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Problem 14.

1 JPMorgan: Petrobrs's WACC


JPMorgans Latin American Equity Research department produced the following WACC
calculation for Petrobrs of Brazil versus Lukoil of Russia in their June 18, 2004 report.
Evaluate the methodology and assumptions used in the calculation. Assume a 28% tax rate
for both companies.
Petrobrs
(Brazil)
4.800%
7.000%
4.500%
16.300%

Lukoil
(Russia)
4.800%
3.000%
5.700%
13.500%

Beta (relevered)
Cost of equity

0.87
18.981%

1.04
18.840%

Cost of Debt
Tax rate
Cost of debt, after-tax

8.400%
28.000%
6.048%

6.800%
28.000%
4.896%

Debt/Capital ratio
Equity/Capital ratio

33.300%
66.700%

47.000%
53.000%

WACC (calculated)

14.674%

12.286%

WACC (I-Bank report)

14.700%

12.300%

Capital Cost Components


Risk Free Rate
Sovereign Risk
Equity Risk Premium
Market Cost of Equity

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's WACC


UNIBANCO estimated the weighted average cost of capital for Petrobrs to be
13.2% in Brazilian reais in August of 2004. Evaluate the methodology and
assumptions used in the calculation.
Capital Cost Components
Risk Free Rate
Levered Beta
Risk Premium
Country Risk Premium
Cost of equity (US$)

2004
4.500%
0.99
6.000%
5.500%
15.940%

Exchange Rate
Cost of equity (R$)

2.000%
18.259%

Cost of Debt
Tax rate
Cost of debt, after-tax (R$)

8.600%
34.000%
5.676%

Debt/Capital ratio
Equity/Capital ratio

40.000%
60.000%

WACC (R$) calculated

13.23%

WACC (R$) (I-bank report)

13.20%

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's WACC


Citigroup regularly performs a U.S. dollar-based discount cash flow (DCF) valuation of Petrobrs 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 Petrobras's WACC below.

Capital Cost Components


Risk free rate
Levered Beta
Risk Premium
Cost of equity

July 28, 2005


2003A
9.400%
1.07
5.500%
15.285%

2004E
9.400%
1.09
5.500%
15.395%

March 8, 2005
2003A
9.000%
1.08
5.500%
14.940%

2004E
9.000%
1.10
5.500%
15.050%

Cost of debt
Tax rate
Cost of debt, after-tax

8.400%
28.500%
6.006%

8.400%
27.100%
6.124%

9.000%
28.500%
6.435%

9.000%
27.100%
6.561%

Debt/capital ratio
Equity/capital ratio

32.700%
67.300%

32.400%
67.600%

32.700%
67.300%

32.400%
67.600%

WACC

12.20%

12.30%

12.10%

12.30%

WACC (calculated)

12.25%

12.39%

12.16%

12.30%

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 riskfree rate, which is difficult to understand or rationalize.
Source: "Petrobras," Citigroup SmithBarney, March 8, 2005, and July 28, 2005.

Problem 14.4 Citigroup SmithBarney (reais)


In a report dated June 17, 2003, Citigroup SmithBarney calculated a WACC for
Petrobrs denominated in Brazilian reais (R$). Evaluate the methodology and
assumptions used in this cost of capital calculation.
Petrobras Cost of Equity
Risk-free rate (Brazilian C-Bond)
Petrobras levered beta ()
Market risk premium
Cost of equity

June 2003
9.90%
1.40
5.50%
17.60%

Petrobras Cost of Debt


Petrobras cost of debt
Brazilian corporate tax rate
Cost of debt, after-tax

10.00%
34.00%
6.60%

WACC Calculation (in R$)


Petrobras cost of debt, after-tax
Long-term debt ratio (% of capital)
Petrobras cost of equity
Long-term equity ratio (% of capital)

6.60%
50.60%
17.60%
49.40%

WACC (I-bank report)

12.00%

WACC (calculated)

12.03%

Identifying the risk-free rate as the Braizilian 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's WACC


BBVA utilized 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
US 10-year risk-free rate (in US$)
Country risk premium (in US$)
Petrobras premium "adjustment"
Petrobras risk-free rate (in US$)

2003 Estimate
4.10%
6.00%
-1.00%
9.10%

2004 Estimate
4.40%
4.00%
-1.00%
7.40%

9.10%
0.80
6.00%
13.90%
2.50%
16.75%

7.40%
0.80
6.00%
12.20%
2.00%
14.44%

Petrobras Cost of Debt


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

8.50%
35.00%
5.53%

8.50%
35.00%
5.53%

WACC Calculation (in R$)


Petrobras cost of debt, after-tax
Long-term debt ratio (% of capital)
Petrobras cost of equity
Long-term equity ratio (% of capital)

5.53%
31.00%
16.75%
69.00%

5.53%
28.00%
14.44%
72.00%

WACC (calculated)

13.27%

11.95%

WACC (I-Bank report)

13.30%

12.00%

Petrobras Cost of Equity


Petrobras risk-free rate (in US$)
Petrobras beta ()
Market risk premium (in US$)
Cost of equity (in US$)
Projected 10-year currency devaluation
Cost of equity (in R$)

2
3

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's WACC Comparison


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

Capital Cost Components


Risk Free Rate
Sovereign/Country Risk Premium
Petrobras Company Premium
"Adjusted" Risk Free Rate
Levered Beta
Market/Equity Risk Premium
Cost of equity (US$)

U.S. dollar WACCs


JPMorgan
Citigroup ($)
(June 18, 2004)
(March 8, 2005)
4.800%
9.400%
7.000%
0.000%
0.000%
0.000%
11.800%
9.400%
0.87
1.09
4.500%
5.500%
18.981%
15.395%

Exchange Rate
Cost of equity (R$)

UNIBANCO
(Aug 12, 2004)
4.500%
5.500%
0.000%
10.000%
0.99
6.000%
15.940%

Brazilian reais WACCs


Citigroup (R$)
(June 17, 2003)
9.900%
0.000%
0.000%
9.900%
1.40
5.500%
17.600%

BBVA
(Dec 20, 2004)
4.400%
4.000%
-1.000%
7.400%
0.80
6.000%
12.200%

2.000%
18.259%

0.000%
17.600%

2.000%
14.444%

Cost of Debt
Tax rate
Cost of debt, after-tax

8.400%
28.000%
6.048%

8.400%
27.100%
6.124%

8.600%
34.000%
5.676%

10.000%
34.000%
6.600%

8.500%
35.000%
5.525%

Debt/Capital ratio
Equity/Capital ratio

33.300%
66.700%

32.400%
67.600%

40.000%
60.000%

50.600%
49.400%

28.000%
72.000%

WACC (calculated)

14.7%

12.4%

13.2%

12.0%

11.9%

WACC (I-bank report)

14.7%

12.3%

13.2%

12.0%

12.0%

Problem 14.7 Copper Mountain Group (USA)


The Copper Mountain Group, a private equity firm headquartered in Boulder, Colorado (US), borrows 5,000,000 for one year at
7.375% interest.
a. What is the dollar cost of this debt if the pound depreciates from $2.0260/ to $1.9460/ over the year?
b. What is the dollar cost of this debt if the pound appreciates from $2.0260/ to $2.1640/ over the year?
Assumptions
Principal borrowed (British pounds)
Pound interest rate, one year (percent per annum)
Beginning of year spot rate, $/
End of year spot rate, $/
Calculation of Principal and Interest
Pound-denominated debt, in pounds sterling:
Principal
Interest
Principal and interest due at end of year
Cost of funds if pound depreciates versus dollar
Repayment cost of pounds, in US dollars (ending spot rate)
Divided by the US dollar value of initial pound debt proceeds
(at beginning of period spot rate)
Equals
Minus 1
Equals the implied US dollar cost of pound-denominated debt
US dollar cost of pound () debt

$
$

a) Depreciating
5,000,000
7.375%
2.0260
1.9460

b) Appreciating
5,000,000
7.375%
2.0260
2.1640

5,000,000.00
368,750.00
5,368,750.00

5,000,000.00
368,750.00
5,368,750.00

10,447,587.50
10,130,000.00

$
$

11,617,975.00
10,130,000.00

1.03135
1.00000
0.03135

1.14689
1.00000
0.14689

3.135%

14.689%

Problem 14.8 McDougan Associates (USA)


McDougan Associates, a U.S.-based investment partnership, borrows 80,000,000 at a time when the exchange rate is $1.3460/. The entire
principal is to be repaid in three years, and interest is 6.250% per annum, paid annually in euros. The euro is expected to depreciate vis vis
the dollar at 3% per annum. What is the effective cost of this loan for McDougan?
Assumptions
Principal borrowed for three years, in euros
Interest rate on loan, percent per annum
Beginning spot rate, $/euro
Expected % change in the euro versus the dollar

Value
80,000,000
6.250%
1.3460
-3.000%

Calculation of the dollar cost of euro debt

Year 0

Proceeds from borrowing euros


Interest payment due, in euros
Repayment of principal in year 3
Total cash flows of euro-denominated debt

Year 1

Year 2

Year 3

- 5,000,000

- 5,000,000

- 5,000,000

- 5,000,000

- 5,000,000
- 80,000,000
- 85,000,000

80,000,000

80,000,000

Note: One way to check this calculaton is to find the


internal rate of return, IRR of this cash flow stream:
This shows it is truly a 6.0% loan.

6.250%

Expected exchange rate, $/euro


(spot rate x (1 - .03))

1.3460 $

1.3056 $

1.2665 $

1.2285

US dollar equivalent of euro-denominated cash flows

107,680,000 $

(6,528,100) $

(6,332,257) $

(104,418,918)

IRR of cash flow stream (the implied US dollar cost)

3.063%

The internal rate of return, IRR, of any stream of cash flows will determine the rate of discount (interest) which results in a NPV
of the cash flow stream of exactly zero.

Problem 14.9 Sunrise Manufacturing, Inc.


Sunrise Manufacturing, Inc, a U.S. multinational company, has the following debt components in its consolidated capital section. Sunrise's finance
staff estimates their cost of equity to be 20%. Current exchange rates are also listed below.
Income taxes are 30% around the world after allowing for credits. Calculate Sunrises weighted average cost of capital. Are any assumptions implicit
in your calculation?
Assumption
Tax rate
10-year euro bonds (euros)
20-year yen bonds (yen)
Spot rate ($/euro)
Spot rate ($/pound)
Spot rate (yen/$)

Component
25 year US dollar bonds
5 year US dollar euronotes
10 year euro bonds
20 year yen bonds
Shareholders' equity
Total

Value
30.00%
6,000,000
750,000,000
1.2400
1.8600
109.00

US Dollar
Amount
10,000,000
4,000,000
7,440,000
6,880,734
50,000,000
78,320,734

Proportion
12.77%
5.11%
9.50%
8.79%
63.84%
100.00%

Pre-tax
Cost (%)
6.000%
4.000%
5.000%
2.000%
20.000%

Post-tax
Cost (%)
4.200%
2.800%
3.500%
1.400%
20.000%
WACC =

Weighted
Component
Cost (%)
0.5363%
0.1430%
0.3325%
0.1230%
12.7680%
13.9027%

The component coupon costs (for example the 6% coupon on the 25-year US dollar bonds) are the same as the current yields to maturity that would be
needed to sell similar bonds in the marketplace today. Current yields to maturity is the proper rate to use. The interest costs used for the euro and yen
bonds reflect actual expected interest costs after any exchange rate changes. This calculation assumes there is no expected change in the exchange rate
over the life of the debt issue (which is indeed highly unlikely).

Problem 14.10 Grupo Modelo S.B.A de C.V.


Grupo Modelo, a brewery out of Mexico that exports such well-known varieties as Corona, Modelo and Pacifico, is Mexican by incorporation. However, the company evaluates all
business results, including financing costs, in U.S. dollars. The company needs to borrow $10,000,000 or the foreign currency equivalent for four years. For all issues, interest is
payable once per year, at the end of the year. Available alternatives are:

a. Sell Japanese yen bonds at par yielding 3% per annum. The current exchange rate is 106/$, and the yen is expected to strengthen against the dollar by 2% per annum.
b. Sell euro-denominated bonds at par yielding 7% per annum. The current exchange rate is $1.1960/, and the euro is expected to weaken against the dollar by 2% per annum.
c. Sell U.S. dollar bonds at par yielding 5% per annum.
Which course of action do you recommend Grupo Modelo take and why?

Alternatives
Coupon rate
Current spot rate, yen/$
Expected change in the value of the foreign currency
Principal needed by Grupo Modelo

Calculation of the dollar cost debt alternatives


Japanese yen bonds:
Proceeds and principal and interest payments
Expected exchange rate (yen/$)
US dollar equivalent in expected cash flows
IRR of US$ cash flow stream (cost of funds)
euro-denominated bonds:
Proceeds and principal and interest payments
Expected exchange rate (yen/$)
US dollar equivalent in expected cash flows
IRR of US$ cash flow stream (cost of funds)
US dollar bonds:
Proceeds and principal and interest payments
IRR of US$ cash flow stream (cost of funds)

Japanese
yen bonds
3.000%
106.00 $
2.000%
100,000,000
Year 0

euro
bonds
7.000%
1.1960
-2.000%

US dollar
bonds
5.000%

Year 1

Year 2

0.000%

Year 3

Year 4

10,600,000,000
106.00
100,000,000 $
5.060%

(318,000,000)
103.92
(3,060,000) $

(318,000,000)
101.88
(3,121,200) $

(318,000,000)
99.89
(3,183,624) $

(10,918,000,000)
97.93
(111,490,512)

83,612,040
1.1960
100,000,000 $
4.860%

- 5,852,843
1.1721
(6,860,000) $

- 5,852,843
1.1486
(6,722,800) $

- 5,852,843
1.1257
(6,588,344) $

- 89,464,883
1.1032
(98,693,393)

100,000,000 $
5.000%

(5,000,000) $

(5,000,000) $

(5,000,000) $

(105,000,000)

Given the expected exchange rate changes, the euro-denominated bonds have the lowest all-in-cost of funds for the Mexico-based company, Grupo Modelo.
(Note that it is the expected changes in exchange rates which determine this outcome. In the event that all currencies were expected to remain fixed, an expected
change of 0%, then the Japanese yen bonds are clearly the cheapest source of capital.)

Problem 14.11 Petrol Ibrico


Petrol Ibrico, a European gas company, is borrowing US$650,000,000 via a syndicated eurocredit for 6 years at 80 basis points over
LIBOR. LIBOR for the loan will be reset every six months. The funds will be provided by a syndicate of eight leading investment
bankers, which will charge up-front fees totaling 1.2% of the principal amount. What is the effective interest cost for the first year if
LIBOR is 4.00% for the first six months and 4.20% for the second six months?
Initial Issuance
Principal borrowed for six years, in US$
Issuance fees

Value
650,000,000
1.20%

Interest Costs
LIBOR
Spread over LIBOR
Total interest cost
Calculation of the effective cost of funds
Face value of syndicated loan
less fees for issuance
Net proceeds of syndicated loan
Interest payment due at end of 6-month period
(annual rate divided by 2 for 6-month period)
Total interest payments in first year of loan
Effective interest cost (interest payment/proceeds)

$
$

Issuance
650,000,000
(7,800,000)
642,200,000
$

(53,950,000)
8.401%

First 6-months
8.000%
0.800%
8.800%

2nd 6-months
7.000%
0.800%
7.800%

First 6-months

2nd 6-months

(28,600,000)

(25,350,000)

Problem 14.12 Adamantine Architectonics


Adamantine Architectonics consists of a U.S. parent and wholly owned subsidiaries in Malaysia (A-Malaysia)
and Mexico (A-Mexico). Selected portions of their non-consolidated balance sheets, translated into U.S.
dollars, are shown below.
What are the debt and equity proportions in Adamantines consolidated balance sheet?
Assumptions
A-Malaysia (in ringgits):
Long-term debt
Shareholders' equity
A-Mexico (in pesos):
Long-term debt
Shareholders' equity
Adamantine Architectonics (non-consolidated)
Investment in subsidiaries (US dollars):
in A-Malaysia
in A-Mexico
Parent long-term debt
Common stock
Retained earnings
Current exchange rates:
Malaysian ringgit per dollar (RM/$)
Mexican pesos per dollar (Ps/$)
Consolidated Balance Sheet (US$)
Debt:
Malaysian ringgit debt (RM converted to US$)
Mexican peso debt (Ps converted to US$)
Parent company debt
Consolidated long-term debt

Value
11,400,000
15,200,000
20,000,000
60,000,000

$
$
$
$
$

4,000,000
6,000,000
12,000,000
5,000,000
20,000,000
3.80
10.00
Value

Percent

3,000,000
2,000,000
12,000,000
17,000,000

40.48%

Shareholders' equity (common + retained)

25,000,000

59.52%

Total capital

42,000,000

100.00%

Note that the equity accounts of the subsidiaries are matched by "investment in subsidiaries" asset account held
in the non-consolidated books of the parent company. In consolidation these two accounts cancel each other out.

Problem 14.13 Morning Star Air (China)


Morning Star Air, headquartered in Kunming, China, needs US$5,000,000 for one year to finance
working capital. The airline has two alternatives for borrowing:
a. Borrow US$25,000,000 in Eurodollars in London at 7.250% per annum
b. Borrow HK$39,000,000 in Hong Kong at 7.00% per annum, and exchange these Hong Kong dollars
at the present exchange rate of HK$7.8/US$ for U.S. dollars.
At what ending exchange rate would Morning Star Air be indifferent between borrowing U.S. dollars
and borrowing Hong Kong dollars?
Assumptions
Working capital debt needed for one year
Borrowing US dollars in London:
Interest rate, percent per annum
Principal borrowed
Borrow Hong Kong dollars in Hong Kong
Interest rate, percent per annum
Initial spot rate, HK$/US$
Principal borrowed

Value
5,000,000

7.250%
5,000,000
7.000%
7.8000
39,000,000

Calculation of the breakeven exchange rate


Cost of repaying the Hong Kong dollar loan in HK$
Cost of repaying the US dollar loan in US$
Breakeven exchange rate (HK$ cost/US$ cost)
Breakeven is the equivalent of "indifferent."

41,730,000
5,362,500
7.7818

Problem 14.14 Pantheon Capital, S.A.


If Pantheon Capital, S.A., is raising funds via a euro-medium-term note with the following characteristics, how much in dollars will Pantheon receive for each $1,000 note sold?
Coupon rate: 8.00% payable semiannually on June 30 and December 31
Date of issuance: February 28, 2011
Maturity:
August
31, payable
2013 semiannually on June 30 and December 31
Coupon rate:
8.00%
Date of issuance: February 28, 2011
Maturity: August 31, 2013
Assumptions
Face value of each note sold
Annual coupon
Semi-annual coupon
(paid June 30th and December 31st)
Date of issuance
Maturity

Cash payment (payment date)


First coupon (30 June 2011)
Second coupon (31 December 2011)
Third coupon (30 June 2012)
Fourth coupon (31 December 2012)
Fifth coupon (30 June 2013)
Sixth and final coupon (31 August 2013)
Principal repayment

Value
1,000.00
8.00%
4.00%

February 28, 2011


August 31, 2013

Days Since
Previous Date

Cumultive Days
From Start

122
180
180
180
180
62

122
302
482
662
842
904
904

Cash Flows
(par x coupon x
days/180)
$
$
$
$
$
$
$

27.11
40.00
40.00
40.00
40.00
13.78
1,000.00

Discount Factor Calculation


Compound Factor
Discount Factor
(cum days/180)
(1.04) compounded
0.6778
1.6778
2.6778
3.6778
4.6778
5.0222
5.0222

1.0269
1.0680
1.1107
1.1552
1.2014
1.2177
1.2177

Note: That the reason these Euro Medium Term Notes each have a market value which exceeds their face value is because the first coupon is paid sooner than the
six month period separating coupon payments. For example, if all coupons payments were made in 180 days increments ("days since previous date"), the
market value of notes would be at the par value of $1,000.

Discounted
Cash Flows
(US dollars)
$
$
$
$
$
$
$
$

26.40
37.45
36.01
34.63
33.30
11.31
821.21
1,000.31

Problem 14.15 Westminster Insurance Company


Westminster Insurance Company plans to sell $2,000,000 of euro-commercial paper
with a 60-day maturity and discounted to yield 6% per annum. What will be the
immediate proceeds to Westminster Insurance?
Assumptions
Principal of Euro Commercial Paper issuance
Maturity (days)
Yield to maturity at issuance

Proceeds of issuance
Face value
Discount rate (1 + ((days/360) x (ytm)))
Proceeds equal (Face value / Discount rate)

Value
2,000,000
60
6.000%

Value
$
$

2,000,000.00
1.01000
1,980,198.02