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Pioneer petroleum

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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%.

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.

 If multiple hurdle rates are used how should they be determined? ANS: First, the firm should estimate the debt and equity proportion in each sector. Second, in each sector, the firm need to determine the cost of debt and cost of equity which was invested in the sector. Finally, the firm should use the discount rates times each weights, and get the specific rate for each sector.

How should Pioneer set capital budgeting criteria for different projects within a given division? What distinctions among projects might be captured in these criteria? How should the different standards be determined? ANS: Different projects should be set according to their risks and expected returns, even though they are in a given division. The various situation and market fluctuation for each project might lead to different returns. So Pioneer should set the cost of capital and weights distinctly among those projects. Because Beta represents the risk of a project and different projects show different risks, Beta used to calculate the CAPM should be determined depending on the risks. In addition, in determination of weights of debt and equity, they should also consider differently because initially Pioneer set half and half. But we believe in the future capital budgets, being more specific when setting the weight instead of just evenly distributed would be more reasonable.

Should the discount rate for environmental projects vary by division or be one corporate rate? ANS: The discount rate for environmental projects should be vary by division. Because environmental project is very special and difficult to predict the return. Sometimes it would show its benefit for the firm in a long term, and sometimes it couldn’t have any benefit directly for the firm. So, the firm should not only vary its discount rate by division but also should vary the discount rate based on different situation.

How can you quantify or address the different risk levels of potential projects? ANS: As we all known, there should be the industrial average discount rate. The firm can address the different risk levels based on comparison of their discount rates with the industrial index. So, if the cost of capital for the potential project is higher than industrial average rate, then it should be considered high risk; if the cost of capital for the potential project is lower than industrial average, then it should be low risk; if the cost of capital is around the industrial average, then it should be defined average risk.

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