Midland Energy Resources

MIDLAND ENERGY RESOURCES, INC.

DONALD L PALMAFINC 430.01

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

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

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

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

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

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?

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

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= rƒ+β*(EMRP) (EQUITY MARKET RISK PREMIUM)• (E/V)= PERCENT OF FINANCING THAT IS EQUITY

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

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

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%

• rƒ+β(EMRP)

• rƒ= 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%

VALUES USED FOR COST OF DEBT

FIRM WIDE WACC INPUT: TAX

• TAX RATE: 39.7%• AVERAGE OF 2004, 2005, 2006

TAX RATE • TAX RATE= INCOME TAX/INCOME

BEFORE TAXES

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%

E&P, R&M, AND PETROCHEMICALS WACC

DIVISION BETAS

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%

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%

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

PETROCHEMICAL WACC

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

• 6.14%

MIDLAND ENERGY RESOURCES WACC’S

• WHOLE FIRM: 8.13%• E&P: 8.06%• R&M: 9.02%• PETROCHEMICAL: 6.14%

• 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