CASE: Pioneer Petroleum
I. Does Pioneer estimate its overall weighted average cost of capital correctly
One could argue that their assumption of debt policy staying same (12%) isn't very good since all estimates predict on growing investments worth billions during the next year. In addition, a closer analysis of the sources of the infromation shows that the return on equity (10%) is just an assumption made based on current earnings yield.
Their first alternative would have been using divident and growth information, but the most accurate way is using the CAPM.
CAPM = | rf+B(rr-rf) | 14,56 |
| | |
New WACC | (1-TC)*(rD*D)+(rE*E)= | 11,24 |
rf | 7,8 |
B | 0,8 |
rm | 16,25 |
This new CAPM based cost of capital is much higher than Pioneers estimation of 9%, so their calculations are incorrect.
II. Should Pioneer use a single or multiple divisional costs of capital in evaluating projects? If multiple rates are used, how they should be determined?
Because Pioneer Petroleum has divisions in many different economical sectors each having different kind of risk structure and investment strategies, I would recommend using multiple rates of capital costs. The idea of discounting in general is to divide the cash flow of a project with its riskiness and a company-wide discount rate definately wouldn’t tell anything about the risk involved in a specific investment in one of the different divisions.
Instead, these multiple discount rates should be determined according to the risk of the division, forming a single rate for a group of sectors with simiral risk structure. For example, the divional cost of capital for the production and exploration was 20% and the divisional cost of capital for transportation was just 10% - which represents this major differens in risk rather well. At the moment riskier divisions are having more projects funded than divisions with lower risk - but still steady profit - hence decreasing shareholder value....