Pioneer Petroleum Portfolio Project Case Solution And Analysis, HBR Case Study Solution & Analysis of Harvard Case Studies

Problem Diagnosis

This case emphasizes on one of the critical problems that is usually faced by the companies having multiple divisional businesses with different risk profiles and return characteristics(RUBACK, 2004). Pioneer Petroleum Corporation is one of the integrated oil companies and their ranges of the operations include marketing, transportation, production, development and oil exploration.The management of Pioneer Petroleum Corporation was facing the issue of determining the most suitable, feasibly and the acceptable minimum rate of return for all the new capital projects and investments that are undertaken by the management of the company.

In July 1991 the management of the company was not sure that whether to use a single corporate weighted average cost of capital or use different divisional cost of capital for each of the division of the company. Furthermore, this case also provides insights on how the company plans its weighted average cost of capital and the method for estimating the weighted average cost of capital will also have to be analyzed and interpreted(RUBACK, 2004). An in-depth analysis needs to be performed on the company’s current cost of capital estimation techniques and then suitable recommendations need to be made to the management of Pioneer Petroleum.

Analysis

A range of the weighted average cost of capital components has been analyzed first and then the actual weighted average cost of capital for Pioneer Petroleum Corporation has been calculated and analyzed. All the misconceptions of the management of Pioneer Petroleum Corporation have also been highlighted and based on the analysis performed specific recommendations have been made to the management. The current approach that had been followed by the management of Pioneer Petroleum Corporation was that it accepted all those investments and capital projects that had a positive net present value, however, the determination of the appropriate discount rate was a challenge.

Current Estimation of Overall Weighted Average Cost of Capital

If we look at the current estimation of the weighted average cost of capital for Pioneer Petroleum Corporation then it seems to be correct, however, there seem to be certain issues associated with certain components of the corporate weighted average cost of capital. First of all the weights used in the weighted average cost of calculation of the company are always set at a ratio of 50%/50%, however, this might not always be the most optimal debt to capitalization ratio to be used in the calculation of the weighted average cost of capital.

A second issue was with the calculation of the debt and equity of the company, which is discussed in separate sections below. It seems that the management of Pioneer Petroleum Corporation currently has calculated the cost of equity of the company’s stocks on the basis of the dividend growth model; however, in this case the management of the company is using the earnings per share and that too just for the current year 1990(RUBACK, 2004).

This is not appropriate as the company uses the weighted average cost of capital to evaluate new capital investments that are undertaken by the management of the company. Therefore, the calculation of the cost of equity should be based upon the forecasted or next year’s projected values as described in the next section. Based on these certain factors, the value of the company’s weighted average cost of capital might not seem to be right as some of the component values are not computed correctly by the management of the company.

Estimation of Cost of Equity

As stated, that management of Pioneer Petroleum Corporation used the Gordon dividend growth model, in order to estimate the cost of equity of the company. Currently, based upon the 1990 earnings per share of $ 6.15 and a stock price of $ 63, the management has estimated the cost of equity for the company t0 be 10%. However, this is not correct as Gordon’s dividend growth model is based upon the dividends of the next year(Gordon, 1956). The formula is as follows:Pioneer Petroleum Portfolio Project Case solution

Cost of Equity (r) = D1/Po + g

Where,

D1 is the next year’s dividend per share

Po is the current stock price i.e. standing at the end of the year 1990

g is the estimate or calculated growth rate of the dividends

If we estimate the growth rate for the dividend for the next year based upon the historical 8 year dividends as provided in exhibit 1, then the average growth rate is calculated to be as follows:

DIVIDEND GROWTH
	1983	1984	1985	1986	1987	1988	1989	1990
Dividend Per Share	1.75	1.5	1.2	2	2	2	2.2	2.45
Growth		-14%	-20%	67%	0%	0%	10%	11%
Average Growth	8%

Based on a historical dividend growth rate of 8%, if we calculate the new cost of equity based upon the dividend growth model, then it would be around..................

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