Pioneer Petroleum Corp

Pioneer Petroleum Corporation

Pioneer Petroleum Corporation inappropriately calculated their cost of capital:

The company’s debt to equity ratio was calculated using the firm’s book value of equity. Market values portray the true worth of owner’s stakes in the business and are sufficient to book values, which are irrelevant and represent historic numbers. By reversing the eps calculation and multiplying the outstanding shares by the 1990 market value per share, the market value of debt is $160,297 (Note 1), this is significantly larger then the book value of debt which is only $6,195. (Note 2)

This in turn would cause their debt to equity ratio to be 3.86%, essentially changing their WACC to 9.91%, disregarding the understated cost of equity.

The use of multiple hurdle rates would provide Pioneer Petroleum Corp. with a more accurate assessment of the firm’s investment opportunities. A common cost of capital across a firm could lead to inappropriate investments, as investments are assessed based on their individual expected return comparative to the firms cost of capital. The cost of capital is the required return a firm must earn on existing projects and is used as an appropriate criterion to evaluate the riskiness of new investments.

Companies that have high costs of capital also have high discount rates which in effect lead to lower investment values; the entity is required to earn a higher return on investments to meet the higher expectations of creditors and shareholders.

Using a single measurement base can lead to an inaccurate evaluation basis; investments that have lower excepted returns maybe rejected based on the firms overall cost of capital despite its unique fundamental level of risk. Multiple hurdle rates based on the entities divisional risks avoids the risk of inappropriately rejecting worth-while, low-risk investments for lack of expected return and accepting uneconomic, high-risk investments because of their prospective returns....