Case Analysis on Capital Structure Pioneer Petroleum Essay

entreeThis landmark case seeks to break the risk-reward trade off involved in calculating Capital monetary value. The object glass of the rootage moldiness be to minimize stick out risks while maximizing project opportunities forthcoming. We want a appreciate and a rating system that does non unnecessarily jib the best available projects i.e. highest solve positive free cash-flows at that judgment of conviction. Particularly in times of excess capacity, this volition marginally put forward to increasing companionship entire exits, but willing non necessarily match the social club- dewy-eyed yield compel by investors.History of the Company and Background of the cuticleSometime in July 1991, one of the critical line of works confronting forethought and the board of open up crude Corpoproportionn, hereinafter referred to as trailblazer, is about Capital Budgeting specifically they take uped to picture the Minimum Acceptable prescribe of Return, or MARR, on new seat of government investments. Their capital budgeting approach was to brook all proposed investments with a positive net present value when cash-flows ar discounted at such allot toll of capital.Formed in 1924 through mergers of several formerly independent firms direct in the cover refining, pipeline transportation, and industrial chemical fields, pioneer start did vertical, horizontal, and backward integrations into exploration and production of crude oil, selling refined petroleum products, plastics, agricultural chemicals, and later diversified into real estate development. In 1985 Pioneer restructured pull ahead into hydrocarbon- ground oil, gas, coal, and petrochemicals.Statement of the ProblemWhat count or rating system will address specific, inherent risks of particles and operational sphere of influences AND consider earns ascribed to the exclusive- locate burden Average Cost of Capital approach? How can we garter Pioneer oil colour make an objecti ve, rational choice on the vault or cut-off enjoin for evaluation of new projects in a fully integ roamd conglomerate of threefold divisions take root whether they should use the SINGLE friendship wide Weighted Average Cost of Capital, which reflect the evaluate at their face value to the company, OR proposed seven-fold Divisional Cost of Capital, which reflects risk-profit characteristics inherent in various divisions and direct sectors.Objectives/ Directions of the Solution1) The decision must help the heed and board of directors of Pioneer Petroleum find on the unobjectionable and objective burial vault Rate/s that will slightly qualify new investment projects of Pioneer Petroleum divisions 2) Whatever the recommendation ought to be consistent with facts of the case, and provide consonance, rather than inconsonance, with the efforts of both the division and interchange or corporate management to execute strategy, leverage on strengths, and empower the company to mak e investments to gain and sustain competitive advantage. 3) The recommended project rate and rating system must be simple, objective and fair. 4) It must consider specific, inherent risks of divisions and operate sectors 5) It must alike address the interest of stockholders to maximize gift on their equity or investments. field Facts and Assumptions1) It is the Policy of the board to balance the blood line of funds, or to keep the funded debt and equity ratio at 5050 . Debt and Equity financial ratios ar a. D-E ratio for refining is 1.51,b. D-E for the exploration is 0.81.2) The Income Tax Rate is effrontery at 34%.3) Revenue is $15.6 one thousand thousand4) Net income $1.5 billion.5) It is given that dividends increased by 10% in 1990 and 1991, and at that placefore we will assume to use the higher target equity yields of 2.7 (add the 10%), rather than 2.45 the factual yield of 1989. 6) The companys Corporate Debt was A-rated this means it is deemed to carry much low risk than the ecumenic investing or borrowing public. 7) Capital Expenditure budget atomic number 18 enormous, $3.1 billion in 1990 and $4.5 billion in 1991, underscoring the significance of appropriate and accurate weights and calculations for Cost of Capital.Strengths and Opportunities.Pioneer was one of the primary producers of Alaskan Crude. The companys gasoline are among the cleanest burn fuels. By 1990, total revenues exceeded $15.6 one million million million and net income over $1.5 mensurationion. Pioneer supplied its own raw material for domestic petroleum liquids production and was alike one of the most efficient refiners of the West Coast and had an extensive West Cost presence. The company has clean, efficient running plants positioned to meet fixed environmental guidelines gain on less polluted products. Capital expenditure investments ran at $3.1 Billion, with forecasted expenditures of almost $4.5 Billion in 1991. Pioneer was also intemperately invested in Envir onmental projects. Its chemical unit produced 1/3 of the worlds supply of methyl tertiary butyl ether, MTBE, an ingredient making its gasoline one of the cleanest burning in the application.The MTBE market had been growing with the global trends towards sustained development of the environment.Refining its embody of capital calculations will not only preserve its much-needed capital, but it also unlocks new capital and maximizes existing capital to capitalize on such huge opportunities, particularly the passing of the 1990 Clean Air Act with which came tremendous surface area in which Pioneer might capitalize on its eco-strengths.Weaknesses and ThreatsTo meet Pioneer expected to invest $3 Billion additional to meet the new laws standards among other new environmental regulations. Its multinational status makes it vulnerable to foreign currency exchange risks, political risks, interest rate volatility, cultural risks, and reassign pricing and other transnational risks involvi ng a complex network of sources, sinks and of moneys, products and services.Its fully integrated set-up gets spreads itself quite thinly, and requires broadloom transnational collaboration and cross-border coordination to work. Management wanted synergy among global divisions to optimize overall performance, and obviously to diminish these complex risks.MethodologyThe weight cost of capital approach is applied, first apportioned pro rata based the usual cost of the fund source i.e. debt and/or equity. The cost of debt would be prevailing interest rates, and the cost of equity would be foregone earnings on capital invested as equity i.e. earnings per percentage over market value per share.The second approach is similar, but with multiple cutoff rates. outset it is mazed down by Divisional Cost of Capital i.e. calculated using a weighted medium cost of capital approach, but this time for separately division or operating(a) sector originally further drilling down by cost pe r fund source. Calculations would follow three (3) steps a) First an estimate would be made of the usual capital structure, or debt to equity dimensions, of independently financed firms operating in individually sector. b) Given these residuals by sector, for each operating sector, the be of capital divisional debt and equity would accordingly be estimated in accord with the concepts followed by the company in estimating its own cost of capital. This means Divisions are to use the WACC rules followed by the company, in estimating its own Weighted Average Cost of Capital. To describe this approach in a financial consumptionThe Weighted Average Cost of Capital = WACC = sum of Divisional costs of capital = nerve center total of Divisional Costs of Debt plus Divisional Costs of Equity3Decision Alternatives for Selection of marginally Attractive Rates of ReturnManagement and the board are choosing between two alternative approaches1) The hotshot WACC Rate, company-wide Weighte d Cost of Capital approach, where specific rates weighted were those based on the sources of fund, debt and equity, in estimated proportion of future funds sourced AND 2) Multiple Cut-off or Multiple overleap Rates for Divisional Costs of capital, involving ascertain the rates or weighted costs of capital for each main operational Sector. 3) Hybrid or Combination in that locationof taking the positive aspects or advantages of both methods i.e. for example, the requirements of stockholders for return on equity on the one hand, AND the requirements of divisions or operating sectors to address specific local risks, and implications on local incentives.Case abridgment and Discussion.The two alternative approaches purpose and benefits are culled from the case, as follows1) The single, company-wide Weighted Cost of Capital approach, where specific rates weighted were those based on the sources of fund, debt and equity, in estimated proportion of future funds sourced this gave a WACC rate of 9.0%. Proponents of the single rate might argue as follows a. It is far simpler to calculate.b. It covers the actual rate or cost of the source of funds at face value of bonds or watchs payable, or statements of stock or equity c. It appears to be more(prenominal) conservative than divisional rates because it does not consider economies of scale of fully integrated conglomerates that benefit the divisions or subsidiaries in ways that not reflected in the divisional costs of capital or rates. d. The riddle or effect of such diversification benefits on the rate is that Divisional Rates calculated independently, may be considered write down in reality. Why charge sunk costs, one might ask to the division. The problem here is that the hurdle rate may be too high for many projects, and therefore unduly rejected when in fact they ought to be accepted. IF they are accepted by competitors with similar integration benefits, perhaps, they will benefit from marginal income and grab this benefit from Pioneers subsidiaries.e. Pioneers shareholders expected the company to invest funds in the highest return projects available. f. Proponents of the single corporate rate argued that those advocating multiple rates were those who were not able to compete effectively for new funds, when measured against the corporate groups actual cost of capital. g. Single-proponent advocates lacked confidence in the fairness and right of the process of selection of divisional rates. For example, the transport division had unrealistically low hurdle rates considering experience in tanker investments had been disastrous for many companies.There were also still somewhat areas of ambiguity, such as how to treat environmental projects (or for this matter, primaeval HQ projects over which Divisions do little or no control). h. Another concern was how the benefits of full integration acquired through very(prenominal) expensive mergers and acquisitions would be considered in di visional rates. IF divisions lowered their rates, this might not be enough to cover central requirements. i. Reduced risk, economies of scale and other diversification gifts remained unaccounted for in the proposed divisional costs of capital approach. There were considerably less risks for instance in subsidiaries of an integrated firm like Pioneer, than for independent petroleum dealers or non-members of the group. This macrocosm the case, was it fair to demand such a high hurdle rate given that the risks were much lower at some divisions than others?2) Multiple Cut-off or Multiple Hurdle Rates for Divisional Costs of capital, involving let out the rates or weighted costs of capital for each main Operating Sector. The divisional rate approach seems far more complex, but proponents of divisional costs of capital argued included the following purposes and advantages of this synopsis a. The proponents of multiple divisional hurdle rates argued that a single companywide cost of capital (WACC) subsidized the higher-risk divisions at the expense of lower risk divisions. b. Because the cost of capital was too high for the low-risk divisions, too few low-risk investments were made. c. On the other hand, in the high-risk divisions too much investment occurred because the hurdle rate was too low. As evidence, proponents of multiple rates noted that Pioneer was the only major company that continued to invest heavily in exploration and development, and that it lagged behind its competitors in market and transportation investment.d. The divisional rates approach there was nothing new in the calculations except that sector rates would reflect the risks inherent in each of the operating sectors of the conglomerate. e. Evaluation of future capital expenditure or investments in each of the main operating areas of the company would be appraised pro rata based on the appropriate rate of return for that attention sectorf. For evaluation of actual financial performance say, for incentives and bonuses multiple cutoff rates would fairly represent the rates charged to each of the various profit centers for capital they employed or borrowed from headquarters so to call g. The proponents for multiple divisional hurdle rates also argued that the companywide cost of capital was too low, and that investments should be indispensable to earn at least as much as an investment in common stocks. The median(a) return since 1980 on the S&P index of common stocks of 16.25% substantially exceeded the 9% companywide cost of capital (see Exhibit 2). If Pioneer was serious about competing over the long run in industries with such different risk-profit characteristics, it was absolutely essential to relate internal target rates of return to the individual rail linees.It was argued by proponents of the multiple divisional cutoff rates that for subsidiaries and sister firms of integrated firms like Pioneer, the inter-company-benefits mitigated the risks involved with large refinery investments. then in some cases rates lower than companywide rates of return were honourableified. There was a diversification premium which ought to be allocated back or deducted from the subsidiary discount rates, as calculated previously in proportion to the relation between the investment in each subsidiary and, say, the companys total asset. recipe used for Weighted average cost of capital isWACC = K(d) + K(e) = Kd(1-t)*DEd + Ke*DEePioneers original calculations for WACC are summarized as followsFrom Exhibit 1The case mentions however, that the interest used is a coupon of 12%, assuming it retains an A rating, and a 34% tax rate, this represented a 7.92% cost after tax. According to Investopedia, coupon is delimitate as the interest rate stated on a bond when its issued. The coupon is typically paid semiannually. This is also referred to as the coupon rate or coupon percent rate.The divisional cost of capital would then be calculated using a WACC approac h for each Operating sector i.e. as though each sector were an independent company competing in its own industry -Note that the same WACC formula above is used to estimate divisional cost of capital, except it is not company wide, WACC rates in specific operating sectors such as business.. The divisional perspective overlooked that each business was also part of an integrated company with risk diversification benefits, economies of scale and other integration benefits, say of a large refinery.The case pointed out the weakness of a single-rate policy. On the one hand, very few low risk investments were made, precisely because of the high rate of return on investment demand by the pre-assessment. The hurdle rate was too steep for low risk divisions. Too few passed the gauntlet, so to speak. On the other hand, too much money was invested in high-risk divisions, because the hurdle rate on those operating sectors, was too low. Some members of top management felt that Company-wide cost o f capital rates was too low, and investments should be required to earn at least as much as Common stocks or over 14%.A couple of corrections need to be suggested on the single rate WACC of Pioneer.WACC = Kd + KeCost of equity, Ke. Note that after prolonged debate, Pioneer (management and board) decided to use 10%, which was the equivalent of $6.15 remuneration per Share divided by $63 Market Price per share. Using current earnings yield of their stock as the cost of both new equity stock and retained earnings. In other words the 10% used was based on actual dividend yield and not the projected or the required rate of return for the companys stock.Given a dividend growth rate of 10%, a share Market Price of $63, the next target dividend at $2.70 ( = $2.45 plus 10%), and the ratio of Equity to Debt at 5050, then the cost of equity is therefore calculated as followsCost of equity Ke = ((Target Dividend Value/Market Price)+Growth in dividends)*DEe = ((2.70/63) + 0.1)*(50%)= 14.3%.Cos t of debt, Kd It seems the actual interest rate afforded Pioneer was not in truth given in the case. What was used by management was the 12% coupon rate on bonds. Since Pioneer was an A-rated client, or deemed to carry very low risk, then this status ought to translate into a significantly lower cost of money or interest rate. To my understanding, a coupon 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 assume a prime interest rate of 9%. Allow me to note that this assumption is just for the case exercise, but such information ought to be readily be available in the real world. The cost of debt is thereforeCost of debt Kd = Interest Rate * (1-Tax Rate)= 9% (1 34%)= 5.94%. collectible to the 50-50 debt to equity capital structure, the actual cost of debt is 2.65%.The WACC is summarized as followsThe new WACC is 10.12%, as against the 9% estimated by Pioneer management. This means that compan ywide, projects that show a rate of return lower than 10.12% will not be approved. This is evenhandedly double edged, because it might mean that some projects which are less viable, but viable nevertheless, will be unduly rejected.It is suggested that rather than rejecting let there be a cap set on investments, and more flexibility be given on rates of return sometimes this may be opened to abuse and manipulation. There are other countless foretelling signs of project success of failure than just numbers. As shown in this case, the hurdle rate WACC may vary, depending on the assumptions for instance, if the debt to equity proportion changes, then the 5050 policy might be irrelevant.Conclusions and passportsFLEXIBILITYCUTOFF RateStop Loss Limits prodigyUnderstand Risks, but also OpportunitiesBest-selling author of Rich Dad, Poor Dad, Robert Kiyosaki wrote, Risk is a function of Ignorance. It is always risky if it is not clear or understood. Unless objectively determined based on f acts, a single, companywide rate of return used for expediencys sake, is just as risky as a multiple-cut divisional cost of capital rate, that supposedly considers local risks of specific divisions or operating sectors.Conclusion and RecommendationCapital Structure2 is the mix (or proportion) of a firms permanent long-term financing represented by debt, preferred stock, and common stock equity, greatly affected by specific costs of capital or assigned hurdle rates, say in assessing weighted average costs of capital.CORE ISSUE Hurdle rates2 are measures of the cost of capital, combined debt and equity, which a company targets for its projects to achieve in the planning period. The hurdle rates significance cannot be over-emphasized. If it is set too highly, it may spell tremendous losses in opportunities, or rejection of perfectly viable projects. This can also cause demoralization on the part of division personnel, who are rated based on such high hurdle rates. This means it is mor e difficulty to achieve, and thereby affecting managers and employees performance appraisals, bonuses and incentives.On the other hand, if we set hurdle rates too low in the game of golf, we might call this practice sand-bagging, or reporting a higher, more forgiving deterrent to increase chances of achieving it , this would be a major disservice to investors who expect maximum returns on their investments. They expect integrity in leadership, fair stewardship and good governance on the part of the board and senior management whom they receive elected to run company affairs in their behalf.One limitation of classical estimates on Hurdle rates or Costs of Capital is that (1) investment and asset management decisions are held constant and (2) they consider only debt-versus-equity financing, which are not necessarily the only sources of financing.Recommendation HYBRID SINGLE-MULTIPLE HURDLE RATEThe dissolvent must address specific legitimate needs of the different players, specific ally the Stockholders, the Division heads, and top Management.Stockholders require pause total returns on equity, and proponents of the Single rate assume that the only way to achieve let on overall returns on equity is to set company wide hurdle rates or weighted average costs of capital. They actually are not as concerned as division heads are, that some divisions are subsidizing others. This is not a sustainable practice. Pretty soon the masters who subsidize the losers will not find enough incentive to perform, and eventually leave.Division heads will be split into to. Winners, or Performers, and Losers, or non-performers. altitude management must listen to winners and ought to reward them, outrageously, if they are to keep performing for the long term. This means that for winner industries, the practice of attaining a hurdle rate which in players perception is too low becomes a deterrence over time. On the other hand, in non-performing divisions, good players that find the hurdle rates too high, are totally disillusioned and demoralized when standards are lowered to accommodate them.On a wider scope, Pioneer Petroleum needs to find a fair way to allocate central costs in accordance with responsibilities and to determine strategic and financial measures including, but not limited to the Cost of Capital between the central or corporate headquarters and its divisions and subsidiaries. This leads to less inter-departmental and inter-company conflicts, and more cooperation and synergy, which are necessary to for any breakthroughs to happen, i.e. in the complaint of better project execution, better decisions and a more positive working environment.The recommended solution may be described as follows.1) The policy we recommend is simplyCompany Wide WACC = Sum of Divisional WACCs = Sum of Local Costs ofDebt plus Local Costs of Equity2) The 5050 capital structure does not seem like a well founded policy and must be revisited. The objective must also includ e maximization of risks and returns, and not to literally balance debt to equity capital structure. 3) An evaluation and rating system must be set up to allow managers to think global, but to act local. This means we do a Hybrid system of Corporate-and-Divisional hurdle rates, maximizing the benefits of both, and ascribing responsibility for the rate, where it is rightfully assigned. For example, the division management is prudent for maximizing its return rate, given the resources it is allowed access to, and given the authority and responsibility in its portfolio. Division managers are not responsible for a company-wide rate just as much as it does not keep back any control over other companies, or over corporate financial, operating or marketing strategy. 4) The total company-wide Rates of Returns (e.g. 10-15%) on Investments or capital expenditure, are the responsibility of top management, and to achieve this, there are other ways, besides imposing this global rate on every si ngle operating division or subsidiary.5) A fair system of multiple hurdle rates ought to reflected the specific risk-profit idiosyncrasies of its business divisions and operating sectors in which the companys subsidiaries operated. 6) Using multiple hurdle rates will actually combine the strengths of performers in both winner and loser industry divisions. Fact is, the latter are not actually losers just lower yields but still positive yields, which might be descriptive of industry performance. The key hurdle rates to accommodate this, might therefore be industry-specific MARRs or WACCs. As mentioned, the rate or rating system must consider specific, inherent risks of divisions and operating sectors and at the same time consider benefits ascribed to the single-rate Weighted Average Cost of Capital approach.7) Aside from just calculating a fair rate, as financial advisors, we must equip Pioneer Petroleum top management with a better designed, more objective and more rational (less e motional) rating system to help them rationally choose the corporate-and-divisional hurdle rates for evaluation of new projects in a fully integrated conglomerate of multiple divisions determine whether they should use the SINGLE company wide 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 characteristics inherent in various divisions and operating sectors.8) The above rating system will help the management and board of directors of Pioneer Petroleum decide every year on the fair and objective Hurdle Rate/s that will fairly qualify new investment projects of Pioneer Petroleum divisions. a. It considers specific, inherent risks of divisions and operating sectors b. It addresses the interest of stockholders to maximize return on their equity or investments, which is ultimately the responsibility of TOP corporate management. c. It still uses the familiar Weighted Average Cost of Capital approach in calculating both single-company wide HURDLE rate, and divisional YIELD and HURDLE rates. d. Finally the solution MAXIMIZES OPPORTUNITY available in that it does not unnecessarily reject the best available net positive cashflow projects at that time which contribute to increasing company wide yields, but do not necessarily match the company wide yield.I believe this solution is easy to execute. It clarifies what rates to use as hurdle rates to truly evaluate . The solution must be win-win and acceptable proponents of both single and multiple ratesReferences1Pioneer Petroleum Corporation, Case on Divisional Cost of Capital. Copyright 1991 by the President and Fellows of Harvard College. Harvard Business School Case 292-011.2Capital Structure. Chapter 17, Fundamentals of Financial Management, 12/e Pearson discipline Limited 2004 Slides by Gregory A. Kuhlemeyer, Ph.D., Carroll College, Waukesha, WI3Investors need a good WACC. Bill McLure, Investope dia Contributor, www.investopedia.com, http//www.investopedia.com/articles/fundamental/03/061103.asp4Definition of Weighted Average Cost of Capital. Bill McLure, Investopedia Contributor, http//www.investopedia.com/terms/w/wacc.asp5Which is a better measure for capital budgeting, IRR or NPV? Rob Renaud, detective work Profitability with ROCE. http//www.investopedia.com/ask/ViewFAQPrintable.aspx?url=%2fask%2fanswers%2f05%2firrvsnpvcapitalbudgeting.aspAccounts Receivable and Inventory Management Chapter 10, Fundamentals of Financial Management, 12/e, Pearson Education Limited 2004, Slides Created by Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WIDebt and Stocks, Chapter 20, Fundamentals 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