Pioneer Petroleum
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Pioneer Petroleum is a multinational corporation that is in position to capitalize on investments all around the World. Within the industry Pioneer’s gasoline are among the cleanest burning fuels. They are better position than most to meet strict environmental guidelines as they currently have clean efficient running plants positioned to capitalize on less polluted products. Also Pioneer Petroleum is heavily involved in exploration and devilment. From 1924 to the present, pioneer has been able to expand both vertically and diversify horizontally. With such resources and capital, the company has to oversee so many opportunities and ventures. Presently the company is at odds over whether they should use a company wide cut off rate based on the overall weighted average cost of capital or if Pioneer should use multiple rates that reflect risk-profit characteristics of the several businesses or economic sectors. At first we must decide if the methodology used in computing the company’s overall weighted average cost of capital is just. Second, we should decide in which terms Pioneer adheres to future investments. Should they adjust discount rates for different divisions and projects and stay away from a universal cutoff rate? Third, the capital budgeting criteria must be set for different projects across Pioneer’s divisions. What distinctions among projects need to be noted and how the standards should be determined are all questions that arise from judging how to proceed forward.
Estimated overall corporate weighted average cost of capital:
We assume all the basic data are correct. Given is the future Debt/Equity ratio (Estimated Proportions of future Funds Sources). Also Pioneer’s cost of equity was given as 10% (Rs). The company’s after tax cost of debt was 7.9% (Rb*(1-Tc). Tax rate was 34%.
From the formula:
Rwacc = 0.5*10% + 0.5*7.9% = 9%
There maybe issue with the future debt – equity ratios being used as opposed to the current ratio. However we think it is right to use the forecasted ratio rather than the current ratio. The target weights are expected to prevail over the life of the firm or project. Conversely to define the weights of debt and equity, Pioneer should look at market value, because it is closer to the real world. In some instances for short term projects, the market values would be helpful.
Pioneer should continue to use multiple divisional hurdle rates in evaluating projects and allocating investment funds among divisions. For the various departments, they have various risks. The divisional cost of capital for the production and the exploration (%20) is different than the divisional cost of capital for transportation (%10). These rates represent the rate charged to each of the various profit centers. Each project should be paired with a financial asset of comparable risk. If a project’s beta differs from that of the firm, the project should be discounted at the rate commensurate with its own beta. Unless all the projects are the same risk, we can not choose the same discount rate for all projects. The project with high beta is more risky than the other projects and should be discounted at a high rate. The discount rate should be determined by calculating the Weighted Average Cost of Capital (WACC) for the each sector followed by the NPV equation. There are three steps for WACC. First, they should make an estimate for the future funds sources for the each sector; second, calculate the costs of debt and equity of these separate divisions and these costs should be assigned to the sources; third, these costs should be combined to determine the weighted average cost of capital on the basis of the proportions and costs. This WACC tells us the discount rate on the Net Present Value and is a measurement of cost of equity capital and the cost of debt. If the NPV is negative, this means that each of the various profit centers are in the same risk class which means that the project should be rejected. Since the financial markets could offer better projects for the same risk class.
One of the problems with divisional rates, as the advocates for the single rate contend, is that the categories suggested were not helpful in grouping projects by their risk. Although the use of multiple divisional hurdle rates may capture the appropriate discount rate for most projects (given that most projects among the division carry similar characteristics), a more accurate determinant for evaluating projects within a division would be to use multiple discount rates based on individual projects. Assuming that