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: 99-034322
00-011121
01-009496
620014701
620019181
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.