Case Analysis on Capital Structure Pioneer Petroleum

Analysis, Pages 17 (4241 words)

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Introduction:

This landmark case seeks to break the risk-reward trade off involved in calculating Capital Cost. The object of the solution must be to minimize project risks while maximizing project opportunities available. We want a rate and a rating system that does not unnecessarily reject “the best available projects – i.e. highest net positive free cash-flows at that time.” Particularly in times of excess capacity, this will marginally contribute to increasing company wide yields, but will not necessarily match the company-wide yield imposed by investors.

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History of the Company and Background of the Case:

Sometime in July 1991, one of the critical problems confronting management and the board of Pioneer Petroleum Corporation, hereinafter referred to as Pioneer, is about Capital Budgeting; specifically they needed to determine the Minimum Acceptable Rate of Return, or MARR, on new capital investments. Their capital budgeting approach was to accept all proposed investments with a positive net present value when cash-flows are discounted at such appropriate cost of capital.

Formed in 1924 through mergers of several formerly independent firms operating in the oil refining, pipeline transportation, and industrial chemical fields, pioneer Pioneer 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 Pioneer restructured further into hydrocarbon-based oil, gas, coal, and petrochemicals.

Statement of the Problem:

What rate or rating system will consider specific, inherent risks of divisions and operating sectors AND consider benefits ascribed to the single-rate Weighted Average Cost of Capital approach? How can we help Pioneer Petroleum make an objective, rational choice on the hurdle or cut-off 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.

Objectives/ Directions of the Solution

1) The decision must help the management and board of directors of Pioneer Petroleum decide on the fair and objective Hurdle Rate/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 provide consonance, rather than inconsonance, with the efforts of both the division and central or corporate management to execute strategy, leverage on strengths, and empower the company to make 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 operating sectors 5) It must also address the interest of stockholders to maximize return on their equity or investments.

Case Facts and Assumptions:

1) It is the Policy of the board to balance the source of funds, or to keep the funded debt and equity ratio at 50:50 . Debt and Equity financial ratios are: a. D-E ratio for refining is 1.5:1,

b. D-E for the exploration is 0.8:1.
2) The Income Tax Rate is given at 34%.
3) Revenue is $15.6 billion
4) Net income $1.5 billion.
5) It is given that dividends increased by 10% in 1990 and 1991, and therefore we will assume to use the higher target equity yields of 2.7 (add the 10%), rather than 2.45 the actual yield of 1989. 6) The company’s Corporate Debt was A-rated; this means it is deemed to carry much low risk than the general investing or borrowing public. 7) Capital Expenditure budget are 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 company’s gasoline are among the cleanest burning fuels. By 1990, total revenues exceeded $15.6 Billion and net income over $1.5 Billion. Pioneer supplied its own raw material for domestic petroleum liquids production and was also one of the most cost-efficient refiners of the West Coast and had an extensive West Cost presence. The company has clean, efficient running plants positioned to meet strict environmental guidelines capitalize 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 heavily invested in Environmental projects. Its chemical unit produced 1/3 of the world’s supply of methyl tertiary butyl ether, MTBE, an ingredient making its gasoline one of the cleanest burning in the industry.

The MTBE market had been growing with the global trends towards sustained development of the environment.

Refining its cost 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 area in which Pioneer might capitalize on its eco-strengths.

Weaknesses and Threats:

To meet Pioneer expected to invest $3 Billion additional to meet the new law’s 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 transfer pricing and other transnational risks involving a complex network of sources, sinks and of moneys, products and services.

Its fully integrated set-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 overall performance, and obviously to decrease these complex risks.

Methodology:

The weighted 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 share over market value per share.

The second approach is similar, but with multiple cutoff rates. First it is broken down by Divisional Cost of Capital – i.e. calculated using a weighted average cost of capital approach, but this time for each division or operating sector; before further drilling down by cost per fund source. Calculations would follow three (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) Given 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 function:

The Weighted Average Cost of Capital = WACC = sum of Divisional costs of capital = Sum total of [Divisional Costs of Debt plus Divisional Costs of Equity]3

Decision Alternatives for Selection of Marginally Attractive Rates of Return:

Management and the board are choosing between two alternative approaches:

1) The Single WACC Rate, 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; AND 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. 3) Hybrid or Combination thereof – 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 Analysis and Discussion.

The two alternative approaches “purpose and benefits” are culled from the case, as follows:

1) 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 notes payable, or statements of stock or equity; c. It appears to be more 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 problem or effect of such diversification benefits on the rate is that Divisional Rates calculated independently, may be considered lower – 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 Pioneer’s subsidiaries.

e. Pioneer’s 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 group’s “actual cost of capital.” g. Single-proponent advocates lacked confidence in the fairness and integrity 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 some 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. Another concern 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 enough to cover central requirements. i. Reduced risk, economies of scale and other diversification premiums -- 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 being 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 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 included 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) “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 marketing 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 industry sector;

f. 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 speak; g. The proponents for multiple divisional hurdle rates also argued that the companywide cost of capital was too low, and that investments should be required 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 essential to relate internal target rates of return to the individual businesses.

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. Thus in some cases rates lower than companywide rates of return were justified. 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 company’s total asset.

Formula used for Weighted average cost of capital is

WACC = K(d) + K(e) = Kd(1-t)*DEd + Ke*DEe

Pioneer’s original calculations for WACC are summarized as follows

From Exhibit 1

The 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 defined as the interest rate stated on a bond when it's 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 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 required 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 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 + Ke

Cost of equity, Ke. Note that “after prolonged debate,” Pioneer (management and board) decided 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 company’s 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 50:50, then the cost of equity is therefore calculated as follows:

Cost 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 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 therefore:

Cost of debt: Kd = Interest 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 follows:

The 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 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 50:50 “policy” might be irrelevant.

Conclusions and Recommendations:

FLEXIBILITY
CUTOFF Rate
Stop Loss Limits
Forecasting
Understand Risks, but also Opportunities

Best-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 facts, a single, companywide rate of return used for expediency’s 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 Recommendation

Capital Structure2 is the mix (or proportion) of a firm’s 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 rate’s 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 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 reporting 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 financing, which are not necessarily the only sources of financing.

Recommendation: HYBRID SINGLE-MULTIPLE HURDLE RATE

The 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 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. 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 industries, 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 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 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 simply:

Company Wide WACC = Sum of Divisional WACCs = Sum of [ Local Costs of
Debt plus Local Costs of Equity]

2) The 50:50 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 responsible 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 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 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 company's 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 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 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 rates

References:

2“Capital Structure.” Chapter 17, Fundamentals of Financial Management, 12/e © Pearson Education Limited 2004; Slides by: Gregory A. Kuhlemeyer, Ph.D., Carroll College, Waukesha, WI

3“Investors need a good WACC.” Bill McLure, Investopedia Contributor, www.investopedia.com, http://www.investopedia.com/articles/fundamental/03/061103.asp

4“Definition of Weighted Average Cost of Capital.” Bill McLure, Investopedia Contributor, http://www.investopedia.com/terms/w/wacc.asp

5“Which is a better measure for capital budgeting, IRR or NPV?” Rob Renaud, Spotting Profitability with ROCE. http://www.investopedia.com/ask/ViewFAQPrintable.aspx?url=%2fask%2fanswers%2f05%2firrvsnpvcapitalbudgeting.asp

‘Accounts 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, WI