Case Analysis on Capital Structure Pioneer Petroleum

Table of Content


This landmark instance seeks to interrupt the risk-reward trade off involved in ciphering Capital Cost. The object of the solution must be to minimise undertaking hazards while maximising undertaking chances available. We want a rate and a evaluation system that does non unnecessarily reject “the best available undertakings – i. e. highest net positive free cash-flows at that clip. ” Particularly in times of extra capacity. this will marginally lend to increasing company broad outputs. but will non needfully fit the company-wide output imposed by investors.

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History of the Company and Background of the Case:

Sometime in July 1991. one of the critical jobs facing direction and the board of Pioneer Petroleum Corporation. hereinafter referred to as Pioneer. is about Capital Budgeting ; specifically they needed to find the Minimum Acceptable Rate of Return. or MARR. on new capital investings. Their capital budgeting attack was to accept all proposed investings with a positive net nowadays value when cash-flows are discounted at such appropriate cost of capital.

Formed in 1924 through amalgamations of several once independent houses runing in the oil refinement. grapevine transit. and industrial chemical Fieldss. open up Pioneer did perpendicular. horizontal. and backward integratings into geographic expedition and production of rough oil. selling refined crude oil merchandises. plastics. agricultural chemicals. and subsequently diversified into existent estate development. In 1985 Pioneer restructured further into hydrocarbon-based oil. gas. coal. and petrochemicals.

Statement of the Problem:

What rate or evaluation system will see specific. built-in hazards of divisions and runing sectors AND see benefits ascribed to the single-rate Leaden Average Cost of Capital attack? How can we assist Pioneer Petroleum make an aim. rational pick on the hurdle or cut-off rates for rating of new undertakings in a to the full incorporate pudding stone of multiple divisions ; find whether they should utilize the SINGLE company broad Weighted Average Cost of Capital. which reflect the rates at their face value to the company. OR proposed MULTIPLE Divisional Cost of Capital. which reflects risk-profit features built-in in assorted divisions and runing sectors.

Objectives/ Directions of the Solution

1 ) The determination must assist the direction and board of managers of Pioneer Petroleum make up one’s mind on the just and nonsubjective Hurdle Rate/s that will reasonably measure up new investing undertakings of Pioneer Petroleum divisions 2 ) Whatever the recommendation ought to be consistent with facts of the instance. and supply consonant rhyme. instead than inconsonance. with the attempts of both the division and cardinal or corporate direction to put to death scheme. purchase on strengths. and authorise the company to do investings to derive and prolong competitory advantage. 3 ) The recommended undertaking rate and evaluation system must be simple. nonsubjective and just. 4 ) It must see specific. built-in hazards of divisions and runing sectors 5 ) It must besides turn to the involvement of shareholders to maximise return on their equity or investings.

Case Facts and Premises:

1 ) It is the Policy of the board to equilibrate the beginning of financess. or to maintain the funded debt and equity ratio at 50:50. Debt and Equity fiscal ratios are: a. D-E ratio for refinement is 1. 5:1.

b. D-E for the geographic expedition is 0. 8:1.2 ) The Income Tax Rate is given at 34 % .3 ) Gross is $ 15. 6 billion4 ) Net income $ 1. 5 billion.5 ) It is given that dividends increased by 10 % in 1990 and 1991. and hence we will presume to utilize the higher mark equity outputs of 2. 7 ( add the 10 % ) . instead than 2. 45 the existent output of 1989. 6 ) The company’s Corporate Debt was A-rated ; this means it is deemed to transport much low hazard than the general investment or borrowing public. 7 ) Capital Expenditure budget are tremendous. $ 3. 1 billion in 1990 and $ 4. 5 billion in 1991. underlining the significance of appropriate and accurate weights and computations for Cost of Capital.

Strengths and Opportunities.

Pioneer was one of the primary manufacturers of Alaskan Crude. The company’s gasolene are among the cleanest combustion fuels. By 1990. entire grosss exceeded $ 15. 6 Billion and net income over $ 1. 5 Billion. Pioneer supplied its ain natural stuff for domestic crude oil liquids production and was besides one of the most cost-effective refiners of the West Coast and had an extended West Cost presence. The company has clean. efficient running workss positioned to run into rigorous environmental guidelines capitalize on less contaminated merchandises. Capital outgo investings ran at $ 3. 1 Billion. with forecasted outgos of about $ 4. 5 Billion in 1991. Pioneer was besides to a great extent invested in Environmental undertakings. Its chemical unit produced 1/3 of the world’s supply of methyl third butyl quintessence. MTBE. an ingredient doing its gasolene one of the cleanest combustion in the industry.

The MTBE market had been turning with the planetary tendencies towards sustained development of the environment.

Polishing its cost of capital computations will non merely continue its much-needed capital. but it besides unlocks new capital — and maximizes bing capital — to capitalise on such immense chances. peculiarly the passing of the 1990 Clean Air Act with which came enormous country in which Pioneer might capitalise on its eco-strengths.

Failings and Menaces:

To run into Pioneer expected to put $ 3 Billion extra to run into the new law’s criterions among other new environmental ordinances. Its transnational position makes it vulnerable to foreign currency exchange hazards. political hazards. involvement rate volatility. cultural hazards. and reassign pricing and other multinational hazards affecting a complex web of beginnings. sinks and of moneys. merchandises and services.

Its to the full integrated set-up requires spreads itself rather thinly. and requires seamless multinational coaction and cross-border coordination to work. Management wanted synergism among planetary divisions to optimise overall public presentation. and evidently to diminish these complex hazards.


The leaden cost of capital attack is applied. first dealt out pro rata based the usual cost of the fund beginning: i. e. debt and/or equity. The cost of debt would be prevalent involvement rates. and the cost of equity would be “foregone” net incomes on capital invested as equity – i. e. net incomes per portion over market value per portion.

The 2nd attack is similar. but with multiple cutoff rates. First it is broken down by Divisional Cost of Capital – i. e. calculated utilizing a leaden mean cost of capital attack. but this clip for each division or operating sector ; before farther boring down by cost per fund beginning. Calculations would follow three ( 3 ) stairss: a ) First an estimation would be made of the usual capital construction. or debt to equity proportions. of independently financed houses runing in each sector. B ) Given these proportions by sector. for each operating sector. the costs of capital – divisional debt and equity – would so be estimated in conformity with the constructs followed by the company in gauging its ain cost of capital. This means Divisions are to utilize the WACC regulations followed by the company. in gauging its ain Leaden Average Cost of Capital. To depict this attack in a fiscal map:

The Leaden Average Cost of Capital = WACC = amount of Divisional costs of capital = Sum sum of [ Divisional Costs of Debt plus Divisional Costs of Equity ] 3

Decision Alternatives for Selection of Marginally Attractive Ratess of Tax return:

Management and the board are taking between two alternate attacks:

1 ) The Single WACC Rate. company-wide Weighted Cost of Capital attack. where specific rates weighted were those based on the beginnings of fund. debt and equity. in estimated proportion of future financess sourced ; AND 2 ) Multiple Cut-off or Multiple Hurdle Rates for Divisional Costs of capital. affecting finding the rates or leaden costs of capital for each chief Operating Sector. 3 ) Hybrid or Combination thereof – taking the positive facets or advantages of both methods ; i. e. for illustration. the demands of shareholders for return on equity on the one manus. AND the demands of divisions or runing sectors to turn to specific local hazards. and deductions on local inducements.

Case Analysis and Discussion.

The two alternate attacks “purpose and benefits” are culled from the instance. as follows:

1 ) The individual. company-wide Weighted Cost of Capital attack. where specific rates weighted were those based on the beginnings of fund. debt and equity. in estimated proportion of future financess sourced ; this gave a WACC rate of 9. 0 % . Advocates of the individual rate might reason as follows: a. It is far simpler to cipher.

B. It covers the existent rate or “cost of the beginning of funds” at face value of bonds or notes collectible. or statements of stock or equity ; c. It appears to be more conservative than divisional rates because it does non see economic systems of graduated table of to the full integrated pudding stones that benefit the divisions or subordinates in ways that non reflected in the divisional costs of capital or rates. d. The job or consequence of such variegation benefits on the rate is that Divisional Rates calculated independently. may be considered lower – in world. Why charge sunk costs. one might inquire to the division. The job here is that the hurdle rate may be excessively high for many “projects. ” and hence unduly rejected ; when in fact they ought to be accepted. IF they are accepted by rivals with similar integrating benefits. possibly. they will profit from fringy income and catch this benefit from Pioneer’s subordinates.

e. Pioneer’s stockholders expected the company to put financess in the highest return undertakings available. f. Advocates of the individual corporate rate argued that those recommending multiple rates were those who were non able to vie efficaciously for new financess. when measured against the corporate group’s “actual cost of capital. ” g. Single-proponent advocators lacked assurance in the equity and unity of the procedure of choice of divisional rates. For illustration. the conveyance division had “unrealistically low hurdle rates” sing experience in oiler investings had been “disastrous for many companies. ”

There were besides still some countries of ambiguity. such as how to handle environmental undertakings ( or for this affair. cardinal HQ undertakings over which Divisions have small or no control ) . h. Another concern was how the benefits of full integrating – acquired through really dearly-won amalgamations and acquisitions — would be considered in divisional rates. IF divisions lowered their rates. this might non be plenty to cover cardinal demands. I. Reduced hazard. economic systems of graduated table and other variegation premiums — remained unaccounted for in the proposed divisional costs of capital attack. There were well less hazards for case in subordinates of an incorporate house like Pioneer. than for independent crude oil traders or non-members of the group. This being the instance. was it just to demand such a high hurdle rate given that the hazards were much lower at some divisions than others?

2 ) Multiple Cut-off or Multiple Hurdle Rates for Divisional Costs of capital. affecting finding the rates or leaden costs of capital for each chief Operating Sector. The divisional rate attack seems far more complex. but advocates of divisional costs of capital argued included the undermentioned intents and advantages of this strategy: a. The advocates of multiple divisional hurdle rates argued that a individual companywide cost of capital ( WACC ) “subsidized the higher-risk divisions” at the disbursal of lower hazard divisions. B. Because the cost of capital was excessively high for the low-risk divisions. excessively few low-risk investings were made. c. On the other manus. in the bad divisions excessively much investing occurred because the hurdle rate was excessively low. As grounds. advocates of multiple rates noted that Pioneer was the lone major company that continued to put to a great extent in geographic expedition and development. and that it lagged behind its rivals in selling and transit investing.

d. The divisional rates approach – there was nil new in the computations – except that sector rates would reflect the hazards built-in in each of the operating sectors of the pudding stone. e. Evaluation of future capital outgo or investings in each of the chief operating countries of the company would be appraised pro rata based on the appropriate rate of return for that industry sector ;

f. For rating of existent fiscal public presentation — say. for inducements and fillips — multiple cutoff rates would reasonably stand for the rates charged to each of the assorted net income centres for capital they employed or “borrowed from headquarters” so to talk ; g. The advocates for multiple divisional hurdle rates besides argued that the companywide cost of capital was excessively low. and that investings should be required to gain at least every bit much as an investing in common stocks. The mean return since 1980 on the S & A ; P index of common stocks of 16. 25 % well exceeded the 9 % companywide cost of capital ( see Exhibit 2 ) . If Pioneer was serious about viing over the long tally in industries with such disparate risk-profit features. it was perfectly indispensable to associate internal mark rates of return to the single concerns.

It was argued by advocates of the multiple divisional cutoff rates that for subordinates and sister houses of incorporate houses like Pioneer. the inter-company-benefits mitigated the hazards involved with big refinery investings. Thus in some instances rates lower than companywide rates of return were justified. There was a “diversification premium” which ought to be allocated back or deducted from the subordinate price reduction rates. as deliberate antecedently in proportion to the relation between the investing in each subordinate and. state. the company’s entire plus.

Formula used for Leaden mean cost of capital is

WACC = K ( vitamin D ) + K ( vitamin E ) = Kd ( 1-t ) *DEd + Ke*DEe

Pioneer’s original computations for WACC are summarized as follows

From Exhibit 1

The instance references nevertheless. that the involvement used is a voucher of 12 % . presuming it retains an Angstrom evaluation. and a 34 % revenue enhancement rate. this represented a 7. 92 % cost after revenue enhancement. Harmonizing to Investopedia. voucher is defined as the involvement rate stated on a bond when it’s issued. The voucher is typically paid biyearly. This is besides referred to as the “coupon rate” or “coupon per centum rate” .

The divisional cost of capital would so be calculated utilizing a WACC attack for each Operating sector ; i. e. as though each sector were an independent company viing in its ain industry -Note that the same WACC expression above is used to gauge divisional cost of capital. except it is non company broad. WACC rates in specific runing sectors such as concern. . The divisional position overlooked that each concern was besides portion of an integrated company with “risk variegation benefits. ” economic systems of graduated table and other integrating benefits. say of a big refinery.

The instance pointed out the failing of a single-rate policy. On the one manus. really few low hazard investings were made. exactly because of the high rate of return on investing required by the pre-assessment. The hurdle rate was excessively steep for “low hazard divisions. ” Too few passed the gantlet. so to talk. On the other manus. excessively much money was invested in bad divisions. because the hurdle rate on those runing sectors. was excessively low. Some members of top direction felt that Company-wide cost of capital rates was excessively low. and investings should be required to gain at least every bit much as Common stocks – or over 14 % .

A twosome of corrections need to be suggested on the individual rate WACC of Pioneer.

WACC = Kd + Ke

Cost of equity. Ke. Note that “after drawn-out argument. ” Pioneer ( direction and board ) decided to utilize 10 % . which was the equivalent of $ 6. 15 Net incomes per Share divided by $ 63 Market Price per portion. Using current net incomes output of their stock as the cost of both new equity stock and retained net incomes. ” In other words the 10 % used was based on “actual” dividend output and non the “projected” or the “required rate of return” for the company’s stock.

Given a dividend growing rate of 10 % . a portion Market Price of $ 63. the following mark dividend at $ 2. 70 ( = $ 2. 45 plus 10 % ) . and the ratio of Equity to Debt at 50:50. so the cost of equity is hence deliberate as follows:

Cost of equity: Ke = ( ( Target Dividend Value/Market Price ) +Growth in dividends ) *DEe = ( ( 2. 70/63 ) + 0. 1 ) * ( 50 % )= 14. 3 % .

Cost of debt. Kd It seems the existent involvement rate afforded Pioneer was non really given in the instance. What was used by direction was the 12 % voucher rate on bonds. Since Pioneer was an “A-rated” client. or deemed to transport really “low hazard. ” so this position ought to interpret into a significantly lower cost of money or involvement rate. To my apprehension. a voucher rate would be like the hotel “rack rate” which would be much higher than what an A-rated client like Pioneer would be accommodated with.

Let us presume a premier involvement rate of 9 % . Let me to observe that this premise is merely for the instance exercising. but such information ought to be readily be available in the existent universe. The cost of debt is hence:

Cost of debt: Kd = Interest Rate * ( 1-Tax Rate )= 9 % ( 1 – 34 % )= 5. 94 % .

Due to the 50-50 debt to equity capital construction. the existent cost of debt is 2. 65 % .

The WACC is summarized as follows:

The new WACC is 10. 12 % . as against the 9 % estimated by Pioneer direction. This means that companywide. undertakings that show a rate of return lower than 10. 12 % will non be approved. This is slightly dual edged. because it might intend that some undertakings which are less feasible. but feasible nevertheless. will be unduly rejected.

It is suggested that instead than rejecting allow there be a cap set on investings. and more flexibleness be given on rates of return – sometimes this may be capable to mistreat and use. There are other infinite announcing marks of undertaking success of failure than merely Numberss. As shown in this instance. the hurdle rate WACC may change. depending on the premises ; for case. if the debt to equity proportion alterations. so the 50:50 “policy” might be irrelevant.

Decisions and Recommendations:

FlexibilityCUTOFF RateStop Loss LimitsForecastingUnderstand Risks. but besides Opportunities

Best-selling writer of “Rich Dad. Poor Dad. ” Robert Kiyosaki wrote. “Risk is a map of Ignorance. ” It is ever hazardous if it is non clear or understood. Unless objectively determined based on facts. a individual. companywide rate of return used for expediency’s interest. is merely every bit hazardous as a multiple-cut divisional cost of capital rate. that supposedly considers local hazards of specific divisions or runing sectors.

Decision and Recommendation

Capital Structure2 is the mix ( or proportion ) of a firm’s lasting long-run funding represented by debt. preferable stock. and common stock equity. greatly affected by specific costs of capital or assigned hurdle rates. state in measuring leaden mean costs of capital.

CORE ISSUE – Hurdle rates2 are steps of the cost of capital. combined debt and equity. which a company targets for its undertakings to accomplish in the planning period. The hurdle rate’s significance can non be over-emphasized. If it is set excessively extremely. it may spell enormous losingss in chances. or rejection of absolutely feasible undertakings. This can besides do demoralisation on the portion of division forces. who are rated based on such high hurdle rates. This means it is more trouble to accomplish. and thereby impacting directors and employees’ public presentation assessments. fillips and inducements.

On the other manus. if we set hurdle rates excessively low [ in the game of golf. we might name this pattern “sand-bagging. ” or describing a higher. more forgiving disability to increase opportunities of accomplishing it ] . this would be a major ill service to investors who expect maximal returns on their investings. They expect unity in leading. just stewardship and good administration on the portion of the board and senior direction whom they have elected to run company personal businesss in their behalf.

One restriction of classical estimations on Hurdle rates or Costss of Capital is that ( 1 ) investing and plus direction determinations are held changeless and ( 2 ) they consider merely debt-versus-equity funding. which are non needfully the lone beginnings of funding.


The solution must turn to specific legitimate demands of the different participants. specifically the Stockholders. the Division caputs. and top Management.

Stockholders require better entire returns on equity. and advocates of the Single rate assume that “the merely manner to accomplish better overall returns on equity is to put company broad hurdle rates or leaden mean costs of capital. They really are non every bit concerned as division caputs are. that some divisions are subsidising others. This is non a sustainable pattern. Pretty shortly the victors who subsidize the also-rans will non happen adequate inducement to execute. and finally go forth.

Division caputs will be split into to. Winners. or Performers. and Losers. or non-performers. Top direction must listen to victors and ought to honor them. outrageously. if they are to maintain acting for the long term. This means that for victor industries. the pattern of achieving a “hurdle rate” which in players’ perceptual experience is “too low”… becomes a deterrence over clip. On the other manus. in “non-performing” divisions. good participants that find the “hurdle rates” excessively high. are wholly disillusioned and demoralized when criterions are lowered to suit them.

On a wider range. Pioneer Petroleum needs to happen a just manner to “allocate cardinal costs in conformity with responsibilities” and to find “strategic and fiscal measures” – including. but non limited to the Cost of Capital – between the cardinal or corporate central offices and its divisions and subordinates. This leads to less inter-departmental and inter-company struggles. and more cooperation and synergism. which are necessary to for any discoveries to go on. i. e. in the way of better undertaking executing. better determinations and a more positive working environment.

The recommended solution may be described as follows.

1 ) The policy we recommend is merely:

Company Wide WACC = Sum of Divisional WACCs = Sum of [ Local Costss ofDebt plus Local Costss of Equity ]

2 ) The 50:50 capital construction does non look like a good founded “policy” and must be revisited. The aim must besides include maximization of hazards and returns. and non to literally “balance” debt to equity capital construction. 3 ) An rating and evaluation system must be set up to let directors to believe planetary. but to move local. This means we do a Hybrid system of Corporate-and-Divisional hurdle rates. maximising the benefits of both. and imputing duty for the rate. where it is truly assigned. For illustration. the division direction is responsible for maximising its return rate. given the resources it is allowed entree to. and given the authorization and duty in its portfolio. Division directors are non responsible for a “company-wide rate” merely every bit much as it does non hold any control over other companies. or over corporate fiscal. operating or selling scheme. 4 ) The entire company-wide Ratess of Returns ( e. g. 10-15 % ) on Investings or capital outgo. are the duty of top direction. and to accomplish this. there are other ways. besides enforcing this planetary rate on every individual operating division or subordinate.

5 ) A just system of multiple hurdle rates ought to reflected the specific risk-profit foibles of its concern divisions and runing sectors in which the company’s subordinates operated. 6 ) Using multiple hurdle rates will really unite the strengths of performing artists in both “winner” and “loser” industry divisions. Fact is. the latter are non really “losers” ; merely lower outputs but still positive outputs. which might be descriptive of industry public presentation. The cardinal hurdle rates to suit this. might hence be industry-specific MARRs or WACCs. As mentioned. the rate or evaluation system must see specific. built-in hazards of divisions and runing sectors – and at the same clip – see benefits ascribed to the single-rate Leaden Average Cost of Capital attack.

7 ) Aside from merely ciphering a “fair” rate. as fiscal advisers. we must fit Pioneer Petroleum top direction with a better designed. more nonsubjective and more rational ( less emotional ) evaluation system ; to assist them rationally take the corporate-and-divisional hurdle rates for rating of new undertakings in a to the full incorporate pudding stone of multiple divisions ; find whether they should utilize the SINGLE company broad Weighted Average Cost of Capital. which reflect the rates at their face value to the company. OR proposed MULTIPLE Divisional Cost of Capital. which reflects risk-profit features built-in in assorted divisions and runing sectors.

8 ) The above evaluation system will assist the direction and board of managers of Pioneer Petroleum make up one’s mind – every twelvemonth – on the just and nonsubjective Hurdle Rate/s that will reasonably measure up new investing undertakings of Pioneer Petroleum divisions. a. It considers specific. built-in hazards of divisions and runing sectors b. It addresses the involvement of shareholders to maximise return on their equity or investings. which is finally the duty of TOP corporate direction. c. It still uses the familiar Weighted Average Cost of Capital attack in ciphering both single-company broad HURDLE rate. and divisional Output and HURDLE rates. d. Finally the solution MAXIMIZES OPPORTUNITY available in that it does non unnecessarily reject “the best available net positive cashflow undertakings at that time” which contribute to increasing company broad outputs. but do non needfully fit the company broad output.

I believe this solution is easy to put to death. It clarifies what rates to utilize as hurdle rates to truly evaluate. The solution must be win-win and acceptable advocates of both individual and multiple rates


1“Pioneer Petroleum Corporation. ” Case on Divisional Cost of Capital. Copyright © 1991 by the President and Fellows of Harvard College. Harvard Business School Case 292-011.

2“Capital Structure. ” Chapter 17. Fundamentalss of Financial Management. 12/e © Pearson Education Limited 2004 ; Slides by: Gregory A. Kuhlemeyer. Ph. D. . Carroll College. Waukesha. WI

3“Investors need a good WACC. ” Bill McLure. Investopedia Contributor. World Wide Web. investopedia. com. hypertext transfer protocol: //www. investopedia. com/articles/fundamental/03/061103. asp

4“Definition of Leaden Average Cost of Capital. ” Bill McLure. Investopedia Contributor. hypertext transfer protocol: //www. investopedia. com/terms/w/wacc. asp

5“Which is a better step for capital budgeting. IRR or NPV? ” Rob Renaud. Descrying Profitableness with ROCE. hypertext transfer protocol: //www. investopedia. com/ask/ViewFAQPrintable. aspx? url= % 2fask % 2fanswers % 2f05 % 2firrvsnpvcapitalbudgeting. asp

‘Accounts Receivable and Inventory Management’ Chapter 10. Fundamentalss of Financial Management. 12/e. © Pearson Education Limited 2004. Slides Created by: Gregory A. Kuhlemeyer. Ph. D. Carroll College. Waukesha. WI

‘Debt and Stocks. ’ Chapter 20. Fundamentalss of Financial Management. 12/e. © Pearson Education Limited 2004.

Finance Decisions and Investments. © 2012 Lecture Notes by Dean Atty Joe-Santos Bisquera. LLB. CPA. MBA. De La Salle University College of Business – Graduate School

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