Pioneer Petroleum

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Pioneer Petroleum Corporation
One of the critical problems confronting management and the board of Pioneer Petroleum Corporation was the determination of a minimum acceptable rate of return on new capital investments, The company’s basic capital budgeting approach was to accept all proposed investments with a positive net present value when discounted at the appropriate cost of capital. At issue was how the appropriate discount rate would be determined.
The company was weighing two alternative approaches for determining a minimum rate of return: (1) a single cutoff rate based on the company’s overall weighted average cost of capital, and (2) a system of multiple cutoff rates that reflected the risk-profit characteristics of the several
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Divisional Costs of Capital
The alternative proposed by the supporters of multiple cutoff rates in lieu of a single companywide rate involved determining the cost of capital for each division. The divisional rate would reflect the risks inherent in each of the economic sectors or industries in which the company’s principal operating subsidiaries worked. For example, the divisional cost of capital for production and exploration was 20%, and the divisional cost of capital for transportation was 10%. All the other divisional rates fell within this range. The suggestion was that these multiple cutoff rates determined the minimum acceptable rate of return on proposed capital investments in each of the main operating areas of the company and represented the rate charged to each of the various profit centers for capital employed. However, there were still areas of ambiguity. For example, it was unclear whether all environmental projects would have the same discount rate or the discount rate corresponding to the division.
The divisional cost of capital would be calculated using a weighted average cost of capital approach for each operating sector. The calculations would follow three steps: first, an estimate would be made of the usual debt and equity proportions of independently financed firms operating in each sector. Second, the costs of debt and equity given these proportions and sectors would be estimated in

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