 7.67%. The corporate and divisional costs of capital are shown in the table below.