Midland Energy Capital Planning
• Fund significant overseas growth
• As domestic natural resources dwindle, overseas investments are the main drivers of growth for Midland. These investments are analyzed and evaluated is US dollars (foreign cash flows are converted to US dollars) and have a US dollar discount rate applied to them. In 2006, 77.7% of Midland’s total earnings from equity affiliates came from non-US investments.
• Invest in value creating projects across all divisions
• Midland generally used traditional discounted cash flow methods to evaluate potential projects and investments. Some overseas projects were analyzed as streams of future equity cash flows, and were discounted based on cost of equity as a result. Once funded, a project/investment’s performance was measure in two ways. The first being actual performance vs forecasted plan over 1, 3, and 5 year periods, and the second being Economic Value Added (EVA). EVA was calculated as:
EVA = EBIT(1-t) – WACC(period capital expenditure)
Midland Energy Capital Planning
• Optimize capital structure
• Midland primarily optimized its capital structure by taking advantage of the borrowing capacity inherent in its energy reserves and long term assets, such as refining facilities. Midland maintained an optimal debt level which was based on energy prices and its own stock prices. This practice allowed them to shield additional profits from taxes. In addition to prudent utilization of the debt capacity inherent to the industry, Midland also had unique ways to strengthen its balance sheet via its access to global financial and commodity markets. A group in-house traders actively managed a variety of risks via the securities and commodities market.
• Opportunistically repurchase undervalued shares
• Midland regularly estimates the intrinsic values of it’s stock and when prices fall below this internally calculated intrinsic value, has considered repurchasing shares. While current Midland stock is high, board members feel that intrinsic value has risen as well, and Midland remains committed to repurchasing shares if they are indeed undervalued.
Janet Mortensen’s Role
• Ms. Mortensen’s main contribution has been to calculate the corporate and divisional cost of capital on a yearly bases for the company.
• This includes the cost of debt which is especially integral when it comes to optimizing capital structure.
• Ms. Mortensen also calculated the cost of equity using the CAPM model which was used when analyzing value creating investments
• Ms. Mortensen also presumably helped calculate the WACC, which would be routinely to assess the viability of potential investments.
Cost of Capital, WACC, and CAPM
• Cost of Capital is, most simply put, the weighted average of the costs of debt and equity. This number generally represents a hurdle rate that a company must overcome before it can generate value. As such, it is extensively used in the capital budgeting process to determine whether the company should proceed with a project. • WACC or Weighted Average Cost of Capital, is a calculation of a firm's cost of capital in which each category of capital (stock, bonds, long-term debt, etc.) are all included. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC.
• CAPM or the Capital Asset Pricing Model helps calculate investment risk and what return on investment one should expect. This model is often used to calculate the Cost of Equity as it describes the relationship between risk and expected return.
Uses for Cost of Capital
• Optimizing Capital Structure
• Mortensen’s calculation of the cost of debt would be used regularly when trying to optimize divisions debt ratios.
• Overseas Growth and Value Creating Investments
• The cost of...
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