Corporate Financial Management EPMS - Case Pioneer Petroleum
1. Describe in 3 lines of text the context of this case and the issues being faced. In addition
define 2 learning points after completion of the case.
The case is about two alternative approaches to determine Pioneer Petroleum’s minimum rate of
return with the goal of the firm to maximize shareholder wealth: (1) an overall weighted average
cost of capital of Pioneer Petroleum or (2) based on several divisional rates that reflects the risk-
profit characteristics of Pioneer Petroleum’s diversified business activities.
- The first learning is to fairly qualify new investment projects to maximize shareholder
wealth you can look at overall weighted average cost of capital or take into account the
risk-profit characteristics of business segment of a cooperation.
- The second learning is that it might be of great importance for big corporates with a
diversified portfolio, like Pioneer Petroleum, to look at WACC calculations per specific
business division instead of company-wide average costs of capital. The reason is that
the latter might lead to investments in division with high risk (with high required rate of
return) or to not invest in low risk division (that would be profitable), because they do not
exceed the company minimum rate.
2. You are tasked with calculating the required rate of return for Pioneer’s investments. Start
with the CAPM.
a. What is the average excess return on the market portfolio over 1980-1990?
Average return 91 T-Bills : 8.4%
Average return S&P 500 : 16.3%
Average excess returns : 7.9%
b. What are the disadvantages of using historic returns to calculate the CAPM? Give at
least two reasons why expected returns may be calculated incorrectly when using
historic returns to calculate CAPM.
1. These historic returns will not necessarily give a good indication about the future, the last
10 years are not necessarily representative for the next 10 years.
2. These historic returns are on basis of 91-day T-bills, the investments could be more long-
term.
3. These historic returns are on basis of the S&P 500, this shows an average on the market
and will therefore not necessarily represent the risk profile of Pioneer Petroleum.
c. What is the latest risk-free rate observed in the case?
7.8% on basis of the 91-day T-Bills.
d. Calculate the required rate of return of Pioneer’s equity.
E ( r i ) =r f + βi∗( E [ r ] −r f ) =8.4+ 0.8∗(16.3−8.4 )=14.7 %
m
e. Calculate Pioneer’s weighted average cost of capital after taxes (WACC).
After tax−Rwacc=0.5∗r e +0.5∗r d (after taxes)=0.5∗14.7 % +0.5∗7.9 %=11.3 %
3. Suppose an investment opportunity arises that has a similar risk profile as the existing
operations of Pioneer. Assume leverage is unchanged by the new project.
a. If the project has an internal rate of return of 10%, would you expect Pioneer to accept
it?
Yes, on basis of their own calculations the WACC is 9%. The project has a higher return.
b. Should the project be accepted using the internal rate of return but based on your own
calculations?
1. Describe in 3 lines of text the context of this case and the issues being faced. In addition
define 2 learning points after completion of the case.
The case is about two alternative approaches to determine Pioneer Petroleum’s minimum rate of
return with the goal of the firm to maximize shareholder wealth: (1) an overall weighted average
cost of capital of Pioneer Petroleum or (2) based on several divisional rates that reflects the risk-
profit characteristics of Pioneer Petroleum’s diversified business activities.
- The first learning is to fairly qualify new investment projects to maximize shareholder
wealth you can look at overall weighted average cost of capital or take into account the
risk-profit characteristics of business segment of a cooperation.
- The second learning is that it might be of great importance for big corporates with a
diversified portfolio, like Pioneer Petroleum, to look at WACC calculations per specific
business division instead of company-wide average costs of capital. The reason is that
the latter might lead to investments in division with high risk (with high required rate of
return) or to not invest in low risk division (that would be profitable), because they do not
exceed the company minimum rate.
2. You are tasked with calculating the required rate of return for Pioneer’s investments. Start
with the CAPM.
a. What is the average excess return on the market portfolio over 1980-1990?
Average return 91 T-Bills : 8.4%
Average return S&P 500 : 16.3%
Average excess returns : 7.9%
b. What are the disadvantages of using historic returns to calculate the CAPM? Give at
least two reasons why expected returns may be calculated incorrectly when using
historic returns to calculate CAPM.
1. These historic returns will not necessarily give a good indication about the future, the last
10 years are not necessarily representative for the next 10 years.
2. These historic returns are on basis of 91-day T-bills, the investments could be more long-
term.
3. These historic returns are on basis of the S&P 500, this shows an average on the market
and will therefore not necessarily represent the risk profile of Pioneer Petroleum.
c. What is the latest risk-free rate observed in the case?
7.8% on basis of the 91-day T-Bills.
d. Calculate the required rate of return of Pioneer’s equity.
E ( r i ) =r f + βi∗( E [ r ] −r f ) =8.4+ 0.8∗(16.3−8.4 )=14.7 %
m
e. Calculate Pioneer’s weighted average cost of capital after taxes (WACC).
After tax−Rwacc=0.5∗r e +0.5∗r d (after taxes)=0.5∗14.7 % +0.5∗7.9 %=11.3 %
3. Suppose an investment opportunity arises that has a similar risk profile as the existing
operations of Pioneer. Assume leverage is unchanged by the new project.
a. If the project has an internal rate of return of 10%, would you expect Pioneer to accept
it?
Yes, on basis of their own calculations the WACC is 9%. The project has a higher return.
b. Should the project be accepted using the internal rate of return but based on your own
calculations?
