Pioneer Petroleum

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Cost of Capital _ Pioneer Petroleum Corporation Copyright © 1991 by the President and Fellows of Harvard College. Harvard Business School Case 292-011. One of the critical problems confronting management and the board of Pioneer Petroleum Corporation in July 1991 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…show more content…
The market for MTBE had been growing, and the new regulations were expected to lead to even higher growth. Also, Pioneer's SMOGMAN service centers specialized in state-required smog checks and related repairs. Weighted Average Cost of Capital The company's weighted average cost of capital was calculated in three steps: first, the expected future target proportions of debt and equity in the company's capital structure were estimated; second, costs were assigned to each of these capital components; third, a weighted average cost of capital was calculated on the basis of these proportions and costs (see Table A). TABLE A 1990 Weighted Average Cost of Capital Calculation Target Proportion of Future Capital Components Debt Equity .5 .5 Estimated Future After-Tax Cost 7.9% 10.0% Weighted Cost 4.0% 5.0% 9.0% There was a general consensus in management on the future mix of debt and equity in Pioneer's capital structure. A firm policy had been adopted that debt should represent approximately 50% of total capital (defined as total debt plus book equity) to balance the competing objectives of enhancing the returns to shareholders and maintaining financial flexibility. The company was committed to using its dividend and stock repurchase program to maintain

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