Pioneer Petroleum was founded in 1924, through a merger within industrial, pipeline transportation, and refining fields. PP has evolved over the last 60 years into a company that now also works with agricultural chemicals, plastics, and real estate development concentrating in gas, oil, petrochemicals, and coal. In 1990, PP improved their coker and sulfur recovery facility to make their refining process more efficient and in turn has become one of the lowest cost refiners on the West Coast.
Due to the refining process PP’s gasolines are among the most cleanest-burning in the industry. PP’s is also the producer of one-third of the world’s supply of methyl tertiary butyl ether (MTBE), which is a chemical used to make cleaner burning gasolines. They also produce one third of the world’s supply of MTBE. Major Issues
The major issue that PP is facing right now is that the management board of PP is trying to decide whether to use a single cutoff rate or a system of multiple cutoff rates to determine the minimum acceptable rate of return on new capital investments. As of right now PP is using one single company-wide cutoff rate that is based on their overall weighted cost of capital.
The current single rate system that PP is using has increased their overall risk by causing them to choose investment decisions in divisions with higher risk because they exceed the cutoff hurdle, while not investing in lower risk areas because they do not exceed the hurdle rate. In addition PP has not been calculating their weighted cost of capital correctly. This has caused them to invest in riskier areas rather than those with greater chance of having a positive net present value. PP needs to reevaluate which method to use as well as how to correctly compute WACC. Analysis
As stated before PP has been weighing two alternatives options to calculate the minimum acceptable rate of return on their capital investments. As of right now PP’s approach is to accept all proposed investments with a positive net present value, after being discounted at the appropriate rate.
The issue with this is that this approach has been reliant on a single company-wide cutoff rate based on PP’s overall WACC that has continuously been calculated incorrectly for each investment decision. PP has been calculating their WACC by three steps: (1) the expected proportions of future funds sources were estimated; (2) costs were assigned to each of the future funds sources; and (3) a WACC was calculated by multiplying the estimated proportions of future funds sources by the estimated future after-tax cost percent.
Due to the fact that PP has calculated their WACC this way it has led to their adopted rule that funded debt should represent approximately 50% of total capital. In addition it has led to the cost of equity being 10% with current earnings yield on stock equaling the cost of both new equity and retained earnings for PP. Alternative Options PP has two alternative options to choose from when considering acceptable rates of return on future investments. 1. Single company-wide rate.2. Multiple cutoff rates based on each economic sector within the company.
The multiple rate system will also use WACC approach for each operating sector within the company to determine the individual’s rates for each economic sector within PP. This should allow them to see differences in divisions.
Determining Pioneer Petroleum’s Cost of CapitalPP has been finding their equity while determining the WACC of capital by using the CAPM formula but has been finding the incorrect equity value. PP has correctly found the cost of debt, but has failed to find the correct cost of equity because they have set their equity’s weight to 10%. In order to determine WACC PP needs to correctly calculate equity, debt, and also the weighted averages of both.
Cost of bond after-tax cost Debt
KD=Y(1-tax rate), where Y=12% and tax rate=34% (p. 66)KD=12%(1-34%)KD=7.92%
Cost of common equity
Ki=Rf+(Rm–Rf)Bi, where Rf=7.8%, Rm=16.25% and Bi=0.8 (p. 68-69) Ki=7.8%+(16.25%-7.8%)0.8Ki=14.56%
Weighted average cost of capital
Kw=KD(WtD)+Ki(Wti), where WtD=50% and Wti=50% (p.66)Kw=7.92%(50%)+14.56%(50%)Kw=11.3%
Analysis of AlternativesIn recalculating PP’s WACC correctly their actual average cost of capital came out to be 11.3% as opposed to the 9% that PP has calculated. This shows that PP underestimated their WACC by 2.3% due to the fact that they set equity at 10%. If PP chooses to continue to use their single cutoff rate based on the company’s overall WACC, they will now have a cutoff of 11.3%. Again, the problem with using the single rate method is that it does not allow use to see, or account for the differences in each division of PP.
Another problem with the single cutoff rate is that due to the increased rate PP will invest their funds in higher return projects which will result in higher risk. This risk is a result of only the high-risk divisions being able to exceed the single rate hurdles using the single rate cutoff method.
If PP chooses to go with the multiple cutoff rate approach it allows them to create cutoff rates that reflect the risk-profit characteristics of the individual economic sectors in which PP’s subsidiaries operate. In order to do this you need to determine the equity, debt, and WACC of each firm for each sector as opposed to the single cutoff rate. The discount rate will also vary for each project due to the use of different divisions and sectors. A multiple cutoff rate may actually exceed PP’s overall average costs because of the vertically integrated parts involved.
In using the multiple cutoff rate approach PP can have cutoff rates that are better tailored to the economic sectors that will allow lower risk divisions to exceed their cutoff rate. This decreases risk for PP by essentially allowing them to diversify their portfolio, or the ‘Portfolio effect’. CONCLUSION
Suggested Course of ActionThe multiple hurdle rates for each division based on the corresponding risk for each division is the suggested course of action for PP. The problem that PP has with using the current single company-wide cutoff rate is that it limits PP to projects that exceed that rate which tend to be more risky. The single rat method ignores differences in each division as well as the different risks of those divisions.
This led to a misallocation of funds for each division and also did not allow PP to participate in low risk projects that could have been profitable and made PP more risk averse. Using the multiple cutoff rate approach will diminish the imbalance of divisions over investing in cutoff rates that are too low and divisions under investing in cutoff rates that are too high. In using the multiple cutoff rate approach PP will be able to make better investment decisions based on the NPV of potential investments for each division due to the fact that each division will have their own hurdle rate.
BIBLIOGRAPHYRuback, Richard S. “Pioneer Petroleum.” Pearson Custom Business Resources. Ed. FrankBacon. Boston: Pearson Learning Solutions, 2011. 65-69. Print.