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    Midland Energy Group A5

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    Deepesh Moolchandani
    Midland Energy Resources operates in oil and gas exploration, refining, and petrochemicals. To meet its financial goals, it must estimate the cost of capital for each segment. [1] The asset betas were estimated using comparable public companies' debt ratios and equity betas. Exploration and production had the highest asset beta of 0.84, while petrochemicals was lowest at -0.07. [2] The risk-free rate was set at 4.66% based on long-term US treasury bonds. The market risk premium was estimated between 2-4.7% based on historical US stock returns. [3] Using the same cost of capital for all segments could misvalue projects, as

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    Midland Energy Group A5

    Uploaded by

    Deepesh Moolchandani
    767 views3 pages
    Midland Energy Resources operates in oil and gas exploration, refining, and petrochemicals. To meet its financial goals, it must estimate the cost of capital for each segment. [1] The asset betas were estimated using comparable public companies' debt ratios and equity betas. Exploration and production had the highest asset beta of 0.84, while petrochemicals was lowest at -0.07. [2] The risk-free rate was set at 4.66% based on long-term US treasury bonds. The market risk premium was estimated between 2-4.7% based on historical US stock returns. [3] Using the same cost of capital for all segments could misvalue projects, as

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    Midland Energy Resources operates in oil and gas exploration, refining, and petrochemicals. To meet its financial goals, it must estimate the cost of capital for each segment. [1] The asset betas were estimated using comparable public companies' debt ratios and equity betas. Exploration and production had the highest asset beta of 0.84, while petrochemicals was lowest at -0.07. [2] The risk-free rate was set at 4.66% based on long-term US treasury bonds. The market risk premium was estimated between 2-4.7% based on historical US stock returns. [3] Using the same cost of capital for all segments could misvalue projects, as

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    767 views3 pages

    Midland Energy Group A5

    Uploaded by

    Deepesh Moolchandani
    Midland Energy Resources operates in oil and gas exploration, refining, and petrochemicals. To meet its financial goals, it must estimate the cost of capital for each segment. [1] The asset betas were estimated using comparable public companies' debt ratios and equity betas. Exploration and production had the highest asset beta of 0.84, while petrochemicals was lowest at -0.07. [2] The risk-free rate was set at 4.66% based on long-term US treasury bonds. The market risk premium was estimated between 2-4.7% based on historical US stock returns. [3] Using the same cost of capital for all segments could misvalue projects, as

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    © All Rights Reserved
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    At a glance
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    Midland is a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. Its most profitable segment is E&P, which produces 67% of net income.

    Midland's three main business segments are E&P, R&M, and petrochemicals. E&P is the most profitable, producing 67% of net income. R&M faces stiff competition and petrochemicals is the smallest segment.

    The team estimated asset betas by calculating unlevered betas of comparable public companies for each segment. They then levered the asset betas based on the target debt-to-equity ratios for each segment.

    Name Aditya Kumar Abhijit Saurav Deepesh Moolchandani Harshita Gangrade Zahra Khan Group

    PG ID 61810168 61811007 61810805 61810743 61810698 A5

    1. Introduction

    Midland Energy Resources, is a global energy company with operations in oil and gas exploration and production (E&P),
    refining and marketing (R&M), and petrochemicals. The company was incorporated over 120 years ago, and in 2007 had
    more than 80,000 employees. Midlands most profitable business segment is E&P division which produces 67% of the
    companys net income, its net margin over the previous 5 years were among the highest in the industry. The R&M division
    has highly commoditized products and it faced stiff competition while Petrochemical division is the smallest with a profit
    after tax of $2.1 Billion.

    Problem Statement
    The primary purpose of this case is to help Midland meet the 4 pillars of its financial strategy - to fund significant
    overseas growth, invest in value-creating Investments, optimize capital structure and repurchase its undervalued
    shares. In order to accomplish these goals, Midland Energy Resources must effectively estimate the annual cost of
    capital for each of its business segments. The estimates of cost of capital were used by Midland in many analyses, to
    aid strategy decisions. For instance, in evaluating value-adding investments, Midland used discounted cash flow
    methodologies to evaluate most prospective investments or when deciding when and how to repurchase shares, Midland
    would estimate the intrinsic value of its shares, using DCF analysis.

    2. Estimate the asset betas for each of Midland's three businesses


    The betas for Midlands different divisions were not observable because they were not traded in the securities
    individually. However, to estimate betas for the different divisions we can use data of betas for comparable public traded
    companies. Exhibit 5 gives a list of such traded companies. As the D/E ratios for different divisions given in Table-1 is
    an estimated value and can change hence we take average of unlevered A. The equity betas E for the given companies
    are unlevered based on the D/E ratio to calculate respective A (Asset beta). The assumptions are that D for the companies
    is approximately zero (Low risk of default has been assumed due to stability of the firms debts) and the taxes are zero.

    A = E/(1+(D/E))

    The average of the A of the companies in each segment is taken to calculate respective asset betas A for Exploration &
    Production and Refining divisions. The Midland energy resources equity beta E is unlevered to calculate A which is then
    used to calculate the asset beta for the third division, petrochemical, by using the following correlations:

    The results for the beta asset values has been summarized below. Refer Exhibit 1 for calcs-
    Business Segment: Debt/ Equity/ Target Debt/ Asset/ Asset Beta Desired Equity Beta
    Value Value Equity total Assets

    Consolidated 42.20% 57.80% 0.73 1 0.79 1.36

    1|Page
    Exploration & Production 46.00% 54.00% 0.85 0.53 0.84 1.56

    Refining & Marketing 31.00% 69.00% 0.45 0.36 0.98 1.41

    Petrochemicals 40.00% 60.00% 0.67 0.11 -0.07 -0.12

    The respective asset betas are levered again by taking into account the target D/E estimates given in Table 1 of the case
    which have been tabulated above. The desired equity betas are calculated by using the following formula
    E = (1+(D/E)) A

    3. Risk-free rate and market risk-premium for estimating the discount rate\

    Referring to Exhibit 6 the US stock returns minus treasury bond yields varies depending on the period in consideration.
    The company is in existence since last 120 years hence we should be taking data for 1900-2006 which is 6.8%. However,
    the survey result portrays a conservative risk premium which lies between 2-4.7%. Hence the value must lie between these
    two estimates. This value is much closer to average excess return on US equities for 1798-2006 which is 5.1%.
    As the projects in the company are long term and explicit forecast for the cash flow is not known hence the Rf value is
    4.66%.

    4. Effects of the same cost of capital to discount cash-flows for all projects over time on:

    Midland as large enterprise has diverse business units with different risks. The beta value calculated for each division
    represents the risk for each division. In Exhibit 1 the required returns are calculated using CAPM model. If the cost of
    capital to discount cash flow is same for all the projects, then evaluations of investment can be misleading.

    The relative mix of the three business segments in Midland's operations


    Midland as large enterprise has diverse business units with different risks. The beta value calculated for each
    division represents the risk for each division. In Exhibit 1 the required returns are calculated using CAPM model.
    If the cost of capital to discount cash flow is same for all the projects, then evaluations of investment can be
    misleading. There would be equal investments in all three segments, and all would have the same returns and same
    risks. Therefore, Midland would end up investing more in the risky segments such as Exploration and Production
    and Refining and Marketing and less in less risky segments such as Petrochemicals. Therefore, the mix would be
    riskier.

    The market value of Midland's assets


    Midlands current market value of assets is 130,168.61 and this overall market value is likely to go down as
    the company has diversified businesses, market value will be higher for a few assets and lower for some. So
    taking the same cost of capital will overvalue R&M and undervalue E&M. While the Asset beta for the
    petrochemicals business is negative, i.e. less than 0, which would indicate an inverse relation to the market. This
    will lead to poor overall investment decisions, bringing the profitability down eventually.

    Please Note: We have Ignored all taxes, any capital structure issues and have not discussed WACC.

    2|Page
    Exhibit 1

    3|Page

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