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    AF 325 Pioneer Petroleum

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    HiepXick
    Pioneer Petroleum Corporation is weighing using single or multi-rate cutoffs to determine project returns. Their current WACC calculation and some input costs are incorrect. They should use division-specific hurdle rates that account for different risk levels rather than a single corporate rate. Environmental projects should be discounted at the division rate to reflect varying risks. Multiple cutoff rates can better represent each project's risk-return profile within a division rather than a single rate.

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    AF 325 Pioneer Petroleum

    Uploaded by

    HiepXick
    1K views6 pages
    Pioneer Petroleum Corporation is weighing using single or multi-rate cutoffs to determine project returns. Their current WACC calculation and some input costs are incorrect. They should use division-specific hurdle rates that account for different risk levels rather than a single corporate rate. Environmental projects should be discounted at the division rate to reflect varying risks. Multiple cutoff rates can better represent each project's risk-return profile within a division rather than a single rate.

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    Pioneer Petroleum Corporation is weighing using single or multi-rate cutoffs to determine project returns. Their current WACC calculation and some input costs are incorrect. They should use division-specific hurdle rates that account for different risk levels rather than a single corporate rate. Environmental projects should be discounted at the division rate to reflect varying risks. Multiple cutoff rates can better represent each project's risk-return profile within a division rather than a single rate.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    1K views6 pages

    AF 325 Pioneer Petroleum

    Uploaded by

    HiepXick
    Pioneer Petroleum Corporation is weighing using single or multi-rate cutoffs to determine project returns. Their current WACC calculation and some input costs are incorrect. They should use division-specific hurdle rates that account for different risk levels rather than a single corporate rate. Environmental projects should be discounted at the division rate to reflect varying risks. Multiple cutoff rates can better represent each project's risk-return profile within a division rather than a single rate.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 6
    At a glance
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    Pioneer Petroleum Corporation is one of the primary producers of crude oil, providing 60% of its petroleum liquids production to Alaska. Currently the company is weighing two alternatives to determining the minimum rate of return: single or multi-rate cutoffs.

    Table: 1991-Weighted Average Cost of Capital Source Estimation Proportions of future Fund source Estimated Future after tax cost Weight Cost Debt .50 7.92% 3.96% (7.92/2) Equity .50 14.56% 7.28% (14.56/2) 11.24% Cost of debt = interest rate to finance new debt * (1-tax rate) = 12%* (1-34%) = 0.0792 or 7.92% RE = .078 + .8 (0.1625 - 0.078) = 0.1456 or 14.56 %

    In cases when the beta is known for separate divisions it is more accurate to use multiple divisional hurdle rates to determine each divisions specific risk.

    Dinh, Lobo,Pham, Phung, Velez

    Phyllis Lobo
    Jose Velez
    Hong Pham
    Hiep Dinh
    Maggie Phung
    Professor Ertugrul
    December 18, 2014

    Pioneer Petroleum Case Write-up

    Executive Summary:
    Pioneer Petroleum Corporation is one of the primary producers of crude oil, providing
    60% of its petroleum liquids production to Alaska. Currently the company is weighing
    two alternatives to determining the minimum rate of return. There choices are single or
    multi-rate cutoffs.
    Question 1:
    Does Pioneer estimate its overall corporate weighted average cost of capital (WACC) correctly?
    Currently Pioneer estimates its WACC based on expected portions of future fund sources
    and costs were assigned to each of these sources then calculated based on these
    proportions and costs.
    Are they using correct weights? Explain.
    Debt
    Est. prp ftr fds .50 Est. ftr after-tax cst 7.9%

    Weighted Cost 4.0%

    Equity
    Est. prp ftr fds .50 Est. ftr after-tax cst 10%(set) Weighted Cost 5.0% Total = 9.0%

    Dinh, Lobo,Pham, Phung, Velez

    Investments should be expected to earn at least what an investment in common stock


    would. Since 1980 the average return on S&P index of common stocks is 16.25%.

    Is cost of debt estimation correct? Explain.


    Current Cost of Debt estimate (YTM) = 9.4%
    After-Tax Cost of Debt = 7.9%
    *Cost of debt estimation is incorrect. Steve, Mitchell, O'Hara-Pioneer's investment
    bankers forecast early in 1990 that the company's future debt issues would required
    coupon of 12% but Pioneer has to calculate the actual interest rate after tax.
    Cost of debt = interest rate to finance new debt * (1-tax rate) = 12%*(1-34%) =
    0.0792 or 7.92%
    Is cost of equity estimation correct? Explain.
    Current cost of equity is set 10%.
    *The estimation on cost of equity is incorrect because Pioneer Petroleum used current
    earning yield on the stock as cost at both new equity and Retain earning but they should
    better use either the CAPM model or Dividend growth model.
    * Dividend growth model:
    g=10%, P=$63, D0=$2.45

    so D1=2.45(1.1)=$2.70

    RE=D1/P+g=2.7/63+0.1=0.1429 or 14.29%
    * CAPM model
    Beta =.8, RM =..1625, Rf = .078 RM = 0.1625: is the average return since 1980 on
    S&P index of common stock.
    RE = .078 + .8 (0.1625 - 0.078) = 0.1456 or 14.56 %

    Dinh, Lobo,Pham, Phung, Velez

    * Comparing between 2 methods, CAPM model is more accurate than Dividend


    growth model because CAPM used market rate which includes beta and market
    risk premium.
    Question 2:
    Calculate cost of capital for Pioneer.
    Table: 1991-Weighted Average Cost of Capital
    Source

    Estimation

    Estimated Future

    Weight Cost

    Proportions of future after tax cost


    Fund source
    .50
    .50

    Debt
    Equity

    7.92%
    14.56%

    3.96% (7.92/2)
    7.28% (14.56/2)
    11.24%

    Cost of debt = interest rate to finance new debt * (1-tax rate) =


    12%* (1-34%) = 0.0792 or 7.92%
    RE = .078 + .8 (0.1625 - 0.078) = 0.1456 or 14.56 %

    Question 3:
    Should Pioneer use a single corporate cost of capital or multiple divisional hurdle rates in
    evaluating projects and allocating investment funds among divisions? Explain. If multiple rates
    are used, how should they be determined?
    In cases when the beta is known for separate divisions it is more accurate to use multiple
    divisional hurdle rates to determine each divisions specific risk.
    Example:

    Production and Exploration

    Transportation

    Dinh, Lobo,Pham, Phung, Velez

    IRR

    20%

    risk free 7.8 + beta P/E 0.6 [16.25%-7.8%]


    =

    5.15%

    10%
    7.8 + beta T 1.3 [16.25%-7.8%]
    = 11.06%

    Using this method you can determine if each division has fallen short or exceeded the
    companys overall average cost of capital.
    Question 4:
    How should Pioneer set capital budgeting criteria for similar projects in different divisions (e.g.,
    should all environmental projects have the same discount rate or should they have the discount
    rate corresponding to the division.)?
    Pioneer should have discounted at appropriate rate because the operations of each
    division vary in risk. Environmental projects should have the discount rate corresponding to the
    divisions due to risks.

    Question 5:
    How should Pioneer set capital budgeting criteria for different projects within a given division?
    What distinctions among projects might be captured in these criteria? How should these
    different standards be determined?
    Pioneer Petroleums capital budgeting criteria for different projects within a given
    division was to accept all proposed investments with a positive net present value when

    Dinh, Lobo,Pham, Phung, Velez

    discounted at the appropriate cost of capital. The company approaches a single cutoff rate based
    on the companys weighted average cost of capital.
    The multiple cutoff rates should be able to represent the risk-profit characteristics of
    some business. It would determine the minimum acceptable rate of return on proposed project
    investment in every operating portions of the company. It also represents the rate charged to
    every different profit centers for capital employed.

    Dinh, Lobo,Pham, Phung, Velez

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