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 = Equity/(Equity+Debt)*Rs + Debt/(Equity+Debt) * (Rb*(1-tc)) 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 all projects within a division carry the same risk may potentially lead to projects being accepted or rejected in an inappropriate manner.
Similar to the case in which one corporate discount rate is used, projects that are riskier than average would be mistakenly accepted and low risk project would be rejected. A situation in which this would occur would be in the volatile tanker industry, which proved to be devastating for many companies in the industry. Under divisional rates Pioneer would evaluate tanker investments under the transportation division, which has a much lower discount rate than is realistic for high-risk tanker investments.
Pioneer should consider using discount rates for individual projects within divisions based on their relative risk factor. One tool the company can use to measure project risk is through Beta. A project that is considered to be more risky than the industry norm would result in a higher Beta and thus a higher discount rate. Evaluating the characteristics of a project can help the company determine whether the appropriate Beta is being used for a project. This can be accomplished by comparing characteristics of a project to those of a similar industry. In the case of the tanker project, it does not fit into the transportation division within Pioneer.
Since this is the case using a higher risk premium, perhaps one which is consistent with the tanker industry, and reexamining the project’s Beta within this industry may be appropriate. However, if the given project is fundamentally different from the projects in the tanker industry; even more risk maybe assumed. Therefore careful evaluation is needed to determine to what extent an adjustment maybe needed to assign the proper Beta for the project.
Another important aspect that impacts the project’s risk factor is the project’s operating leverage. A project’s operating leverage is measured by the relationship between the fixed and variable cost incurred by the project. A project that has higher fixed costs and lower variable cost is considered to have higher operating leverage and is therefore considered riskier. This occurs because as sales increase or decrease in a project with high operating leverage, the profit is impacted more than a project with lower fixed and higher variable costs. It is also important to note that the amount of financial leverage a firm uses will also impact the fixed costs of operations.
As the firm takes on more debt in its capital structure, interest payments will increase and as a result fixed costs of financing will increase. Although from a corporate perspective, Pioneer management has decided to maintain relatively equal shares of debt and equity, projects within various economic sectors may carry different proportions of debt to equity and therefore result in varying levels of fixed costs from financing. By examining the level of operating leverage and financing leverage among projects at Pioneer, managers can identify what level of risk they may be undertaking on industry projects.
One last characteristic of Pioneer Petroleum’s operation that impact their project evaluations are in their vertically and horizontally integrated operations. Given this level of integration in operation, Pioneer would incur lower than average industry risk in their projects. Thus as a slight adjustment may be needed to reflect for added project risk, an adjustment would also be necessary to account for the diversification premium that should be assigned to each project within divisions. Due to the number of elements that impact risks associated with projects at Pioneer, it is critical that these criteria be considered to properly determine appropriate discount rates within Pioneer Petroleum’s divisions.
With the given criteria and focus Pioneer will have a universal agreement on how to proceed further. Pioneer must comply with using several cutoff rates for projects. The criteria given will help categorize on how to select Beta and how to estimate risks based on financial and operational leverage. With the company expanding both vertically and horizontally, multiple/divisional rates of return can properly allow for true evaluation of a project. With proper understanding of how to evaluate future investments, projects like the Tanker venture can be properly assigned the right rate of return and Pioneer won’t be diluted with low expected returns on a very risk oriented project.