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Management and Board of Pioneer Petroleum (PP) FROM: Corporate Finance Consultants Gal Gabriel, Lina Fedirko, Tara Patel DATE: March 20, 2012 RE: Cost of Capital: Methods and Approach to Divisional Discount Rates MEMORANDUM
Recommendation:
Pioneer
Petroleum
(PP)
should
use
multiple
divisional
hurdle
rates
in
evaluating
projects,
because
the
operations
of
each
division
vary
in
risk
and
thus
should
be
discounted
at
appropriate
rates
reflecting
the
industry.
Further,
when
computing
a
firm-wide
Weighted
Average
Cost
of
Capital,
Pioneer
should:
(1)
use
dividend
growth
rate
when
using
dividend
growth
model
approach
for
cost
of
equity,
(2)
the
firm
should
also
compute
cost
of
equity
using
Capital
Asset
Pricing
Model
to
account
for
market
risk,
(3)
final
cost
of
equity
should
reflect
an
average
rate
from
both
approaches.
Pioneer
Petroleum
Weighted
Average
Cost
of
Capital
In
terms
of
calculating
cost
of
debt,
we
found
your
approach
to
be
reasonable,
assuming
three
things
will
stay
constant:
(1)
tax
rate,
(2)
debt
to
equity
ratio,
and
(3)
debt
rating.
Given
those
three
assumptions,
cost
of
debt
equates
to
7.9%,
using
standard
cost
of
debt
computing
technique1.
In
order
to
arrive
at
the
cost
of
equity,
PP
employed
the
dividend
growth
model.
Using
this
technique,
the
company
has
to
look
at
its
dividend
per
share,
and
in
this
case
PP
used
earnings
per
share.
In
addition,
the
cost
of
equity
calculation
should
employ
projected
dividends
for
1991,
the
year
when
new
investments
are
discussed.
If
we
apply
the
10%
dividend
growth
(g)
assumption,
a
stock
price
of
$63
and
project
a
$2.70
dividend
per
share
for
1991,
the
cost
of
equity
is
as
follows:
R(e)
=
Div.
projected/Price
of
stock
+
g
=
$2.70/
$63
+
10%
=
14.28%.
Therefore,
using
the
dividend
growth
model
approach,
the
average
weighted
cost
of
capital
is
11.1%.
(Table
1)
Table
1
1991
Weighted
Average
Cost
of
Capital
Dividend
Growth
Model
Approach
with
a
10%
growth
Source
Debt
Equity
WACC
Estimated
Proportions
of
Future
Funds
Sources
0.50
0.50
Estimated
Future
After- Tax
Cost
7.92%
14.28%
Weighted
Cost
3.96%
7.14%
11.10%
Also,
wed
like
to
point
out
that
It
is
worth
taking
another
look
at
the
10%
measure
for
the
dividends
growth.
The
firm
uses
this
percentage
based
on
its
commitment
to
its
shareholders
and
actual
dividends
increase
in
1990
and
1991.
However,
looking
back
at
data
given
for
previous
years,
PPs
dividend
growth
may
not
always
stay
at
this
rate.
For
example,
between
1986
and
1989
there
was
no
growth.
The
large
1
66.66%
of
dividend
per
share
growth
in
1986
must
have
happened
due
to
the
company
restructure,
so
we
can
ignore
it.
We
know
from
past
data
that
average
dividend
growth
can
be
low
as
5.34%.
(See
Appendix
1)
With
an
assumption
of
a
lower
dividend
growth
rate,
the
cost
of
equity
decreases
to
9.85%.
The
resulted
WACC
is
8.88%.
(Table
2)
(R(e)
=
Div.
projected/Price
of
stock
+
g
=
$2.84/
$63
+
5.34%
=
9.85%)
Table
2
1992
Weighted
Average
Cost
of
Capital
Calculation
Dividend
Growth
Model
for
average
dividend
growth
Source
Debt
Equity
WACC
Estimated
Proportions
of
Future
Funds
Sources
0.50
0.50
Estimated
Future
After- Tax
Cost
7.92%
9.85%
Weighted
Cost
3.96%
4.92%
8.88%
Moving
to
the
second
method
for
the
cost
of
equity
calculation,
the
Capital
Asset
Pricing
Model
(CAPM)
based
on
Security
Market
Line
(SML),
Pioneer
could
use
an
available
Beta
value
of
0.82,
a
risk
free
rate
of
7.8%3
and
6.84%
as
the
average
market
risk
premium
for
the
last
10
years
(calculation
shown
in
appendix
2)
4.
In
this
case,
the
cost
of
equity
could
be
as
follows:
R(e)
=
7.8%
+
0.8
x
6.84%
=
13.27%.
Based
on
this
approach,
Pioneer
Petroleums
average
cost
for
capital
will
be
10.66%.
Table
3
1990
Weighted
Average
Cost
of
Capital
Calculation
CAPM
SML
Source
Estimated
Proportions
of
Future
Funds
Sources
Debt
0.50
Equity
0.50
WACC
If
PP
was
to
adopt
the
single
corporate
WACC
method,
it
should
compute
an
average
of
the
above
mentioned
two
methods,
which
is:
10.66%
+
8.88%
=
9.77%.
This
average
will
account
to
the
overall
market
risks.
Case
for
multiple
hurdle
rates
Pioneer
should
use
multiple
divisional
hurdle
rates
to
evaluate
projects
and
allocate
investment
funds
among
divisions.
The
company
has
multiple
lines
of
business:
it
was
involved
in
the
exploration
and
production
of
crude
oil
and
marketing
refined
petroleum
products,
as
well
as
plastics,
agricultural
2 3
Exhibit 1 Exhibit 2, yield on T-bills 4 This rate is essentially the same as the 7% estimate for a market risk premium, which is based on large common stocks and given as a general assumption in Fundamentals of Corporate Finance (FCF), page 442 (Ross, Westerfield, Jordan 2010)
chemicals
and
real
estate
development;
the
company
was
later
restructured
and
now
concentrates
on
oil,
gas,
coal
and
petrochemicals.
Companies
that
are
involved
in
multiple
business
lines
should
utilize
divisional
costs
of
capital
to
ensure
that
investments
are
measured
separately
and
accurately.
Using
multiple
divisional
rates
provides
a
more
accurate
rate
of
investment
assessment,
because
a
single
weighted
average
cost
of
capital
is
not
an
adequate
tool
for
evaluation
as
it
is
a
standardized
rate.
This
can
skew
the
measure
of
profitability
or
riskiness
of
an
investment
as
projects
can
be
rejected
or
accepted
in
comparison
to
WACC.
If
the
hurdle
rate
is
set
too
low,
less
high
risk
investments
could
be
accepted.
On
the
other
hand,
the
WACC
could
also
result
in
too
few
low
risk
investments
made.
Thus,
WACC
is
not
the
best
evaluation
method
for
Pioneer
because
it
can
both
accept
unprofitable
or
too
risky
investments5.
In
order
to
avoid
potentially
bad
investments
evaluated
by
WACC
and
to
capitalize
on
profits,
Pioneer
should
use
divisional
rates
to
select
successful
investments.
To
do
this,
the
cost
of
capital
needs
to
be
determined
for
each
division
using
CAPM,
which
allows
for
a
stronger
measure
of
risk
and
expected
return,
and
a
diversified
portfolio
to
increase
profits.
Calculating
divisional
discount
rates
As
mentioned
before,
the
required
return
on
investment
should
be
based
on
cost
of
capital
derived
from
how
the
investment
is
financed.
Assuming
that
Pioneer
aims
to
retain
its
debt
to
equity
ratio,
each
new
investment
will
be
funded
based
on
that
ratio
(50%
from
equity
and
50%
from
debt).
Each
subsidiary
would
need
to
establish
an
individual
required
return
on
investment,
by
computing
individual
WACC
using
CAPM.
The
variance
in
cost
of
equity
will
result
in
the
variance
of
beta.
The
subsidiaries
will
need
to
establish
individual
beta
rates
based
on
beta
rates
used
in
similar
or
highly
comparable
industries
(industries
that
fall
within
same
risk
class).
So
essentially,
Pioneer
will
use
the
pure
play
approach,
to
determine
the
beta
for
subsidiaries
that
have
a
counterpart
in
the
industry.
In
terms
of
cost
of
debt,
all
subsidiaries
can
use
the
firms
established
cost
of
debt,
assuming
that
firm
ability
to
issue
debt
at
a
certain
rate
remains
fairly
constant.
If,
however,
Pioneers
debt
rating
increases,
the
cost
of
debt
should
be
recalculated,
as
the
financing
interest
rate
is
likely
to
decrease.
Once
each
subsidiary
establishes
its
own
WACC,
this
rate
will
serve
as
the
minimum
required
return
on
investment.
This
means
that
an
estimated
IRR
for
an
investment
should
always
exceed
the
WACC
in
order
for
the
project
to
be
accepted.
Typically,
if
a
project
is
considered
less
risky,
the
beta
will
be
higher
than
firms
beta,
and
if
less
risky
beta
will
be
lower.
Utilizing
different
betas
for
each
subsidiary
will
illustrate
their
level
of
sensitivity
to
market
fluctuations.
Incorporating
it
into
cost
of
equity
calculation,
Pioneer
will
capture
the
level
of
risk
involved
in
investing
into
various
subsidiaries.
Further,
this
will
assure
that
Pioneer
is
not
lagging
behind
its
competitors
in
different
market
segments,
and
is
retains
its
competitive
edge.
Environmental
Projects
5
Lastly,
weve
determined
that
Pioneer
should
use
separate
required
rate
of
return
on
environmental
projects
that
are
more
aligned
with
divisional
rates,
given
a
few
following
factors.
First,
environmental
projects
vary
in
value
and
risk
across
divisions
(e.g
environmental
project
in
sustainable
resource
extraction
might
have
a
higher
risk
than
an
environmental
project
in
sustainable
transportation
of
the
products.)
Second,
Pioneer
is
a
front
runner
in
producing
cleaner
energy
than
competitors,
assuming
that
the
firm
wants
to
retain
its
competitive
edge,
it
needs
to
review
environmental
project
within
each
division
with
a
primary
aim
of
following
new
regulations
while
making
profit6.
And
lastly,
due
unique
goals
of
environmental
projects
(not
just
profit-motive),
those
projects
need
to
be
given
a
discount
rate
that
reflects
not
just
quantitative
assessment
of
future
gains,
but
a
qualitative
analysis
of
future
value
that
will
be
created
(given
resource
depletion,
growing
regulation
constraints,
and
growing
market
for
sustainable
products).
6
New regulations continue to be passes calling for higher investment into environmental projects but also allowing for new market profit.
Year 1986 1987 1988 1989 1990 Current Assumption 1991 Proposed 1992 *1986-1991 average dividend growth
Percent Change - 0% 0% 10.00% 11.36% PP's projection based on 10% increase *Based on dividend-increase average since 1986 5.34%
Dividends
per
share
($)
3.00
2.50
2.00
1.50
1.00
0.50
0.00
1983
1984
1985
1986
1987
1988
1989
1990
1991
Dividends
per
share
($)
Appendix 2: Market Returns 10 years average calculation 500 index (%) of common stocks -4.9 21.4 22.5 6.3 32.2 18.5 5.3 16.8 31.5 -3.2 14.64%
1 2 3 4 5 6 7 8 9 10
Year 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990