UNIVERSITY OF THE WEST INDIES

MONA SCHOOL OF BUSINESS

MBA (Part-Time) COHORT 13 (Monday/Tuesday/Thursday)

SBFI6030: International Monetary Economics &

Finance

Case Analysis Groupwork

CASE: Petrobas of Brazil & the Cost of Capital

LECTURER: Dr. Lavern McFarlane

DUE DATE: March 24, 2011

GROUP MEMBERS IDs: 99-03432200-01112101-009496

620014701620019181

Why do you think Petrobas cost of capital is so high? Are there better ways, or

other ways, of calculating its weighted average cost of capital (WACC)?

Petrobras, unlike other oil producing multinationals (such as Exxon, BP, Shell,

etc.) whose cost of capital ranges between of 7.6 and 9 percent, has a high cost of capital

because it lacks a strong international presence which would enable the company to

source capital in cheaper markets. This results from the fact that Petrobras is a highly

domestic Brazilian firm whose operation is centered on the domestic market. With the

Brazilian economy having a long history of high inflation, economic instability, currency

devaluation and depreciation, these sovereign risks would be mirrored in the company’s

cost of capital as a result of the undiversified nature of Petrobas’ operations. Accordingly,

investors would have required a higher premium to compensate for the relatively higher

levels of operational risk to which Petrobas was exposed.

While the company had embarked on a global strategy, this was confined largely

to expansion in the South American region. Given the similarities between these regional

markets and the Brazilian market, this did not translate into reduced cost of capital to the

level of the other oil producers as the market risks would have been similar to the risks

associated with the Brazilian market. These markets, therefore, did not provide access to

cheaper sources of capital hence did not facilitate a reduction in the company’s weighted

average cost of capital.

There are a number of ways to compute the cost of capital of a firm, but with the

inherent risk faced by Brazil, there exists no better way as all investors having

information about Brazil’s political history and sovereign risk will require higher rates of

return to compensate for the risk taken. Perhaps if Petrobras can relinquish some of the

governmental control and venture in strong international market where risk

diversification can be had, then investors would require lower returns, hence a lower

weighted cost of capital for Petrobras.

Does this method of using the sovereign spread also compensate for currency risk?

Sovereign spread is the difference in the yield received from a government bond

issued by Brazil and the yield received from a similar bond issued by the US. This

difference is due to the US having a better sovereign rating and therefore a greater

creditworthiness (relative to Brazil). Here the US dollar is being used as the benchmark

currency. Brazil’s creditworthiness is affected by factors such as; the levels of external

debt, the pace of economic growth and political stability, among other factors. Currency

risk is not the same as sovereign spread. In this instance, currency risk represents the

possibility that the value of the Brazilian Reais will fluctuate more than the value of the

US dollar.

In the case of Petrobras, its share price is highly correlated with the EMBI+ sovereign

spread borne by Brazil. Since investors will use this to assess the Petrobras’ cost of

capital (WACC), it would appear that it will also reflect the risk of changes in the

exchange rate (currency risk). Therefore while they are different, in the context of this

case study; the sovereign spread does compensate for the currency risk.

The final quote that “one’s view on the direction of the broad Brazilian market”

suggests that potential investors consider the relative attractiveness of Brazil in

their investment decision. How does this perception show up in the calculation of

the company’s cost of capital.

Cost of Capital (WACC), which is often used as a hurdle rate against which to access the

Return on Invested Capital (ROIC) performance is employed by security analysts to

value and make recommendations for investments. It is what is recommended for

consideration by potential investors related to the capital market imperfections of Brazil,

the country in which Petrobras is located.

Calculation: WACC = (Debt/capital) x kd x (1 – Tax rate) + (Equity/capital x ke)

The cost of equity (ke) from Petrobras is also influenced by the country risk that has been

tailored to the risk free interest rate (risk-free rate). The estimated cost of equity of

Petrobras can be done by using the Capital Asset Pricing Model (CAPM):

ke = risk-free rate + (βPetrobras x market risk premium)

A base Brazilian portfolio will result in an increase in βPetrobras, which would increase the

value of ke, thus increasing the WACC. Petrobras WACC would be greater than if the

investor is using a base of global NYSE portfolio.

Is the cost of capital really a relevant factor in the competitiveness and strategy of a

company like Petrobas? Does the corporate cost of capital really affect

competitiveness?

The cost of capital is definitely an important factor in the competitiveness and

strategy for all “for profit’ companies because it determines the hurdle rate that

investment opportunities must exceed in order to be considered viable. The higher the

cost of capital the higher the required rate of return on potential investments and

consequently the fewer project can be undertaken. However it must be noted that the cost

of capital is only one among a number of factors that affect a business’ competitive

advantage. These, as outlined by Michael Porter’s Five Forces Industry Analysis Model,

include the nature of the industry in which the company operates, the corporate strategy

pursued by the company and the company’s external environment (macro economic and

political factors). Therefore for any company, enduring competitiveness is the result of

the strategic blend of policies and practices pursued given its unique set of competitive

factors.

In the case of Petrobrás, which operates in the highly capital intensive petroleum

industry, the cost of capital is clearly considered a critical factor to its competiveness.

However Petrobas is still largely government owned and controlled and therefore in

addition to its economic objectives has broader national objectives such as energy

security with possible attendant subsidies, incentives and government loan guarantees

that wholly privatized international oil companies would not enjoy. All of these factors in

addition to the cost of capital would affect Petrobras competitiveness.