Sunday, February 24, 2019

Case Analysis on Capital Structure Pioneer Petroleum Essay

entryThis landmark case seeks to break the encounter-reward trade off involved in calculating nifty greet. The object of the resultant moldiness be to smear project ventures while maximizing project opportunities available. We want a position and a rating administration that does not unnecessarily reject the shell available projects i.e. highest wampum positive free cash-f clinical depressions at that eon. Particularly in snips of excess capacity, this allow for borderlinely contri providede to increasing f rollrnity wide haves, but will not necessarily match the phoner-wide deport imposed by investors.History of the Comp any and Background of the Case one- beat(prenominal) in July 1991, one of the critical hassles confronting way and the gore of start oil Corporation, presentinafter referred to as introduce, is about keen Budgeting specifically they needed to desexualize the Minimum Acceptable pose of Return, or MARR, on new pileus investment finance ss. Their heavy(p) budgeting approach was to accept all proposed investments with a positive net present appreciate when cash-flows atomic number 18 discounted at such(prenominal)(prenominal) appropriate toll of nifty.Formed in 1924 through mergers of several formerly independent firms run in the oil refining, pipeline transportation, and industrial chemical fields, pioneer groundbreaker did vertical, horizontal, and backward integrations into exploration and production of crude oil, marketing refined petroleum products, plastics, agricultural chemicals, and later diversified into real estate development. In 1985 initiate restructured boost into hydrocarbon-establish oil, gas, coal, and petrochemicals.Statement of the ProblemWhat regularise or rating frame will realize specific, built-in risks of pieces and run(a) sectors AND consider benefits ascribed to the hit- grade bur because ordinary toll of Capital approach? How can we help Pioneer oil make an objective, rational choice on the hurdle or cut-off evaluate for evaluation of new projects in a fully integrated garner of multiple divisions determine whether they should use the undivided attach to wide Weighted Average exist of Capital, which reflect the range at their face nurture to the company, OR proposed MULTIPLE divisional Cost of Capital, which reflects risk-profit characteristics inherent in motley divisions and operating sectors.Objectives/ Directions of the Solution1) The decision must help the management and plank of directors of Pioneer petroleum reconcile on the clear and objective everyplaceleap number/s that will fairly qualify new investment projects of Pioneer Petroleum divisions 2) Whatever the recommendation ought to be consistent with facts of the case, and entrust consonance, rather than inconsonance, with the efforts of both the division and interchange or corporeal management to execute strategy, leverage on strengths, and empower the company to make investments to pass on and sustain competitive advantage. 3) The recommended project rate and rating governing body must be simple, objective and fair. 4) It must consider specific, inherent risks of divisions and operating sectors 5) It must a handle palm the intimacy of simple eyeholders to maximize fall on their virtue or investments.Case Facts and Assumptions1) It is the Policy of the board to balance the source of funds, or to keep the funded debt and truth ratio at 5050 . Debt and fair play 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 disposed(p) at 34%.3) Revenue is $15.6 billion4) Net income $1.5 billion.5) It is effrontery that dividends increased by 10% in 1990 and 1991, and in that respectfore we will turn out to use the higher target paleness yields of 2.7 (add the 10%), rather than 2.45 the unquestionable yield of 1989. 6) The companys Corporate Debt was A-rated this means it is deem ed to carry a bully deal low risk than the general investing or borrowing public. 7) Capital Expenditure budget argon 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 pristine producers of Alaskan Crude. The companys gasoline ar among the cleanest burning fuels. By 1990, total revenues exceeded $15.6 one thousand million and net income oer $1.5 Billion. Pioneer supplied its own knife standardised material for domestic petroleum liquids production and was withal one of the virtually court-efficient refiners of the West Coast and had an extensive West Cost presence. The company has clean, efficient running plants positioned to act strict environmental guidelines upper-case letter of the United Statesize on less polluted products. Capital use of goods and services investments ran at $3.1 Billion, with forecasted e xpenditures of almost $4.5 Billion in 1991. Pioneer was to a fault heavily invested in Environmental projects. Its chemical unit produced 1/3 of the worlds supply of methyl radical tertiary butyl ether, MTBE, an ingredient making its gasoline one of the cleanest burning in the manufacture.The MTBE market had been growing with the global trends towards sustained development of the environment.Refining its comprise of enceinte calculations will not barely preserve its lots-needed with child(p), 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 ugly area in which Pioneer power capitalize on its eco-strengths.Weaknesses and ThreatsTo equal Pioneer judge to invest $3 Billion additional to meet the new laws standards among new(prenominal) new environmental regulations. Its transnational status makes it vulnerable to foreign currency exchange risks, politica l risks, worry rate volatility, cultural risks, and transfer pricing and other transnational risks involving a complex ne dickensrk of sources, sinks and of fundss, products and services.Its fully integrated regulate-up requires spreads itself quite thinly, and requires seamless transnational collaboration and cross-border coordination to work. Management wanted synergy among global divisions to optimize general exploit, and obviously to decrease these complex risks.MethodologyThe dull embody of capital approach is applied, first apportioned pro rata based the usual cost of the fund source i.e. debt and/or law. The cost of debt would be prevailing interest range, and the cost of equity would be foregone earnings on capital invested as equity i.e. earnings per share over market value per share.The second approach is similar, but with multiple cutoff grade. First it is furrowed down by divisional Cost of Capital i.e. calculated employ a weight down average cost of cap ital approach, but this time for from to each one one division or operating sector before further drilling down by cost per fund source. Calculations would follow ternary (3) steps a) First an estimate would be made of the usual capital structure, or debt to equity proportions, of independently financed firms operating in each sector. b) disposed these proportions by sector, for each operating sector, the costs of capital divisional debt and equity would then be estimated in accordance 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 functionThe Weighted Average Cost of Capital = WACC = sum of Divisional costs of capital = Sum total of Divisional be of Debt plus Divisional cost of Equity3Decision Alternatives for Selection of Marginally enthralling Rates of ReturnManagement and the board are choosing between two alternative approaches1) The Single WACC Rate, company-wide Weighted Cost of Capital approach, where specific rank 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 vault Rates for Divisional Costs of capital, involving determining the order or weighted costs of capital for each main operating(a) Sector. 3) Hybrid or Combination thereof victorious 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 anesthetic risks, and implications on local incentives.Case Analysis and Discussion.The two alternative approaches purpose and benefits are culled from the case, as follows1) The atomic number 53, company-wide Weighted Cost of Capital approach, where specific pass judgment 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 farthest simpler to calculate.b. It prolongs the existent rate or cost of the source of funds at face value of bonds or notes payable, or statements of stock or equity c. It appears to be much conservative than divisional order because it does not consider economies of scale of fully integrated conglomerates that benefit the divisions or subsidiaries in shipway that not reflected in the divisional costs of capital or rates. d. The problem or effect of such diversification benefits on the rate is that Divisional Rates calculated independently, may be considered lower in reality. wherefore charge sunk costs, one might ask to the division. The problem here is that the hurdle rate may be excessively high for many projects, and therefrom unduly rejected when in fact they ought to b e 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 surveyd against the corporate groups actual cost of capital. g. Single-proponent advocates lacked confidence in the fairness and impartiality of the process of selection of divisional rates. For example, the transport division had unrealistically low hurdle rates considering discover in tanker investments had been disastrous for many companies. there were also becalm vertical about areas of ambiguity, such as how to treat environmental projects (or for this matter, central HQ projects over which Divisions have little or no control). h. Anoth er business enterprise was how the benefits of full integration acquired through very costly mergers and acquisitions would be considered in divisional rates. IF divisions lowered their rates, this might not be full to cover central requirements. i. Reduced risk, economies of scale and other diversification grants remained unaccounted for in the proposed divisional costs of capital approach. There were considerably less risks for instance in subsidiaries of an integrated firm alike(p) 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 abandoned 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 determining 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 in cluded the following purposes and advantages of this scheme a. The proponents of multiple divisional hurdle rates argued that a single companywide cost of capital (WACC) subsidise 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 savage 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 marketing and transportation investment.d. The divisional rates approach there was nobody new in the calculations leave off 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 area s of the company would be appraised pro rata based on the appropriate rate of return for that industry sectorf. For evaluation of actual financial performance place, for incentives and bonuses multiple cutoff rates would fairly represent the rates charged to each of the different profit centers for capital they employed or borrowed from headquarters so to spill the beans g. The proponents for multiple divisional hurdle rates also argued that the companywide cost of capital was too low, and that investments should be inevitable to earn at least as much as an investment in common stocks. The average 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 disparate risk-profit characteristics, it was absolutely native to relate internal target rates of return to the individual businesses.It was argued by proponents of t he 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. Thus in some cases rates lower than companywide rates of return were cleanified. 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 as caboodle.Formula use for Weighted average cost of capital isWACC = K(d) + K(e) = Kd(1-t)*DEd + Ke*DEePioneers fender calculations for WACC are summarized as followsFrom Exhibit 1The case mentions however, that the interest utilise is a verifier of 12%, assuming it retains an A rating, and a 34% tax rate, this correspond a 7.92% cost after tax. According to Inves make passedia, coupon is defined 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 approach for each Operating sector i.e. as though each sector were an independent company competing in its own industry -Note that the homogeneous 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 failing 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 han d, 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 of 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) inflexible to use 10%, which was the equivalent of $6.15 Earnings 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 outgrowth rate of 10%, a share Market Price of $63, the future(a) target dividend at $2.70 ( = $2.45 plus 10%), and the ratio of Equity to De bt 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%.Cost of debt, Kd It seems the actual interest rate afforded Pioneer was not actually 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 claim a indigenous interest rate of 9%. Allow me to note that this assumption is exclusively 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 = bet Rate * (1-Tax Rate)= 9% (1 34%)= 5.94%.Due 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 companywide, projects that show a rate of return lower than 10.12% will not be approved. This is somewhat 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 subject to abuse and manipulation. There are other countless foretelling signs of project success of distress 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 RecommendationsFLEXIBILITYCUTOFF RateStop Loss Limits promiseUnderstand Risks, but also Opportunitie sBest-selling author of Rich Dad, abject Dad, Robert Kiyosaki wrote, Risk is a function of Ignorance. It is always risky if it is not intelligibly or understood. Unless objectively determined based on facts, 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 immix (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 tremendou s 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 more 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 report a higher, more forgiving handicap 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 have 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 financ ing, which are not necessarily the only sources of financing.Recommendation HYBRID SINGLE-MULTIPLE vault RATEThe solution must address specific legitimate needs of the different players, specifically the Stockholders, the Division heads, and top Management.Stockholders require better total returns on equity, and proponents of the Single rate assume that the only way to achieve better 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 winners who subsidize the failures will not view enough incentive to perform, and eventually leave.Division heads will be split into to. Winners, or Performers, and Losers, or non-performers. Top 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 indust ries, the practice of attaining a hurdle rate which in players perception is too low becomes a disincentive over time. On the other hand, in non-performing divisions, good players that find the hurdle rates too high, are totally disillusioned and debauch 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 direction 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 Divisi onal 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 include 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 amenable 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 have any control over other companies, or over corporate financial, operating or marketing strategy. 4) The total company-wide Rates of Return s (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 single 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 allay 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 a pproach.7) Aside from just calculating a fair rate, as financial advisors, we must fit out Pioneer Petroleum top management with a better designed, more objective and more rational (less emotional) 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 addresse s 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 sincerely 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 shoal Case 292-011.2Capital Structure. Chapter 17, Fun damentals of Financial Management, 12/e Pearson nurture confine 2004 Slides by Gregory A. Kuhlemeyer, Ph.D., Carroll College, Waukesha, WI3Investors need a good WACC. Bill McLure, Investopedia 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, Spotting Profitability with ROCE. http//www.investopedia.com/ask/ViewFAQPrintable.aspx?universal resource locator=%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 a nd Investments, 2012 Lecture Notes by Dean Atty Joe-Santos Bisquera, LLB, CPA, MBA, De La Salle University College of Business fine-tune School

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