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