Midland Energy Resources
Autor: Yijing Kelly Pan • December 4, 2015 • Case Study • 2,275 Words (10 Pages) • 1,316 Views
Case Background
Midland Energy Resources, Inc. is a global energy company with three business segments: Exploration and Production (E&P), refining and marketing (R&M), and petrochemicals. These three segments are exposed to different risk factors and vary a lot in their profitability, business scale and outlook for future development. In order to realize the Midland’s financial strategy, Mortensen, Midland’s senior vice president of project finance was assigned to estimate its cost of capital.
Characteristics of Divisions
The case depicts the characteristics of Midland’s three business divisions with the following information:
Midland Energy Resources, Inc. | ||
Exploration & Production | Refining and Marketing | Petrochemicals |
Rev $22.4B, NI $12.6B -Most profitable business -Rising demand due to global population and economic growth -Risks arise from nontraditional sources and shifted geographic composition of output -Expected capital spending is high | Rev $203B, NI $4.0B -Largest revenue but very low margin -Margins are shrinking; approvals to build refinery is difficult to obtained -Expected capital spending would remain stable in near future -In the long run, there may be a shortage of refining capacity | Rev $23.2B, NI $2.1B -Smallest division but a substantial business -Capital spending was expected to grow as old facilities were about to be replaced -New investment would be undertaken by joint ventures outside the US |
The uses of a single corporate cost of capital will be appropriate when performing project financial analysis only if the projects being evaluated are of the same average business risk. If the projects have a different risk compared to the company average, the calculations of WACC may be biased. For example, for a riskier acquisition project in E&P with unclear future, the company may need to adjust the cost of capital by including a higher beta. On the contrary, in appraisals for certain long-lived assets such as petrochemical facilities, cash flow should be of lower risk than the company average.
According to the summary above, we could clearly tell that the operating risk factors are unique to each division so that we should not use a single corporate hurdle rate. Instead, we should view Midland as a portfolio of these three divisions and each division contributes to the corporate business risk.
Likewise, different divisional hurdle rates should be used for ex post evaluation of the divisional managers. Since the performance of a division was measured based on “economic value added” (EVA), capital charge would be appropriate only if the hurdle rate reflect the varied systematic risk of each project. Given the fact that three divisions have different capital structure and risk exposure, we should use different cost of capitals accordingly. If we use a single corporate hurdle rate, the evaluation will be misleading and manager may misbehave to make up for their compensation.
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