Problem 13.

3 Thunderhose Oil

Thunderhorse Oil is a U.S. oil company. Its current cost of debt is 7%, and the 10-year U.S. Treasury yield, the
proxy for the risk-free rate of interest, is 3%. The expected return on the market portfolio is 8%. The company's
effective tax rate is 39%. Its optimal capital structure is 60% debt and 40% equity.

a. If Thunderhorse beta is estimated at 1.1, what is its weighted average cost of capital?

b. If Thunderhorse's beta is estimated at 0.8, significantly lower because of the continuing profit prospects in the
global energy sector, what is the company's weighted average cost of capital?

Assumptions a) Values b) Values

Thunderhorse's beta 1.10 0.80
Cost of debt, before tax 7.000% 7.000%
Risk-free rate of interest 3.000% 3.000%
Corporate income tax rate 25.000% 25.000%
General return on market portfolio 8.000% 8.000%

Optimal capital structure:

Proportion of debt, D/V 60% 60%
Proportion of equity, E/V 40% 40%

Calculation of the WACC

Cost of debt, after-tax 5.250% 5.250%

kd x ( 1 - t )

Cost of equity, after-tax 8.500% 7.000%

ke = krf + ( km - krf ) β

WACC 6.550% 5.950%

WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]
Problem 11.2 Carlton's cost of capital

Exhibit 11.2 showed the calculation of Carlton’s weighted average cost of capital. Assuming that financial conditions have
worsened, and using the following current data, recalculate:

a. Carton's cost of equity

b. Carlton's cost of debt
c. Carlton's weighted average cost of capital

Values used
Original assumptions in Chapter in Chapter New Values
Carlton's beta, β 1.20 1.30
Cost of debt, before tax, kd 8.00% 7.000%
Risk-free rate of interest, krf 5.00% 4.000%
Corporate income tax rate, t 35.00% 30.000%
General return on market portfolio, km 15.00% 9.000%
Optimal capital structure:
Proportion of debt, D/V 40% 50%
Proportion of equity, E/V 60% 50%

a) Carlton's cost of equity 17.000% 10.500%

ke = krf + ( km - krf ) β

b) Carlton's cost of debt, after tax 5.200% 4.900%

kd x ( 1 - t )

c) Carlton's weighted average cost of capital 12.2800% 7.7000%

WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

One of the most interesting aspects of capital costs is how they have been trending downward in recent years as a result of
lower interest rates, lower equity market returns, and in some countries, lower tax rates. As a result of the general decline
in business and economic performance, many firms have been reducing their debt levels -- if possible -- in roder to reduce
their debt service requirements. But, one factor which has not necessarily fallen in value is the beta of the individaul firm.
Here Carlton's cost of capital has fallen dramatically, but its beta is actually higher than before due to more market
volatility.
Problem 13.6 WestGas Conveyance, Inc.

WestGas Conveyance, Inc., is a large U.S. natural gas pipeline company that wants to raise $120 million to finance expansion. WestGas wants a capital structure
that is 50% debt and 50% equity. Its corporate combined federal and state income tax rate is 40%. WestGas finds that it can finance in the domestic U.S. capital
market at the rates listed below. Both debt and equity would have to be sold in multiples of $20 million, and these cost figures show the component costs, each, of
debt and equity if raised half by equity and half by debt.

A London bank advises WestGas that U.S. dollars could be raised in Europe at the following costs, also in multiples of $20 million, while maintaining the 50/50
capital structure.

Each increment of cost would be influenced by the total amount of capital raised. That is, if WestGas first borrowed $20 million in the European market at 6% and
matched this with an additional $20 million of equity, additional debt beyond this amount would cost 12% in the United States and 10% in Europe. The same
relationship holds for equity financing.

a. Calculate the lowest average cost of capital for each increment of $40 million of new capital, where WestGas raises $20 million in the equity market and an
additional $20 in the debt market at the same time.

b. If WestGAs plans an expansion of only $60 million, how should that expansion be financed? What will be the weighted average cost of capital for the
expansion?

Assumptions Values
Combined federal and state tax rate 40%
Desired capital structure:
Proportion debt 50%
Proportion equity 50%
Capital to be raised $ 120,000,000

Cost of Cost of Cost of Cost of

Domestic Domestic European European
Costs of Raising Capital in the Market Equity Debt Equity Debt
Up to $40 million of new capital 12% 8% 14% 6%
$41 million to $80 million of new capital 18% 12% 16% 10%
Above $80 million 22% 16% 24% 18%

Incremental
a. To raise $120,000,000 Debt Market Debt Cost Equity Market Equity Cost WACC

First $40,000,000 European 6.00% Domestic 12.00% 7.80%

Second $40,000,000 European 10.00% European 16.00% 11.00%
Third $40,000,000 Domestic 16.00% Domestic 22.00% 15.80%

Weighted average cost 10.67% 16.67% 11.53%

(equal weights) (equal weights)

Incremental
b. To raise $60,000,000 Debt Market Debt Cost Equity Market Equity Cost WACC

First $40,000,000 European 6.00% Domestic 12.00% 7.80%

Additional $20,000,000 European 10.00% European 16.00% 11.00%

Weighted average cost 7.33% 13.33% 8.87%

(2/3 & 1/3 weights) (2/3 & 1/3 weights)
Problem 13.7 Kashmiri's Cost of Capital

Kashmiri is the largest and most successful specialty goods company based in Bangalore, India. It has not entered the North American
marketplace yet, but is considering establishing both manufacturing and distribution facilities in the United States through a wholly owned
subsidiary. It has approached two different investment banking advisors, Goldman Sachs and Bank of New York, for estimates of what its
costs of capital would be several years into the future when it planned to list its American subsidiary on a U.S. stock exchange. Using the
following assumptions by the two different advisors, calculate the prospective costs of debt, equity, and the WACC for Kashmiri (U.S.),

Assumptions Symbol Goldman Sachs Bank of New York

Components of beta: β
Estimate of correlation between security and market ρjm 0.90 0.85
Estimate of standard deviation of Kashmiri's returns σj 24.0% 30.0%
Estimate of standard deviation of market's return σm 18.0% 22.0%

Risk-free rate of interest krf 3.0% 3.0%

Estimate of Kashmiri's cost of debt in US market kd 7.5% 7.8%
Estimate of market return, forward-looking km 9.0% 12.0%
Corporate tax rate t 35.0% 35.0%
Proportion of debt D/V 35% 40%
Proportion of equity E/V 65% 60%

Estimating Costs of Capital

Estimated beta
β = ( ρjm x σj ) / ( σm ) β 1.20 1.16

Estimated cost of equity

ke = krf + (km - krf) β ke 10.200% 13.432%

Estimated cost of debt

kd ( 1 - t ) kd (1-t) 4.875% 5.070%

Estimated weighted average cost of capital

WACC = (ke x E/V) + ( (kd x (1-t)) x D/V) WACC 8.336% 10.087%
Problem 14.5 Country Equity Risk Premiums

Using the century of equity market data presented in Exhibit 14.3, answer the following questions:

a. Which country had the largest differential between the arithmetic mean and geometric mean?

b. If a Swiss firm were attempting to calculate its cost of equity using this data, assuming a risk-free rate of 2.0% and a security beta of
1.4, what would be its estimated cost of equity using both the arithmetic mean and geometric means for the equity risk premium?

Arithmetic Mean Geometric Mean

Country Risk Premium Risk Premium Differential
Australia 8.0% 6.3% 1.7%
Belgium 4.8% 2.9% 1.9%
Canada 6.0% 4.5% 1.5%
Denmark 3.3% 2.0% 1.3%
France 7.0% 4.9% 2.1%
Germany 9.9% 6.7% 3.2%
Ireland 4.5% 3.2% 1.3%
Italy 8.4% 5.0% 3.4%
Japan 10.3% 6.2% 4.1%
Netherlands 6.7% 4.7% 2.0%
South Africa 7.1% 5.4% 1.7%
Spain 4.2% 2.3% 1.9%
Sweden 7.4% 5.2% 2.2%
Switzerland 4.2% 2.7% 1.5%
United Kingdom 5.6% 4.4% 1.2%
United States 7.0% 5.0% 2.0%
World 5.6% 4.9% 0.7%

a) Japan demonstrates the largest differential between the arithmethic mean and
geometric mean; a full 4.1%.

b) A Swiss firm estimating its cost of equity using the capital asset pricing model,
would find the cost of equity as:

ke = krf + ( km - krf ) β where ( km - krf ) is the risk premium

Arithmetic Geometric
Risk-free rate 2.00% 2.00%
Risk premium 4.20% 2.70%
beta 1.40 1.40
Cost of equity 7.88% 5.78%
Problem 13.8 Cargill's Cost of Capital

Cargill is generally considered to be the largest privately held company in the world. Headquartered in Minneapolis, Minnesota, the
company has been averaging sales of over $113 billion per year over the past 5 year period. Although the company does not have publicly
traded shares, it is still extremely important for it to calculate its weighted average cost of capital properly in order to make rational
decisions on new investment proposals.

Assuming a risk-free rate of 4.50%, an effective tax rate of 48%, and a market risk premium of 5.50%, estimate the weighted average cost of
capital first for companies A and B, and then make a ‘guestimate’ of what you believe a comparable WACC would be for Cargill.

Comparables
Assumptions Symbol Company A Company B Cargill
Total sales Sales $10.5 billion $45 billion $113 billion
Company's beta β 0.83 0.68 0.90
Company credit rating S&P AA A AA
Risk-free rate of interest krf 4.5% 4.5% 4.5%
Market risk premium km-krf 5.5% 5.5% 5.5%
Weighted average cost of debt kd 6.885% 7.125% 6.820%
Corporate tax rate t 48.0% 48.0% 48.0%
Debt to total capital ratio D/V 34% 41% 28%
Equity to total capital ratio E/V 66% 59% 72%
International sales as % of total sales 11% 34% 54%

Estimating Costs of Capital Symbol Company A Company B Cargill

Cost of equity
ke = krf + (km - krf) β ke 9.065% 8.240% 9.450%

Cost of debt, after-tax kd ( 1 - t ) 3.580% 3.705% 3.546%

Weighted average cost of capital WACC 7.200% 6.381% 7.797%

WACC = (ke x E/V) + ( (kd x (1-t)) x D/V)

Once the data is organized, the absence of a beta for Cargill is the obvious data deficiency.
A series of observations is then helpful:
1. Note that beta and credit ratings do not necessarily parallel one another
2. Credit rating and cost of debt do follow expected norms; lower the rating, the higher the cost
3. Both comparable companies, in the same industry as Cargill (commodities), possess relatively low betas
4. Cargill's sales are twice that of the next largest firm
5. Cargill's sales are significantly more internationally diversified than either of the other two companies; the question
is whether this is a positive or negative factor for the estimation of Cargill's cost of equity?

If we take the approach that the beta for Cargill has to pick up all the incremental information, the beta would then fall
between say 0.80 and 1.00. If the higher degree of international sales was interpreted as increasing risk, beta would
be on the higher end; yet being a commodity firm in the current market, its beta would rarely surpass 1.0. A value of
0.90 is shown here giving a WACC of 7.797%. A series of sensitivities would find a WACC between 7.1% and 7.9%.
Problem 13.9 The Tombs

You have joined your friends at the local watering hole, The Tombs, for your weekly debate on international finance. The topic this week is whether the cost of equity can
ever be cheaper than the cost of debt. The group has chosen Brazil in the mid-1990s as the subject of the debate. One of the group members has torn the following table
of data out of a book, which is then the subject of the analysis.

Larry argues that “its all about expected versus delivered. You can talk about what equity investors expect, but they often find that what is delivered for years at a time is
so small – even sometimes negative – that in effect the cost of equity is cheaper than the cost of debt.”

Moe – interrupts: “But you’re missing the point. The cost of capital is what the investor requires in compensation for the risk taken going into the investment. If he
doesn’t end up getting it, and that was happening here, then he pulls his capital out and walks.”

Curly is the theoretician. “Ladies, this is not about empirical results; it is about the fundamental concept of risk-adjusted returns. An investor in equities knows he will
reap returns only after all compensation has been made to debt-providers. He is therefore always subject to a higher level of risk to his return than debt instruments, and
as the capital asset pricing model states, equity investors set their expected returns as a risk-adjusted factor over and above the returns to risk-free instruments.”

At this point both Larry and Mo simply stared at Curly, paused, and both ordered another beer. Using the Brazilian data presented, comment on this week’s debate at the
Tombs.

Brazilian Economic Performance 1995 1996 1997 1998 1999 Mean

Inflation rate (IPC) 23.20% 10.00% 4.80% 1.00% 10.50% 9.90%
Bank lending rate 53.10% 27.10% 24.70% 29.20% 30.70% 32.96%
Exchange rate (reais/$) 0.972 1.039 1.117 1.207 1.700 120.7%
Equity returns (Sao Paulo Bovespa) 16.0% 28.0% 30.2% 33.5% 151.9% 51.92%

All three are on the right track. It is mostly a matter of finding the linkages beween their individual arguments.

1. Theoretically, Curly is correct in that CAPM assumes that all equity returns are over and above risk-free rates. These are of course,
expected returns, and are the investor's expectations or requirements going INTO the investment.

2. Mo is also correct in arguing that regardless of what investors may EXPECT, the results are often quite different, sometimes disappointing.
Theoretically, when the investment does not yield at least the expected return, the investor should indeed liquidate their position. However,
in reality, many investors for a variety of reasons (tax implications, investment horizon, etc.), may stay in the investment and just complain
about the past and hope about the future.

3. Larry also is on the right track arguing that actual market returns will often result in less than various interest or debt instruments. One of
the more helpful arguments here is that equity returns and interest returns arise from very different economic and financial processes. Most
interest rate charges are stated and contracted for up-front, and represent lenders' perception of an adequate risk-adjusted return over the
expected rate of inflation for the coming period. Equity returns, however, are that mystical process of equity markets in which the many
different motives of equity investors combine to move markets in sometimes mysterious ways, independent of interest rates, inflation rates,
or any other fundamental money price.
Problem 11.8 Sushmita-Chen's cost of equity

Use the following information to answer questions 8 through 10. Sushmita-Chen is an American conglomerate which is actively debating the
impacts of international diversification of its operations on its capital structure and cost of capital. The firm is planning on reducing
consolidated debt after diversification.

Senior management at Sushmita-Chen is actively debating the implications of diversification on its cost of equity. Although both parties agree
that the company’s returns will be less correlated with the reference market return in the future, the financial advisors believe that the market
will assess an additional 3.0% risk premium for ‘going international’ to the basic CAPM cost of equity. Calculate Sushmita-Chen’s cost of
equity before and after international diversification of its operations, with and without the hypothetical additional risk premium, and comment
on the discussion.

Before After
Assumptions Symbol Diversification Diversification
Correlation between S-C and the market ρjm 0.88 0.76
Standard deviation of S-C's returns σj 28.0% 26.0%
Standard deviation of market's returns σm 18.0% 18.0%
Risk-free rate of interest krf 3.0% 3.0%
Additional equity risk premium for internationalization RPM 0.0% 3.0%
Estimate of Tata's cost of debt in US market kd 7.2% 7.0%
Market risk premium km-krf 5.5% 5.5%
Corporate tax rate t 35.0% 35.0%
Proportion of debt D/V 38% 32%
Proportion of equity E/V 62% 68%

Estimating Costs of Capital

Estimated beta
β = ( ρjm x σj ) / ( σm ) β 1.37 1.10

Estimated cost of equity

ke = krf + (km - krf) β ke 10.529% 9.038%

Estimated cost of equity with additional risk premium

ke* = krf + (km - krf) β + RPM ke + RPM 10.529% 12.038%

This may be a case where everyone is correct. When Sushmita-Chen's beta is recalculated, it falls in value as a result of
the reduced correlation of its returns with the home market (diversification benefit). This then creates a standard cost of
equity which is cheaper at 9.038% (previous cost of equity was 10.529%).

If, however, the market was to add an additional risk premium to the firm's cost of equity as a result of internationally
diversifying operations, and if that risk premium were on the order of 3.0%, the final risk-adjusted cost of equity is
indeed higher, 12.038% to the before value of 10.529%.
Problem 13.11 Genedak-Hogan's WACC

Calculate the weighted average cost of capital for Genedak-Hogan for before and after international diversification.

a. Did the reduction in debt costs reduce the firm’s weighted average cost of capital? How would you describe the impact of international
diversification on its costs of capital?

b. Adding the hypothetical risk premium to the cost of equity introduced in problem 10 (an added 3.0% to the cost of equity because of
international diversification), what is the firm’s WACC?

Before After
Assumptions Symbol Diversification Diversification
Correlation between G-H and the market ρjm 0.88 0.76
Standard deviation of G-H's returns σj 28.0% 26.0%
Standard deviation of market's returns σm 18.0% 18.0%
Risk-free rate of interest krf 3.0% 3.0%
Additional equity risk premium for internationalization RPM 0.0% 3.0%
Estimate of G-H's cost of debt in US market kd 7.2% 7.0%
Market risk premium km-krf 5.5% 5.5%
Corporate tax rate t 35.0% 35.0%
Proportion of debt D/V 38% 32%
Proportion of equity E/V 62% 68%

Before After
Estimating Costs of Capital Diversification Diversification

Estimated beta
β = ( ρjm x σj ) / ( σm ) β 1.37 1.10

Estimated cost of equity

ke = krf + (km - krf) β ke 10.529% 9.038%

Estimated cost of equity with additional risk premium

ke* = krf + (km - krf) β + RPM ke + RPM 10.529% 12.038%

Cost of debt, after-tax kd (1-t)

kd ( 1 - t ) 4.680% 4.550%

Weighted average cost of capital WACC

WACC = (ke x E/V) + ( (kd x (1-t)) x D/V) 8.306% 7.602%

Weighted average cost of capital with RPM WACC*

WACC = (ke* x E/V) + ( (kd x (1-t)) x D/V) 8.306% 9.642%

There are a number of different factors at work here. First, as a result of international diversification, their access to debt
has improved, resulting in a lower cost of debt capital. This is not fully appreciated, however, as the firm has chosen to
reduce its overall use of debt post-diversification (common among MNEs).

The firm's WACC does indeed drop for the standardized case. If, however, the market assesses an additional equity risk
premium of 3.0%, the benefits are swamped by the higher required return on equity by the market.
Problem 13.12 Genedak-Hogan's WACC and Effective Tax Rate

Many MNEs have greater ability to control and reduce their effective tax rates when expanding international operations. If Genedak-Hogan was
able to reduce its consolidated effective tax rate from 35% to 32%, what would be the impact on its WACC?

Before After
Assumptions Symbol Diversification Diversification
Correlation between G-H and the market ρjm 0.88 0.76
Standard deviation of G-H's returns σj 28.0% 26.0%
Standard deviation of market's returns σm 18.0% 18.0%
Risk-free rate of interest krf 3.0% 3.0%
Additional equity risk premium for internationalization RPM 0.0% 3.0%
Estimate of G-H's cost of debt in US market kd 7.2% 7.0%
Market risk premium km-krf 5.5% 5.5%
Corporate tax rate t 35.0% 32.0%
Proportion of debt D/V 38% 32%
Proportion of equity E/V 62% 68%

Before After
Estimating Costs of Capital Diversification Diversification

Estimated beta
β = ( ρjm x σj ) / ( σm ) β 1.37 1.10

Estimated cost of equity

ke = krf + (km - krf) β ke 10.529% 9.038%

Estimated cost of equity with additional risk premium

ke* = krf + (km - krf) β + RPM ke + RPM 10.529% 12.038%

Cost of debt, after-tax kd (1-t)

kd ( 1 - t ) 4.680% 4.760%

Weighted average cost of capital WACC

WACC = (ke x E/V) + ( (kd x (1-t)) x D/V) 8.306% 7.669%

Weighted average cost of capital with RPM WACC*

WACC = (ke* x E/V) + ( (kd x (1-t)) x D/V) 8.306% 9.709%

The reduction in the effective tax rate obviously impacts WACC through the cost of debt. This does have substantial
benefits in the company's WACC -- as long as additional equity risk premiums are not assessed. Then, even the lower
effective tax rate does not offset the higher equity costs associated with the international risk premium.
Problem 15.1 JPMorgan: Petrobras' WACC

JPMorgan’s Latin American Equity Research department produced the following WACC calculation for Petrobras of
Brazil versus Lukoil of Russia in their June 18, 2004 report. Evalue the methodology and assumptions used in the
calculation. Assume a 28% tax rate for both companies.

Petrobras Lukoil
Capital Cost Components (Brazil) (Russia)
Risk Free Rate 4.800% 4.800%
Sovereign Risk 7.000% 3.000%
Equity Risk Premium 4.500% 5.700%
Market Cost of Equity 16.300% 13.500%

Beta (relevered) 0.87 1.04

Cost of equity 18.981% 18.840%

Cost of Debt 8.400% 6.800%

Tax rate 28.000% 28.000%
Cost of debt, after-tax 6.048% 4.896%

Debt/Capital ratio 33.300% 47.000%

Equity/Capital ratio 66.700% 53.000%

WACC (calculated) 14.674% 12.286%

WACC (I-Bank report) 14.700% 12.300%

This approach applies the sovereign risk premium to the cost of equity for both companies, but not to their cost of debt.
Since the comparison is for two oil companies from two different countries, and the same risk free rate is used for both,
it is implied, though not stated, that the WACC calculation is based in US dollars.

Source: "Petrobras: A Diamond in the Rough," JP Morgan, Latin American Equity Research, June 18, 2004, p. 24.
Problem 14.2 UNIBANCO: Petrobras' WACC

UNIBANCO estimated the weighted average cost of capital for Petrobrás to be

13.2% in Brazilian reais in August 12, 2004. Evaluate the methodology and
assumptions used in the calculation.

Capital Cost Components

Risk Free Rate 4.500%
Levered Beta 0.99
Risk Premium 6.000%
Country Risk Premium 5.500%
Cost of equity (US$) 15.940%

Exchange Rate 2.000%

Cost of equity (R$) 18.259%

Cost of Debt 8.600%

Tax rate 34.000%
Cost of debt, after-tax (R$) 5.676%

Debt/Capital ratio 40.000%

Equity/Capital ratio 60.000%

WACC (R$) calculated 13.2%

WACC (R$) (I-bank report) 13.2%

This calculation adds the country risk premium to the risk free rate in the cost of
equity, but not the cost of debt (as was the case in the previous problem). This cost
of equity in US$, however, is then compounded by a percentage change in the
expected exchange rate of the reais against the dollar to arrive at a cost of equity in
reais. The cost of debt, which indicates reais-denomination, is not adjusted for the
country risk premium or the expected currency movement.

Source: "Petrobras: Reinitiation of Coverage," UNIBANCO, August 12, 2004, p.4.

Problem 14.3 Citigroup SmithBarney (dollar): Petrobras' WACC

Citigroup regularly performs a U.S. dollar-based discount cash flow (DCF) valuation of Petrobrás in its
coverage. That DCF analysis requires the use of a discount rate which they base on the company's
weighted average cost of capital. Evaluate the methodology and assumptions used in the 2003 Actual and
2004 Estimates of Petrobrás' WACC below.

July 28, 2005 March 8, 2005

Capital Cost Compone 2003A 2004E 2003A 2004E
Risk free rate 9.400% 9.400% 9.000% 9.000%
Levered Beta 1.07 1.09 1.08 1.10
Risk Premium 5.500% 5.500% 5.500% 5.500%
Cost of equity 15.285% 15.395% 14.940% 15.050%

Cost of debt 8.400% 8.400% 9.000% 9.000%

Tax rate 28.500% 27.100% 28.500% 27.100%
Cost of debt, after- 6.006% 6.124% 6.435% 6.561%

Debt/capital ratio 32.700% 32.400% 32.700% 32.400%

Equity/capital ratio 67.300% 67.600% 67.300% 67.600%

WACC (calculated) 12.25% 12.39% 12.16% 12.30%

WACC (I-bank report 12.2% 12.3% 12.1% 12.3%

This approach uses a relatively high assumed value for the risk free rate of interest in the cost of equity
calculation, without expressly charging the company a country risk premium. Since the U.S. dollar risk-
free rate at this time was somewhere around 4%, this risk-free rate must implicitly include a country risk
premium. The cost of debt, before-tax, is actually below the risk-free rate, which is difficult to understand
or rationalise.

Source: "Petrobras," Citigroup SmithBarney, March 8, 2005, and July 28, 2005.
Problem 14.4 Citigroup SmithBarney (reais): Petrobras' WACC
In a report dated June 17, 2003, Citigroup SmithBarney calculated a WACC for Petrobrás
denominated in Brazilian reais (R$). Evaluate the methodology and assumptions used in this
cost of capital calculation.

Petrobras Cost of Equity June 2003

Risk-free rate (Brazilian C-Bond) 9.90%
Petrobras levered beta (β) 1.40
Market risk premium 5.50%
Cost of equity 17.60%

Petrobras Cost of Debt

Petrobras cost of debt 10.00%
Brazilian corporate tax rate 34.00%
Cost of debt, after-tax 6.60%

WACC Calculation (in R$)

Petrobrás cost of debt, after-tax 6.60%
Long-term debt ratio (% of capital) 50.60%
Petrobrás cost of equity 17.60%
Long-term equity ratio (% of capital) 49.40%

WACC (calculated) 12.03%

WACC (I-bank report) 12.00%

Identifying the risk-free rate as the Brazilian C-Bond rate, and using a relatively high value of
beta compared to other analyst estimates, the cost of equity is relatively high. The cost of debt,
also high compared to the other estimates, results in a final WACC calculation, in Brazilian
reais, which is similar in value to other estimates.

Source: "Petroleo Brasileiro S.A.,Citigroup Smith Barney, June 17, 2003, p.17.
Problem 14.5 BBVA Investment Bank: Petrobras' WACC

BBVA utilised a rather innovative approach to dealing with both country and currency risk in
their December 20, 2004 report on Petrobras. Evaluate the methodology and assumptions used
in this cost of capital calculation.

Cost of Capital Component 2003 Estimate 2004 Estimate

US 10-year risk-free rate (in US$) 4.10% 4.40%
Country risk premium (in US$) 6.00% 4.00%
Petrobras premium "ad1 -1.00% -1.00%
Petrobras risk-free rate (in US$) 9.10% 7.40%

Petrobras Cost of Equity

Petrobras risk-free rate (in US$) 9.10% 7.40%
Petrobras beta (β) 0.80 0.80
Market risk premium (in US$) 6.00% 6.00%
Cost of equity (in 2 13.90% 12.20%
Projected 10-year currency devaluation 2.50% 2.00%
Cost of equity (in 3 16.75% 14.44%

Petrobras Cost of Debt

Petrobras cost of debt (in R$) 8.50% 8.50%
Brazilian corporate tax rate 35.00% 35.00%
Cost of debt, after-tax (in US$) 5.53% 5.53%

WACC Calculation (in R$)

Petrobras cost of debt, after-tax 5.53% 5.53%
Long-term debt ratio (% of capital) 31.00% 28.00%
Petrobras cost of equity 16.75% 14.44%
Long-term equity ratio (% of capital) 69.00% 72.00%

WACC (calculated) 13.27% 11.95%

WACC (I-Bank report) 13.30% 12.00%

This analysis clearly begins with a U.S. dollar-based risk-free rate, 4.1% and 4.4%, adds a
country risk premium to it, and then adjusts the sum downward for a Petrobras premium. The
Petrobras premium is the analyst's opinion that Petrobras is an oil and gas company, and
therefore operates in a global dollar market which is in many ways less risky than a pure-play
on a Brazilian firm. The resulting cost of equity is then converted from reais to dollars with the
application of a currency devaluation multiplier, a stated average expectation for the coming
decade. The cost of debt assumed is very low - 5.53% - which is clearly a dollar cost and not a
reais cost as stated. The final WACC in reais terms is roughly equivalent to the various
estimates from the previous problems.

Notes:
1 Petrobras premium adjustment is the reduction in country risk given an oil and gas company operating
in a global industry which operates in a market of US dollar denominated returns.
2 Cost of equity in US$ = risk free rate + ( beta x market risk premium )
3 Cost of equity in R$ = [ (1 + cost of equity in US$) x (1 + projected devaluation) ] - 1

Source: "Petrobras," BBVA Securities, Latin American Research, December 20, 2004, p. 7.
Problem 14.6 Petrobras' WACC Comparison

The various estimates of the cost of capital for Petrobras of Brazil appear to be very different, but are they? Reorganise your answers to the previous five problems into those costs of capital whi
dollars versus Brazilian reais. Use the estimates for 2004 as the basis of comparison.

U.S. dollar WACCs Brazilian reais WACCs

JPMorgan Citigroup ($) UNIBANCO
Capital Cost Components (June 18, 2004) (March 8, 2005) (Aug 12, 2004)
Risk Free Rate 4.800% 9.400% 4.500%
Sovereign/Country Risk Premium 7.000% 0.000% 5.500%
Petrobras Company Premium 0.000% 0.000% 0.000%
"Adjusted" Risk Free Rate 11.800% 9.400% 10.000%
Levered Beta 0.87 1.09 0.99
Market/Equity Risk Premium 4.500% 5.500% 6.000%
Cost of equity (US$) 18.981% 15.395% 15.940%

Exchange Rate 2.000%

Cost of equity (R$) 18.259%

Cost of Debt 8.400% 8.400% 8.600%

Tax rate 28.000% 27.100% 34.000%
Cost of debt, after-tax 6.048% 6.124% 5.676%

Debt/Capital ratio 33.300% 32.400% 40.000%

Equity/Capital ratio 66.700% 67.600% 60.000%

WACC (calculated) 14.7% 12.4% 13.2%

WACC (I-bank report) 14.7% 12.3% 13.2%

problems into those costs of capital which are in U.S.

Brazilian reais WACCs

Citigroup (R$) BBVA
(June 17, 2003) (Dec 20, 2004)
9.900% 4.400%
0.000% 4.000%
0.000% -1.000%
9.900% 7.400%
1.40 0.80
5.500% 6.000%
17.600% 12.200%

0.000% 2.000%
17.600% 14.444%

10.000% 8.500%
34.000% 35.000%
6.600% 5.525%

50.600% 28.000%
49.400% 72.000%

12.0% 11.9%

12.0% 12.0%