Finance Pioneer Petroleum

1. Does Pioneer estimate its overall corporate weighted cost of capital correctly?

The formula for weighted average cost of capital (WACC) is calculated as WACC = rD (1- Tc )*( D / V )+ rE *( E / V ), and for each component of WACC formula there are a few assumptions.

One of the basic assumption that could be contentious in Pioneer’s estimations would be around the cost of equity calculations. In the case study, Pioneer used the current earnings yield on the stock to calculate the return on equity. One interesting observation is that earnings per share, dividends per share and return on book equity have quite a high variance; Using current earnings yield on stock might not be a good estimate because it might fluctuate a lot in the near future.

However alternative methods could be used to calculate this value. One other method to calculate cost of equity could be using the Capital Asset Pricing Model (CAPM) model: Required (or expected) Return = RF Rate + (Market Return - RF Rate)*Beta

Using the CAPM formula and the values in the case study, we could calculate return on equity to be 7.8% (90 day T bill) + 0.8 (beta) * (16.25% - 7.8%) = 14.56%. Now with a cost of equity value of 14.56, the new WACC = 0.079 * 0.5 + 0.1456 * 0.5 = 0.1123 or 11.23%. Using CAPM method, the return on equity is higher than the 10% used, which would result in a higher WACC.

Lastly, the assumption of a future targetd 50/50 equity to debt ratio is correctly used here (instead of using the current equity to debt ratio), and the calculations of the cost of debt looks correct albeit with a small rounding error.

In summary, the methodology of calculating return on equity would need to be agreed upon to determine if Pioneer calculated their WACC correctly. Otherwise various assumptions can be applied to arrive at different cost of equity rates. In the next question, another even larger assumption about whether weighted average cost of capital should be calculated as a single number or calculated from multiple rates can further complicate whether the calculations were ‘correct’.

1. Should Pioneer use a single corporate cost of capital or multiple divisional hurdle rates in evaluating projects and allocating investment funds among divisions? If multiple rates are used, how should they be determined?

If an external investor or entity were evaluating Pioneer, using a single corporate cost of capital might be appropriate because it would reflect the overall risk of Pioneer compared to other similar companies. However, it is clear in this case study that the WACC is used by executives to make important internal financing decisions, and thus using multiple divisional hurdle rates in evaluating projects might be more appropriate here.

If the differences in different departments were small, if the departments were relatively homogenous in terms of risk and the industries they operated in, having a single corporate cost of capital would not lead to poor decision making. However, in the case study we see that the divisional cost of capital for production and exploration is twice that of transportation, at 20% and 10% respectively.