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Pioneer Petroleum Corporation Question 2 Pioneer Petroleum in the midst of restructuring their capital budgeting procedures was debating over how their divisional cost of capital rates should be determined Their two methods included a single cost corporate approach or a multiple divisional hurdle approach to capital These rates were to be used in evaluating projects and allocating investment funds among divisions The divisional rate would reflect the risks innate in each of the economic divisions where the companys principal operating subsidiaries worked By working with this assumption single rate supporters claim that all projects should be based on a single rate average taken from each division For example if the companys rate is 10 then every future project should be subject to this rate regardless of the sector Supporters of multiple discount rates had calculated these numbers for several periods and consistently found that their weighted average when compared to each sector exceeded the companys overall average cost of capital The difference was attributed to the fact that Pioneer benefit from its built in asset diversification In order to correct the differences in cost of capital numbers it was proposed that these diversification premiums be allocated back to the overall costs and subsequently deducted from the multiple rates For example if Pioneer Petroleum and British Petroleum were both investing in a new source of coal Pioneer may already have a railroad due to its extreme vertical integration If the cost for British Petroleum to transport the coal is 1 million and for Pioneer the cost is 500000 then this difference should be allocated back to the sectors appropriate estimations With a higher estimate Pioneers weighted average cost of capital would be lo wer explaining the difference in the companies overall average cost of capital There were numerous arguments between the supporters of single and multiple rates Single rate supporters contended that funds should be used in those projects with the highest returns They
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