Pioneer Petroleum Analysis

Pioneer Petroleum Corporation’s (PPC) has been through a diverse amount of changes
throughout the years. They were originally were a merger of several different independent firms
operating in the oil refining, pipeline transportation, and industrial chemicals fields. PPC then
integrated vertically into exploration and production of crude oil and marketing refined
petroleum products, but horizontally into plastics, agricultural chemicals, and real estate
development. They decided to restructure the company into a hydrocarbons-based company,
concentrating on oil, gas, coal, and petrochemicals. They needed to decrease their overall risk
and optimize their overall performance and would only be able to by collaboration and
coordination among their refining and marketing network divisions.

PPC were spending billions of dollars on capital expenditures and were expecting an increase in
the next year. These expenditures were allowing for the company to process heavy Alaskan
crude oil more efficiently and also provided good returns. In the next five years, the company
was going to need to meet new environmental standards, which meant more spending increases.
Along with these expenditures and regulations were expected higher growths because now the
company truly could utilize and capitalize on their strength.

PPC’s management and board are weighing out two alternative approaches in order to determine
a minimum rate of return. They had to decide if a single cutoff rate based on the company’s
overall weighted average cost of capital (WACC) or a system of multiple cutoff rates that
reflected the risk-profit characteristics of the several businesses or economic sectors in which the
company’s subsidiaries operated would be the better alternative. Their basic capital budgeting
approach was to accept all proposed investments with a positive net present value (NPV) when
discounted at the appropriate cost of capital. If Pioneer wanted to compete and remain active in
the industries they were currently in, a decision was needed.

Pioneer believes to estimate their corporate weighted average cost of capital at 9%. With the
economy and the market constantly fluctuating, the actual rate of return fluctuates with the
market. The discounted rate gives a weighted average cost of capital (WACC) of 9% (Example
1). The divisions will ultimately affect the company and the WACC will fluctuate along with the
divisional costs of capital. The risks involved within the divisions are reflected in the risks that
the company overall chooses to invest.

Example 1

WACC = rdebt(1-Tc)(D/V)+requity(E/V)

=.12(1-.34).50+.10*.50 = .0896 = 9%

The company has invested into many different industries and markets. Each industry’s risk is
different and remaining diversified is crucial to obtaining a marginal rate of return. The company
needs to use single corporate cost of capital hurdle rates in order to evaluate projects and in order
to allocate costs. PPC has integrated so many different industries into their portfolio that it would
be best for them to look at each division differently. Their oil division is going to have a higher
risk compared to the plastics division. The divisions need to allocate costs according to the risk
within that division. The multiple hurdle rates need to be determined to this risk.

Pioneer needs to look to the future and determine how they want to compete in the long run.
Though they need to use multiple hurdle rates they need to relate these to the company as a
whole also. This is crucial in order to compete industry-wide in the long run. The hurdle rates
need to stay proportionate to the risk being involved within that division in order to have the
optimal cost of capital.

The level of risk involved along with the particular division should also determine capital
budgeting. The higher a risk was within the particular division within the company the more that
was invested. This was due to a hurdle rate being too low. It is also important to look at the
projects overall contribution to the firm’s borrowing power. It is only natural for the cost of debt
ratio to fluctuate with the cost of equity ratio.

The future process for Pioneer should be a look into each division specifically, not the company
as a whole. Each division’s beta will be represented through the market. The risk will also be
determined by the age of the project. Sometimes projects are riskier at a younger age and some
are not and some are riskier at an older age than others. Pioneer needs to take the age into
consideration just as much as a projected cash flow. If currently the project is at a great financial
risk, there may not want to be as much invested into the project.

1) How does Pioneer calculate its hurdle rate at the moment?

At the moment Pioneer Petroleum uses the overall Weighted Average Cost of Capital to calculate its
hurdle rate. Weighted average cost of capital of Pioneer was calculated in 3 steps:

I. The expected proportions of future funds sources were estimated.

II. Costs were assigned to each of these sources.

III. A weighted average cost of capital was calculated on the basis of these proportions and costs.

2) How does Pioneer estimate the cost of equity? Does it seem reasonable to you?

a. Suppose the company has a bad year. What will be the effect of this on the cost of equity?

Pioneer uses the current earnings yield on stock as the cost of both new equity and retained earnings.

The Earnings Yield Definition is given as:

Earnings Yield: The earnings per share for the most recent 12-month period divided by the current
market price per share. The earnings yield (which is the inverse of the P/E ratio) shows the percentage
of each dollar invested in the stock that was earned by the company.

Hence Earnings yield represents the forecast earnings divided by the market price.
Does it seem reasonable to you?

If earnings yield is used for cost of equity then it will change a lot because the price of the stock
fluctuates every day. So earnings yield is not reliable enough to provide an accurate measure of

Cost of equity.

Moreover, a single company-wide cost of capital subsidizes the higher risk divisions at the expense of
the lower risk divisions.

Effect of bad year on cost of equity:

If the company has had a bad year, then it will reflect on the stock price. The stock price of the company
will come down. Since the company had already made the forecast earnings on each share the previous
year, the earnings yield or E/P ratio will become higher. Consequently the cost of equity for Pioneer will
become high.

Also in simple terms it means that Pioneer will have to give away more equity for less amount.
Eventually this leads to higher cost of equity during bad years of company performance.

3) What should capture the discount rate when analyzing an investment? How does this general answer
compare with the current practice at Pioneer?

The discount rate should capture the future risks of the investment. The current practice at Pioneer of
applying a single discount rate, although is easier to implement, doesn’t capture the risks of each
division. Pioneer petroleum operates in different industries like exploration and production of crude oil,
plastics, agricultural chemicals and real-estate development. The risks of each of these industries are
different. Hence, applying an overall weighted average cost of capital doesn’t reflect the risks of each
sector.

4) Should Pioneer use a different discount rate for each division? How would you calculate them?

The divisional rate would reflect the risks inherent in each of the economic sectors or industries in which
the company’s principle operating subsidiaries worked. It would also help to establish a better
benchmark with the industry.

The divisional cost of capital would be calculated using a weighted average cost of capital approach for
each operating sector. The calculations would follow these 3 steps:

i. An estimate would be made of the usual debt and equity proportions of independently financed
firms operating in each sector.
 ii. The costs of debt and equity given these proportions and sectors would be estimated in accordance
with the concepts followed by the company in estimating its own cost of capital.

iii. These costs and proportions would be combined to determine the weighted average cost of capital,
or minimum acceptable rate of return, for net present value discounting purposes in each sector.

5) In the past Pioneer calculated different hurdle rates per division, but its weighted average was higher
than its real hurdle rate for the whole company. Why?

The difference was attributed to the fact that the divisional cost of capital overlooked the risk
diversification benefits of many investments undertaken by Pioneer Petroleum. For example, the risks
associated with a refinery investment by an integrated company like Pioneer were much less than for an
identical investment made by an independent. It was proposed that this diversification premium be
allocated back and deducted from the multiple subsidiary discount rates as calculated previously in
proportion to the relationship between the investments in each subsidiary to the company’s total
assets.

6) What are the consequences of using the wrong hurdle rate?

Using a wrong hurdle rate could lead to:

i. If the hurdle rate was estimated to be higher than its actual value, then it means actually turning
down good projects. In case it was lower than the actual then the company will be accepting projects
that have negative NPV or very low marginal profits and consequently destroying shareholder value.

ii. Wrong risk analysis: Hurdle rate has a risk component associated with it. So if it’s wrong then the
company is not truly estimating the risk that this debt will have on the shareholders and shareholder’s
value could be destroyed.

7) What would you do?

From the analysis of your class notes,

Combining both the approaches seems like a well-balanced approach. But the problem is although Value
is additive, Risk is not!

NPV(A+B) = NPV(A) + NPV(B)

RISK(A+B) != RISK(A) + RISK(B)

For a well-diversified investor market risk is all that matters. Furthermore, suppose discount rate for
each division is as follows:

Transportation 10%
E&P 20%

If we choose one rate that is between 10% and 20%, then it means there will be an underinvestment in
one of the sectors. That might result in a problem for the company because highly profitable sectors will
lack enough resources to compete in the market!

full version Pioneer Petroleum Essay

Pioneer Petroleum
Category: Business

Autor: student77 24 January 2010

Words: 1514 | Pages: 7

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.

Conclusion

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.
Background:

Pioneer Petroleum was formed in 1924; they refine oil, pipeline transportation, and industrial
fields. PPC has is one of the primary producers of Alaska crude and in 1990s provided 60% of
Pioneer’s domestic petroleum liquids production. PPC are also the lowest cost refiners on the
West Coast. It is merged with several other independent firms in their industry. After the merge
they integrated vertically into exploration and production of crude oil and marketing refined
petroleum products, but horizontally into plastic, agricultural chemicals, and real estate
development. PPC now is reorganized the company into a hydrocarbons-based company,
concentrating on oil, gas, coal, and petrochemicals. PPC needs to decrease their risk and
optimize their performance and would only be able to by collaboration and coordination among
their refining and marketing network divisions.

PPC was spending billions on capital expenditures and were expecting an increase in the next
year. These expenditures allowed the company to process Alaskan crude oil more efficiently and
get a good return while doing so. Since environment standards are chancing PPC will have to
meet these new requirements and in order to do so PPC will have to increase their spending.
With the new expenditures and the new regulations PPC is expecting an increase in growth
because the can capitalize on their strength.

PPC managers are weighing out their alternative in order to determine the minimum rate of
return. PPC has the decision between a single cutoff rate based on the company’s overall WACC
or a system of multiple cutoff rates that reflect risk profit characteristics. PPC approach was to
capital budgeting was to accept any investment that shown a positive NPV when discounted at
the appropriate cost of capital.

Problems Statement:

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

2. Should Pioneer use a single corporate cost of capital or multiple divisional hurdle rates in
evaluating and allocating investment funds among divisions?

3. How should Pioneer set capital budgeting criteria for different projects within a given
division?

Analysis:

PPC believes to have estimated their corporate weighted average cost of capital is 9%. After-
taxes cost to debt was straightforward, debt issues would require a coupon of 12% and at a 34%
tax rate, this represented a 7.9% after-tax cost. The cost of equity had been more difficult to
theorize or to estimate. PPC decided to use the current earnings yield on the stock as the cost of
both new equity and retained earnings. Cost of equity is at 10% this calculated by market price of
$63 dividend by the earning per share of $6.15. The company's weighted average cost of capital
was calculated in three steps: first, the expected future target proportions of debt and equity in
the company's capital structure were estimated; second, costs were assigned to each of these
capital components; third, a weighted average cost of capital was calculated on the basis of these
proportions and costs.

WACC= rdebt(1-TC)(D/V)+equity(E/V)

=.12(1-.34).50+.10*.50 = .0896 or 9%

PPC should use the multipile divisional hurdle rate in evaluating and allocating investment funds
among divisions. The different division have different risk to them. For example, the divisional
cost of capital for production and exploration was 20% and the divisional cost of capital for
transportation was 10%. This rates show the rate charged to the different profit centers. The
discounted rate should be determined by calculating the WACC for each sector followed by the
NPV equation. Unless all the projects are the same rick, we can not choose the same discount
rate for all projects.

Assuming that all projects within a division carry the same risk may lead to projects being
accepted or rejected when they shouldn’t be. Projects that are riskier than average would be
mistakenly accepted and low risk projects would be rejected. PPC should use the discounted rate
for a project within a division based on how risky the project maybe. A project with more risk
than the market will have a high beta and will cause a higher discounted rate. Knowing the
characteristics of a project can help the company determine the beta that needs to be used for a
particular project. This can be done by comparing the beta of the particular project to the
industry.

Another important feature that will impact the riskiness of a project is operating leverage. A
project operating leverage is measured by the relationship between the fixed and variable cost. A
project with high fixed cost and low variable cost is known to have a high operating leverage
which makes the project more of a risk. This happens because when sales increase or decrease
this affects profits more than a project with high variable cost and low fixed cost. By looking at
the level of operating leverage through a project PPC managers can identify what level of risk
they may be undertaking on a particular project.

Another key thing to look at is that PPC operations that impact their project evaluations are in
their vertically and horizontally integrated operations. PPC will incur lower than average
industry risk in their project with respect to the level of integration operations. Since there are a
number of different things impacting risk with respect to the projects, it is serious that these
criteria be considered to determine a discount rate with PPC divisions.

The discounted rate for environmental projects should be the same throughout PPC because the
$3 billion PPC is planning to spend in the next 5 years is going into the division that is working
toward meeting the regulation introduced by the 1990 Clean Air Act amendments and the
California Air Resources Board's regulations. These environmental regulations also provide
opportunities for pioneer to capitalize on its strengths. PPC has one of the cleaner-burning
gasoline in the industry.

Conclusion:
With the company expanding vertically and horizontally the multipile divisional hurdle rate can
allow for a true evaluation of a project. Understanding how to evaluate investments, ventures can
be assigned with the proper rate of return. Also with tools like beta and operating leverage will
help estimate how much risk a project is taking on.