The hurdle rates for the two companies are quite different. This is expected given they operate in
very different lines of business with different levels of risk. On the surface, they both operate in the oil
and gas industry. However, PO focuses on exploration and drilling of new fields which is riskier than
EEI’s secondary-recovery of oil and gas from used fields. This difference is clearly reflected in the fact
that PO beta is higher than that of EEI.
Because of this difference in their business and their risk levels, they should use different hurdle
rates for their projects.
Main Lessons
1. Company is a portfolio of projects, each with different levels of risk.
2. CAPM can be used to calculate hurdle rates for projects with risky cash flows.
3. Perils of using single discount rate for projects with different levels of risk.
4. Mechanics of calculating discount rates using CAPM.
Some other questions to ponder:
1. What happened to EEI’s stock price between July 4 and July 11?
The merger was announced. EEI’s stock price jumped to $98.35 from $88.13. That’s an 11.6% increase
in a week. This huge return reflects the return to EEI shareholders from the merger.
2. Would betas be different if we used daily data?
Not in theory. Time interval should not matter, but non-synchronous trading could result in different beta
estimates.
3. Should Pickens Oil’s company beta be the same following the merger with EEI?
No, it should be a weighted average of betas of Pickens Oil and EEI. The market value of Pickens Oil’s
equity is 10,000,000 shares × $123.75 = $12,375 and the market value of EEI’s shares is 2,778,000 × $99.01
= 2,750 and 2,750/(2,750 + 12,375) = 2,750/15,125 = .181.
company = (0.181)(1.156) + (0.819)(1.344) = 0.209 + 1.101 = 1.31
