Unformatted text preview: TO: 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 Estimated Proportions of Future Funds Sources Estimated Future After-‐
Tax Cost Weighted Cost Debt Equity WACC 0.50 0.50 7.92% 14.28% 3.96% 7.14% 11.10% Also, we’d like to point out that It is worth taking another look at the 10% measure for the dividend’s 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, PP’s dividend growth may not always stay at this rate. For example, between 1986 and 1989 there was no growth. The large 1 Cost of debt = interest rate to finance new debt x (1 – tax rate) 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 Petroleum’s 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 Estimated Future After-‐
Tax Cost 7.92% 13.27% Weighted Cost 3.96% 6.70% 10.60% 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 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) 3 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 firm’s established cost of debt, assuming that firm ability to issue debt at a certain rate remains fairly constant. If, however, Pioneer’s 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 firm’s 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 As stated in the class text Lastly, we’ve 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. Appendix 1: Percentage change in the dividend -‐ recent years average calculation 1 2 3 4 5 Year 1986 1987 1988 1989 1990 Current Assumption 1991 Proposed 1992 *1986-‐1991 average dividend growth Dividend per Share $2.00 $2.00 $2.00 $2.20 $2.45 $2.70 $2.84 Percent Change -‐ 0% 0% 10.00% 11.36% PP's projection based on 10% increase *Based on dividend-‐increase average since 1986 5.34% Dividends per share ($) 3.00 2.50 2.00 1.50 Dividends per share ($) 1.00 0.50 0.00 1983 1984 1985 1986 1987 1988 1989 1990 1991 Appendix 2: Market Returns – 10 years average calculation 1 2 3 4 5 6 7 8 9 10 Year 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 Average for 10 years: 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% R premium = R market – R free risk = 14.64% -‐ 7.8% = 6.84% ...
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