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