Question: What is the current policy of both Pickens Oil and EEI about debt in their capital structures?

The date is September 2, 2018, Dr. Vijay Singal, president of one of the major subsidiaries of Pickens Oil, Inc., is deliberating on the nature of the report he should make to the Board of Directors of the company at its next meeting. The issue of concern is a corporate policy decision about the proper procedure for analyzing capital expenditure proposals. While the company is committed to a discounted-cash-flow approach to evaluating the desirability of investments, a dispute arose at the last Board meeting about a matter of implementation. Specifically, the question was whether different hurdle rates (i.e., costs of capital) for project acceptability should be used in different areas of the business, or whether a single uniform discount rate reflecting the nature of the company as a whole is appropriate. The issue is a serious one for Dr. Singal because the consequence of the disagreement among the Board members was a decision that some dozen or so of the investment projects his division had on the drawing board would have to be postponed until a policy is formulated. In Dr. Singals view, all of these projects are desirable, but there is a strong possibility that they might be rejected by the Board if a single company-wide cost of capital is used in their evaluation.

Twenty years before, Dr. Singal had graduated with a PhD degree and gone to work for a major consulting firm based in Oklahoma City, Oklahoma. After 15 years in that industry, he decided that he wanted to work in an operating firm. In 2016, he accepted the position of CEO and president with Extraction Equipment, Inc. (EEI), a manufacturer of equipment used by oil and gas companies in their exploration and drilling activities. Over the past 15-20 years, the company has prospered, in large part because much of its product line consists of items used in the secondary-recovery of oil and gas from fields considered to be depleted under conventional recovery techniques. The sharp rise in the price of petroleum in recent years made secondary-recovery efforts economically justifiable, and EEI had been perfectly positioned to exploit this event.

The firms prosperity, and the fact that it was of moderate size, made it an attractive acquisition candidate. After rejecting several inquiries from large conglomerate enterprises, EEI accepted a bid from Pickens Oil in July of 2018. The latter firm offered $100 per share, in a stock-for-stock exchange, wherein each EEI share would receive 0.8 shares of Pickens Oil stock. Pickens Oil is engaged in oil and gas exploration and drilling, and has annual sales of $683 million - approximately twice the sales of EEI. Pickens Oil has 10,000,000 shares of common stock outstanding. Prior to the acquisition, EEI had 2,778,000 shares outstanding.

After the merger, the Board of Directors of Pickens Oil decided to leave the management structure of EEI intact and to let the firm be run as an autonomous unit. Dr. Singal remained as chief operating officer of EEI, and became a member of Pickens Oils Board of Directors. At the first post-merger meeting he attended some problems surfaced.

The Board took the position that any capital expenditure proposals coming out of EEI for approval by the Board would be required to earn a discounted-cash-flow rate of return at least as high as Pickens Oils cost of capital in order to be acceptable. Further, the Board indicated that the pre-merger cost of capital of Pickens Oil would continue to be used as the criterion--the argument that, unless EEI investments produced returns comparable to those of the rest of the company, they should be rejected.

Singal is disturbed by this attitude because it has an immediate effect on his operations. He had brought several large plant-expansion proposals with him to the meeting for approval and all were turned down because the returns were judged to be below Pickens Oils cost of capital. Singal knows his plant managers will be equally disturbed when he takes this news back to them, because they fully expect the projects to be approved, as had been true in the past.

Singal strenuously argued that there was no reason to change the hurdle rate for EEI project acceptance merely because the firm is now part of a larger company. He indicated that he could not believe that any of the proposed expenditures in his capital request had suddenly become less desirable than they were a few months before when the original EEI analysis of them was being done. The remainder of the Board expressed some sympathy with this point of view, but still could not be convinced that somehow Pickens Oil wouldnt be letting its EEI subsidiary spend money on poorer projects if it didnt impose Pickens Oils cost of capital as the acceptability threshold.

A compromise was finally reached. The Board agreed to give Dr. Singal time to prepare a full report developing his position for presentation at the next meeting. They insisted, however, that the EEI plant expansion projects be held up until the question of the correct discount rate was resolved.

Singals staff has compiled the information in exhibits 1, 2, and 3 to support his report. As an additional observation, the staff reported to Singal that, over the long run, historically, investments in a well-diversified portfolio of corporate common stocks had provided investors with a rate of return that averaged approximately 6% per year above the return provided by investments in high-quality long-term corporate bonds.

Further, high quality corporate bonds had provided returns of 0.5% per year above investments in similar-maturity federal government notes which, in turn, had provided a return of 1% above short-term treasury bills.

As of September 2, 2018, the annualized yield of long-term treasury bonds is 2.62% and the annualized yield of 90-day U.S. treasury bills is 1.62%.

Singal has decided for purposes of his presentation to use the long-term treasury bond yield as the risk-free rate and to assume that the current policy of both Pickens Oil and EEI that debt be avoided in their capital structures will continue. Both are all-equity financed.