Pioneer Petroleum

Analysis

There were a few mistakes that were made by Pioneer Petroleum in calculating the WACC. First, with respect to the cost of equity, Pioneer incorrectly uses the earnings yield of their stock, which is 10%. The method that should have been used is CAPM, which is the required rate of return for the company’s stock. The formula would be:

KEquity = Rf + (E(Rm) – Rf) β

The yield should not be used because this yield may or may not be the amount of return investors require. There formula that should be used, in order to calculate the company-wide WACC, is:

KEquity = (D1/Po) + G

In this case, the market price is $63, the rate of growth for dividends is 10%, and the next dividend is $2.45 * 1.10 = $2.70. The cost of equity is therefore:

KEquity = (2.70/63) + 10%

KEquity = 14.3%

Since Pioneer wishes to maintain a capital structure of 50% debt to 50% equity, the actual cost of equity is 7.15%.

Furthermore, Pioneer incorrectly calculates the cost of debt. The formula is:

KDebt = I (1 - T)

The company tax rate is 34%. Pioneer uses an interest rate of 12%, which is the coupon rate. However, since the coupon rate is a sunk cost, and the actual interest rate is not given, an assumption must be made. Since the company has an A rating for debt, we estimate an approximate 8% interest rate, which is much less than 12%, because the company has been deemed a low risk. The cost of debt is therefore:

KDebt = 8% (1 – 34%)

KDebt = 5.3%

Due to the 50-50 debt to equity capital structure, the actual cost of debt is 2.65%.

The WACC is therefore:

WACC = 2.65% + 7.15% = 9.8%

Comparing this WACC of 9.8% to the company’s calculated 9%, this higher standard should benefit investors due to the rejection of some of the lower end projects in the 9%-9.7% range.

The reasoning behind the use of WACC is that Pioneer can increase the price of its stock without greatly affecting the financial risk of the company, as long as financing is gained in the...