Pioneer petroleum items for discussion Group#10
Key objectives: calculation of WACC and use of hurdle rates in risk return analysis. 1. Does Pioneer estimate its overall weighted average cost of capital correctly? a. Evaluate technique, weights and rates.
b. How should they estimate their cost of equity capital?
To estimate the overall weighted average cost of capital, Pioneer used the weighted average cost of capital method. First, they find the proportions of each source of capital which is equity and debt. Because the firm policy had been adopted that funded debt should represent approximately 50% of total capital. So the weight of Debt and Equity are 50% respectively. The weights Pioneer used are correct. However, the firm should not use the coupon rate instead of the interest rate when calculating the cost of debt and shouldn’t use the current earnings yield on the stock as the cost of both new equity and retained earnings. Cost of equity should be the required rate of return on equity. They should use CAPM method to estimate the cost of equity. The risk free rate was 7.8%, b was 0.8, and the market rate was -3.2%. So the cost of equity should be -1%. 2. Should they use a single corporate cost of capital or multiple hurdle rates in evaluating projects and allocating investments to divisions? ANS: For evaluating projects and allocating investments to divisions, they should use the multiple hurdle rates. The multiple cutoff rates determined the minimum acceptable rate of return on proposed capital investments in each of the main operating areas of the company and represented the rate charged to each of the various profit centers for capital employed. However, if they want to use multiple hurdle rates in evaluating and allocating, they should make the ambiguous area more clear. And make it more helpful in grouping projects.
3. If multiple hurdle rates are used how should they be determined? ANS: First, the firm should estimate the debt...
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