Pioneer Petroleum

Pioneer Petroleum Corporation

Background: The Pioneer Petroleum Corporation is a hydrocarbons-based company, concentrating on oil, gas, coal, and petrochemicals. One of the critical problems confronting management and the board of Pioneer was the determination of a minimum acceptable rate of return on new capital investments. The company's basic capital budgeting approach was to accept all proposed investments with a positive net present value when discounted at the appropriate cost of capital.

Further, the company is contemplating using either multiple cutoff rates instead of a single companywide rate to determine the cost of capital for each division. The suggestion was that these multiple cutoff rates would determine the minimum acceptable rate of return on proposed capital investments in each of the main operating areas of the company and would represent the rate charged to each of the various profit centers for capital employed.

Issues:

Did Pioneer compute WACC correctly and if not what did they do wrong? Compute your own.

How should the company determine a minimum rate of return: by (1) a single cutoff rate based on the company's overall WACC or (2) a system of multiple cutoff rates that reflect the risk-profit characteristics of the several businesses?

Analysis: Pioneer Petroleum Corporation did not calculate the WACC correctly. Starting with the cost of debt, the formula is

Kd = I(1 T)

where I is the interest rate and T is the tax rate. The company's tax rate is 34%, however, they made the mistake of using the coupon rate of 12% for the interest rate. The coupon rate is a sunk cost and, therefore, the market rate of interest should be used reflecting the cost of new debt. I assumed the interest rate to be 8% because the company's debt was rated A, which indicates low risk.

Further, Pioneer's method for coming up with the cost of equity is incorrect. Their method for finding cost of equity was to use the current earnings yield of their stock of 10%. The more correct method is to use the CAPM approach depicting the required rate of return of investors on the company's stock instead. In other words, the current yield of Pioneer's stock is not necessarily the required rate of return that investors expect. The CAPM formula being

Ke = Rf + (Rm - Rf)B

where Rf is the risk-free rate (generally either the US Treasury bond rate or the short-term Treasury bill rate), Rm is the expected return for the market portfolio, and B is the beta coefficient indicating the company's stock risk. An alternative way of finding the cost of equity is to use the bond yield (instead of the stock yield that was used by the company) plus a risk premium. This method is highly subjective, however, and is not as accurate as the former method or the one I used. The method I used is illustrated by the formula

Ke = (D1/Po) + g

where D1 is the dividend per share expected after year one of $2.70 (according to the case, dividends will grow by 10% the next year, therefore 1.1*2.45=2.70). Po is the current market price of a share of stock of $63, and g is the rate at which dividends are expected to grow of 10%. Below are the results from my calculations of the cost of debt and the cost of equity

WACC

Components Cost Proportion of total financing Weighted cost

Cost of debt* = 5.3% 50% 2.6%

Cost of equity** = 14.3% 50% 7.2%

WACC= 9.8%

* Cost of debt = (1-34%)*8%

** Cost of equity = (2.70/63)+10%

Pioneer Petroleum Corporation has adopted a policy to maintain a capital structure of 50% debt and 50% equity. Therefore, as illustrated in the WACC chart above, the WACC is 9.8%. The rational behind the use of a WACC is that by financing in the proportions specified and accepting projects yielding more than the weighted average required return, Pioneer is able to increase the market price of its stock and the financial risk of the company remains roughly unchanged.

Comparing my calculated WACC of 9.8% to the company's calculated WACC of 9% shows that the company would have a lower acceptable rate of return on new capital investments with the 9%. This implies that following Pioneer's rate would mean certain investment projects that will leave investors worse off than before will be accepted.

Concerning the issue of finding the right minimum rate of return, I agree with the proponents of multiple cutoff rates for each division or economic sector. If Pioneer operated in only one economic sector the use of the company's overall WACC as the acceptance criterion would be appropriate. However, since Pioneer has several economic sectors the appropriate practice becomes the application of individual rates to each division. This divisional rate would reflect the risks inherent in each of the economic sectors in which the company's principal operating subsidiaries worked.

For example, the divisional cost of capital for production and exploration was 20%, and the divisional cost of capital for transportation was 10%, that translates to a WACC of 10% and 5% respectively. Suppose Pioneer uses its calculated overall WACC of 9% as the acceptance criterion for investment decisions. Then the real WACC (10% for the production and exploration division and 5% for the transportation division) will differ from that calculated and used for capital investment decisions (the overall rate of 9%). If the real cost is greater than that which is calculated, certain investment projects that will leave investors worse off than before will be accepted. On the other hand, if the real cost is less than the calculated cost; projects that could increase shareholder wealth will be rejected. In short, capital should be allocated on a risk-return basis specific to the risk of the division.

Recommendations:

Pioneer Petroleum Corporation should recalculate their WACC using a different structure for cost of debt and cost of equity.

Pioneer should use a system of multiple cutoff rates that reflect the risk-profit characteristics of the several businesses. Although, I do not agree with the way Pioneer proposes to calculate these multiple rates being (1) estimate the proportions of debt and equity financing from each