Midland Energy Resources, Inc.: Cost of Capital
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T I M O T H Y A . L U E H R M A N
J O E L L . H E I L P R I N
Midland Energy Resources, Inc.: Cost of Capital
In late January 2007, Janet Mortensen, senior vice president of project finance for Midland Energy
Resources, was preparing her annual cost of capital estimates for Midland and each of its three
divisions. Midland was a global energy company with operations in oil and gas exploration and
production (E&P), refining and marketing (R&M), and petrochemicals. On a consolidated basis, the
firm had 2006 operating revenue and operating income of $248.5 billion and $42.2 billion,
espectively.
Estimates of the cost of capital were used in many analyses within Midland, including asset
appraisals for both capital budgeting and financial accounting, performance assessments, M&A
proposals, and stock repurchase decisions. Some of these analyses were performed at the division or
usiness unit level, while others were executed at the corporate level. Midland’s corporate treasury
staff had begun preparing annual cost of capital estimates for the corporation and each division in the
early 1980s. The estimates produced by treasury were often criticized, and Midland’s division
presidents and controllers sometimes challenged specific assumptions and inputs.
In 2002, Mortensen, then a senior analyst reporting to the CFO, was asked to estimate Midland’s
cost of capital in connection with a large proposed share repurchase. Six months later she was asked
to calculate corporate and divisional costs of capital that the executive and compensation committees
of the board could incorporate in planned performance evaluations. Since then, Mortensen had
undertaken a similar exercise each year and her estimates had become widely circulated de facto
standards in many analyses throughout the company, even ones in which they were not formally
equired. By 2007 Mortensen was aware that her calculations had become influential and she
devoted ever more time and care to their preparation. Lately she wondered whether they were
actually appropriate for all applications and she was considering appending a sort of “user’s guide”
to the 2007 set of calculations.
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For the exclusive use of D. Ghosh, 2020.
This document is authorized for use only by Devleena Ghosh in Behavioral Corporate Finance (Summer 2020) taught by DUCCIO MARTELLI, Universit?? degli Studi di Perugia from Jun 2020
to Aug 2020.
4129 | Midland Energy Resources, Inc.: Cost of Capital
2 BRIEFCASES | HARVARD BUSINESS SCHOOL
Midland’s Operations
Midland Energy Resources had been incorporated more than 120 years previously and in 2007
had more than 80,000 employees. Exhibits 1 and 2 present Midland’s most recent consolidated
financial statements. Exhibit 3 presents selected business segment data for the period XXXXXXXXXX.
Exploration & Production
Midland engaged in all phases of exploration, development, and production, though the last of
these, production, dominated the E&P division’s reported operating results. During 2006, Midland
extracted approximately 2.10 million ba
els of oil per day—a 6.3% increase over 2005 production—
and roughly 7.28 billion cubic feet of natural gas per day—an increase of slightly less than 1% over
2005. This represented $22.4 billion of revenue and after-tax earnings of $12.6 billion. E&P was
Midland’s most profitable business, and its net margin over the previous five years was among the
highest in the industry.
Midland expected continued global population and economic growth to result in rising demand
for its products for the foreseeable future. Nevertheless, the fraction of production coming from non-
traditional sources such as deepwater drilling, heavy oil recovery, liquefied natural gas (LNG), and
arctic technology was expected to increase. Further, the geographic composition of output was
shifting, marked by increases from places such as the Middle East, Central Asia, Russia, and West
Africa.
With oil prices at historic highs in early 2007, Midland anticipated continued heavy investment in
acquisitions of promising properties, in development of its proved undeveloped reserves, and in
expanding production. In particular, continued high prices underlay plans to boost investment in
sophisticated extraction methods that extended the lives of older fields and marginal properties.
Capital spending in E&P was expected to exceed $8 billion in 2007 and 2008.
Refining and Marketing
Midland had ownership interests in 40 refineries around the world with distillation capacity of 5.0
million ba
els a day. Measured by revenue, Midland’s refining and marketing business was the
company’s largest. Global revenue for 2006 was $203.0 billion—a slight decrease of approximately
1.8% over XXXXXXXXXXThe division faced stiff competition, as its products were highly commoditized.
After-tax earnings for refining and marketing totaled only $4.0 billion. The relatively small margin
was consistent with a long-term trend in the industry; margins had declined steadily over the
previous 20 years.
Though most of Midland’s refinery output was gasoline and was sold as fuel for automobiles, the
company also had manufacturing capacity to produce approximately 120,000 ba
els of base-stock
lu
icants per day. Midland believed its capacity was as technologically advanced as any in the
industry. Advanced technology and vertical integration combined to make Midland a market leader
in this business.
Midland projected capital spending in refining and marketing would remain stable, without
substantial growth in XXXXXXXXXXThis reflected both the historical trends of low and shrinking margins
and the difficulty of obtaining the myriad approvals necessary to expand or to build and operate a
new refinery. However, most analysts projected a longer-term global shortage of refining capacity
that would eventually spur investment in this segment.
For the exclusive use of D. Ghosh, 2020.
This document is authorized for use only by Devleena Ghosh in Behavioral Corporate Finance (Summer 2020) taught by DUCCIO MARTELLI, Universit?? degli Studi di Perugia from Jun 2020
to Aug 2020.
Midland Energy Resources, Inc.: Cost of Capital | 4129
HARVARD BUSINESS SCHOOL | BRIEFCASES 3
Petrochemicals
Petrochemicals was Midland’s smallest division, but was a substantial business nonetheless.
Midland owned outright or had equity interests in 25 manufacturing facilities and five research
centers in eight countries around the world. The company’s chemical products included
polyethylene, polypropylene, styrene and polystyrene as well as olefins, 1-hexene, aromatics, and
fuel and lu
icant additives. In 2006, revenue and after-tax earnings were $23.2 billion and $2.1
illion, respectively.
Capital spending in petrochemicals was expected to grow in the near-term as several older
facilities were sold or retired and replaced by newer, more efficient capacity. Much of the new
investment would be undertaken by joint ventures outside the United States in which Midland’s
Petrochemicals Division owned a substantial minority interest.
Midland’s Financial and Investment Policies
Midland’s financial strategy in 2007 was founded on four pillars: (1) to fund significant overseas
growth; (2) to invest in value-creating projects across all divisions; (3) to optimize its capital structure;
and (4) to opportunistically repurchase undervalued shares.
Overseas Growth
The most easily exploited domestic resources had been put into production decades previously.
Consequently, overseas investments were the main engine of growth for most large U.S. producers,
and Midland was no exception. Midland usually invested in foreign projects alongside either a
foreign government or a local business as partner. Often, these investments had specialized financial
and contractual a
angements similar in many respects to project financing. In most cases, Midland
acted as the lead developer of the project, for which it collected a management fee or royalty.
Midland and its foreign partner shared the equity interest, with the foreign partner generally
eceiving at least 50% plus a prefe
ed return. Despite the fact that the investments were located
a
oad, Midland analyzed and evaluated them in U.S. dollars by converting foreign cu
ency cash
flows to dollars and applying U.S. dollar discount rates. In 2006, Midland had earnings from equity
affiliates of approximately $4.75 billion. The majority of these earnings, 77.7%, came from non-US
investments.
Value-creating Investments
Midland used discounted cash flow methodologies to evaluate most prospective investments.
Midland’s DCF methods typically involved debt-free cash flows and a hurdle rate equal to or derived
from the WACC for the project or division. However, Midland’s interests in some overseas projects
were instead analyzed as streams of future equity cash flows and discounted at a rate based on the
cost of equity.
The performance of a business or division over a given historical period was measured in two
main ways. The first was performance against plan over 1- , 3- , and 5-year periods. The second was
ased on “economic value added” (EVA), in which debt-free cash flows1 were reduced by a capital
1 For purposes of EVA