Pioneer Petroleum Case Study
Essay by rlim1 • September 26, 2018 • Case Study • 847 Words (4 Pages) • 1,098 Views
Case Study: Pioneer Petroleum
Jo Kemp
11.21.17
In the case of pioneer petroleum, a hydro-carbons company specializing in oil, gas, coal and petrochemicals, the controversy experienced by management is whether to use a divisional hurdle rates or a single firm-wide rate in calculating the company’s cost of capital. The argument to use a firm-wide cost of capital falls short in capturing each division or investments risk factor. However, a firm-wide rate adds a diversification benefit which increases profits in the short-term. Divisional rates use unlevered betas and therefore reflect the inherent risk within each sector of a firm specializing in multiple industries. Un-levering beta provides a benchmark for how an all equity firm would run and ignores a firm’s level of debt. Each division yields a different return rate to the company and therefore contains different levels of risk. If these different levels of risk are not considered in estimating a firm-wide cost of capital, a resulting error would be a low cost of capital. Subsequently, using a low cost of capital would cause high-risk divisions to be overfunded and low-risk divisions to be underfunded. This capital mispricing within the individual divisions would eventually result in failure of the firm itself.
A discrepancy to be noted in Pioneer’s calculation of the weighted average cost of capital is that the weights assigned to debt and equity are based on book values. Book values fail to capture the current cost of debt and equity because they only reflects the cost the firm had to bear upon issuance. The weights of debt and equity should be based on market values because shareholders would demand the market required rate of return on the market value of capital they are investing. Subsequently, target capital structure weights should be used when calculating weighted average cost of capital. Since the WACC required analysis of future conditions and long-term projects target weights are the expected estimation of the future trends.
The cost of equity, as calculated by Pioneer, provides only the cost of new equity. The same cost is applied to internal equity even though it is cheaper than external equity. Using the same rates for both calculations provides an inflated total cost of equity because it doesn’t subtract flotations costs-which are not applied to existing equity. Flotation costs make the cost of issuing shares greater and should not be applied while calculating the internal cost of equity. Another potential error in Pioneer calculation of the cost of equity is the dividend growth rate being used. To arrive at a cost of equity of 10%, with EPS at 6.15 and share price at $63 per share, the growth rate (g), equals 0.24%-which is not the correct growth rate.
Given the available information from this case, the cost of equity can be calculated either by the dividend discount model (as used by Pioneer Petroleum) or the capital asset pricing model. CAPM yields a slightly higher value than DDM which is expected because it values a company extrinsically using market values of debt and equity. Regardless, 14.3%, calculated using DDM is 5.3% higher than the yield given by Pioneer.
Pioneer Petroleum | ||||
Debt | ||||
Coupon | 12.0% | |||
Tax Rate | 34.0% | |||
After-Tax Cost of Debt | 7.9% | |||
Weight of debt | 0.5 | |||
Equity | CAPM | |||
EPS | $6.15 | risk-free rate | 3.40% | |
Dividend Growth Rate | 10.0% | Rm | 31.50% | |
Share Price | 63.0 | beta | 0.8 | |
Cost of Equity | 20.7% | Cost of Equity | 25.88% | |
Weight of equity | 0.5 | |||
WACC | 14.3% |
|
| 16.9% |
Divisional Hurdle Rates
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