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Midland Energy Resources, Inc.: Cost of Capital ________________________________________________________________________________________________________________ HBS Professor Timothy A. Luehrman and Illinois Institute of Technology Adjunct Finance Professor Joel L. Heilprin prepared this case specifically for the Harvard Business School Brief Case Collection. Though inspired by real events, the case does not represent a specific situation at an existing company, and any resemblance to actual persons or entities is unintended. Cases are developed solely as the basis for class discussion and are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2009 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. 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, respectively. 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 business 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 required. 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. 4129 J U N E 1 9 , 2 0 0 9 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 2004-06. 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 barrels 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 barrels 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 2005. The 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 barrels of base-stock lubricants 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 2007-08. This 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 lubricant additives. In 2006, revenue and after-tax earnings were $23.2 billion and $2.1 billion, 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 arrangements 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 receiving at least 50% plus a preferred return. Despite the fact that the investments were located abroad, Midland analyzed and evaluated them in U.S. dollars by converting foreign currency 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 based on “economic value added” (EVA), in which debt-free cash flows1 were reduced by a capital 1 For purposes of EVA