Pioneer Petroleum Corporation

Case 3: Pioneer Petroleum Corporation

THE PROBLEM

- The determination of a minimum acceptable rate of return on new capital investments

 The critical problems confronting

 Management

 The board of Pioneer Petroleum Corporation in July 1991

- Basic capital budgeting approach

 Accept all proposed investments with a positive NPV

 Discounted at the appropriate cost of capital

- How the appropriate discount rate would be determined?

- Two alternative approach for determining a minimum rate of return

 A single cutoff rate

 Based on the company’s overall WACC

 A system of multiple cutoff rates

 Reflected the risk-profit characteristics - the company’s subsidiaries

 Business

 Economics sectors

- Management’s decision to extend the use of the cutoff rate to the evaluation of existing operations and investments

 Planned to evaluate divisional managers on the basis o their net profits

 After the deduction of a charge for capital employed by the division

BACK GROUND OF THE CASE

- Pioneer Petroleum

 Formed in 1924

 The merger of several formerly independent firms

 Over the next 60 years

 Integrated vertically into exploration and production of crude oil

 Marketing refined petroleum products

 Horizontally into plastics…

 Restructured in 1985

 A hydrocarbons-based company

 Primary producers of Alaskan crude oil

 1990 – Alaska provided 60% of domestic petroleum liquids production

 One of the lowest-cost refiners on the West Coast

- Integration – among divisions

 Collaboration

 Coordination

 to optimize overall performance

 to decrease overall risk

- Financial Statement (1990)

 Total revenues – over 15.6 billion

 Net income – over 1.5 billion

- Volatile oil prices – a major concern for pioneer

 24.50 per barrel on average

 Management of Pioneer

 The importance of operational and financial flexibility to respond to price swings

- Capital expenditures

 3.1 billion (1990)

 4.5 billion (1991...