Pioneer Petroleum
...) = 7.92% 3.96% Equity 50% $6.15 / $63.00 = 9.76% 4.88% WACC = 8.84% Pioneer’s faulty calculation lies in how they figured the cost of equity, which they figured by dividing the earnings per share (EPS) by the market price of stock. Changes in capital structure benefit the stockholder if and only if the value of the firm increases; and conversely, changes only hurt the stockholder if and only if the value of the firm decreases3. Management of a firm should choose a capital structure based off of what they feel would provide the highest firm value because this is the structure that will be most beneficial to stockholders. Additionally, this formula does not take the average return of the market into account. The average return from 1980 to 1990 on the S&P index of common stocks was 16.25%, which is substantially higher then the 9% company-wide cost of capital. Due to Pioneer’s low required rate of return, they are taking on investments that are performing below average. How Pioneer Should Have Calculated WACC: Pioneer should have used the Capital Asset Pricing Model (CAPM) model for determining cost of equity rather than basing it on a return on the investors’ stock. CAPM yields a better determination of the cost of equity because it considers the expected return on the market and the risk of that individual investment by using the beta. This formula helps management determine the investments that have the best impact on overall business value. Additionally, CAPM uses the Beta, which is important because it takes the risk of the overall market into consideration. Pioneer calculated the cost of debt correctly, but they should have calculated the cost of equity by using the CAPM formula as follows: Capital Asset Pricing Model (CAPM) = Rf + B1 x (Rm – Rf) = 7.8% + .8 (16.25% – 7.8%) = 14.56% Financing Components Weight Cost of capital (after corporate tax) Weighted cost of capital (= Weight x Cost of capital) Debt 50% 12% (1 - .34) = 7.92% 3.96% Equity 50% 7.8% + .8 (8.45%) = 14.56% 7.28% WACC = 11.24% The Ideal Balance of Debt & Equity Furthermore, the weights of debt and equity were given by the firm’s policy that debt should be about 50% of the total capital. The weights distributed between debt and equity were determined by management consensus. This policy was most likely adopted because it was an easy rule of thumb for management to go by. We propose that Pioneer use a more accurate weight of 28.1% for debt and 71.9% for equity. This was calculated as follows: Debt = Net Income / Return on book equity = 1,555 / .25 = $6,220 Equity = (Net Income/EPS) x Market price of stock = (1,555 / 6.15) x 63 = $15,929 Weight of debt = Debt / (Equity + Debt) = 6,220 / (6,220 + 15,929) = 28.1% Weight of equity = Equity / (Equity + Debt) = 15,929 / (6,220 + 15,929) = 71.9% The result is a WACC of 12.7%, which is even higher and more selective than the previous calculation. Exhibit B in the appendix shows how the mix of debt and equity affects the WACC and the required rate or return. Revised WACC should be: Financing Components Weight Cost of capital (after corporate tax) Weighted cost of capital (= Weight x Cost of capital) Debt 28.10% 12% (1 - .34) = 7.92% 2.23% Equity 71.90% 7.8% + .8 (8.45%) = 14.56% 10.47% WACC = 12.70% Single vs. Multiple Cut-off Rates Pioneer currently uses a single cut off rate across the entire company. While this may be beneficial for simplicity sake, the divisions are diversified and have different associated risks, and, therefore, different cost of capital numbers. The division differ in many ways: 1) Exploration and development: a low-cost refiner with 60% of petroleum liquids coming from the Alaskan production Pioneer has a great deal of risk as well as reward in this market. Its chemical unit produced about one-third of the world supply of MTBE which has high growth potential in the United States with the 1990 Clean Air Act amendments as well as the California Air Resources Board regulations. While these regulations provide growth for the chemical unit, they can at the same time have a negative affect on exploration and development (such as the moratorium on new drilling in Alaska). 2) Production: the crude production market is very volatile (as seen in Exhibit 1 ), the 1990 price swings from $40 per barrel to $15.50 per barrel emphasize this fact. It would also be effected by issues such as the war in Iraq. 3) Transportation: an integrated function of Pioneer, this division would be affected by new regulations, gasoline costs, cost of labor and scheduling issues. 4) Marketing: an internal function that would serve as the coordinating arm of the company. The imperative activities would be around price, product, place and promotion and how these activities are coordinated within the company. It’s likely that the marketing and transportation divisions take on fewer risky investments than production and development. For example, starting a new advertising campaign would be far less risky than starting a production facility in the Middle East. It would be unfair to judge all of these investments by the same rate of return. Pioneer should use multiple divisional hurdle rates when evaluating projects and allocating funds among its four divisions. It would take the inherent risk of each function and division into consideration and provide a better estimate on the required rate of return for each project. Furthermore, a project should be accepted if and only if its expected return is equal to or greater than that of a financial asset of comparable risk. Therefore, the project’s discount rate is the expected return on the financial asset of comparable risk, or the cost of capital of the division, as determined by the CAPM. Pioneer’s cost of capital for each of the four operating divisions is as follows: 20% for exploration and development, 20% for production, 10% for transportation, and 10% for marketing. All four divisions fall within the desired cost of capital range of 10% to 20%. Because the cost of capital for the marketing division was not given, the assumption was made that marketing’s divisional cost of capital is 10% due to its similarity of risk to the transportation division. Criteria: The risk associated with a refinery investment for Pioneer was much less than for an independent company. Pioneer’s diversification premium should be allocated back. Pioneer should set capital budgeting criteria for each of the four divisions instead of at an overall company level. Due to the nature of the business and heavy cash flows, Pioneer can withstand to accept projects with longer payback periods. Budgeting criteria should be set by each division’s WACC. The betas for each division can be calculated by using CAPM. For example, the beta for the divisions with a 20% cost of capital is calculated as follow by solving for Beta: Capital Asset Pricing Model (CAPM) = Rf + B1 x (Rm – Rf) 20% = 7.8% + B(16.25% - 7.8%) Beta of 20% divisions = 1.4 Also, the Beta for the 10% cost of capital divisions is calculated as follows: 10% = 7.8% + B(16.25% - 7.8%) Beta of 10% divisions = 0.3 Average Beta for Pioneer is 0.85, which is calculated by taking the average of all the Betas (1.4+1.4+0.3+0.3) / 4. For divisions whose projects are less risky by nature, lower betas are associated. On those projects with lower betas, we can anticipate lower returns. It is not feas...
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