Background: The Pioneer Petroleum Corporation is a hydrocarbons-based company, concentrating on oil, gas, coal, and petrochemicals. One of the critical problems confronting management and the board of Pioneer 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.
Further, the company is contemplating using either multiple cutoff rates instead of a single companywide rate to determine the cost of capital for each division. The suggestion was that these multiple cutoff rates would determine the minimum acceptable rate of return on proposed capital investments in each of the main operating areas of the company and would represent the rate charged to each of the various profit centers for capital employed.

Issues: Did Pioneer compute WACC correctly and if not what did they do wrong? Compute your own. How should the company determine a minimum rate of return: by (1) a single cutoff rate based on the company's overall WACC or (2) a system of multiple cutoff rates that reflect the risk-profit characteristics of the several businesses?

Analysis: Pioneer Petroleum Corporation did not calculate the WACC correctly. Starting with the cost of debt, the formula is
Kd = I(1 T) where I is the interest rate and T is the tax rate. The company's tax rate is 34%, however, they made the mistake of using the coupon rate of 12% for the interest rate. The coupon rate is a sunk cost and, therefore, the market rate of interest should be used reflecting the cost of new debt. I assumed the interest rate to be 8% because the company's debt was rated A, which indicates low risk.
Further, Pioneer's method for coming up with the cost of equity is incorrect. Their