Petrobras and cost of capital - Essay Example

? Petrobras and Cost of Capital Insert Insert Grade Insert 30 October Q1. Why Petrobras’ Cost of Capital Is So High andWays or Other Ways of Calculating Its Weighted Average Cost Of Capital Cost of Capital Cost of capital is in essence the lowest yield an investment project must produce in order to cater for the costs of financing (Eun 2009). An organization’s CA (cost of capital) can be said to be the cost of obtaining debt and the required equity. There is also importance in noting that the costs associated with obtaining the two also reflect the relative risks for obtaining them. Therefore, a company that acquires the two at high costs has higher risks compared to one that obtains them at lower costs. Petrobras, therefore, was operating in a higher risk environment due to Brazil’s economic turbulence. The cost of debt for any given company is the cost of raising extra revenue by issuing the debt. Likewise, the cost of equity refers to that extra revenue associated with issue of the equity shares. The cost of capital therefore is derived from the average value of issuing the two in the proportion capital they present and this is what is referred to as the WACC (weighted average cost of capital) as to be discussed later in this paper. For a company like Petrobras, the financing costs can be derived by use of the WACC. The major players in the multinational oil industry as indicated in exhibit 1 of the case have almost a similar cost of capital ranging from 7.6% of BP to 9.0% of ocean energy indicating an average difference of 1.4%. Petrobras’ cost of capital is further up at 15% reflecting a massive difference of 6%. This is largely attributed to the company’s distinct domestic involvement in terms of its operations. The company is largely owned by the government and hence it was solely producing for a Brazilian market in the quest to eliminate its over dependence on international oil imports. This is despite the economic turbulence of the country’s economy that has been characterized by fluctuations in interest rates, inflation rates, local currency depreciation among other economic downfall, which is further reflected into the company’s CA. The company choice of not internationalizing its operations made investors assign it the country risks assigned to similar firms operating in the country and as a consequence, the cost of capital was significantly raised. There are sentiments by analysts that the company’s CA ought to have been excluded from the “burden” of the respective additional costs incurred from Brazil's sovereign spread during the derivation of kd (cost of debt) and derived capital or equity (Antweiler 2005). This will ensure that the risk bored or characterized by the company’s operations are optimally constituted hence bringing its cost of capital at par with similar companies. This is the main reason why the company embarked on expansion in the South American markets like Argentina, as mentioned in the case. Petrobras's WACC Analysis To begin, there are two ways that companies may use to evaluate their cost of capital: the first one is by use of expected equity cash flow and the required rate of return whereas the second approach focuses on the use of free cash flow and the weighted average cost of capital. The WACC calculation for Petrobras uses comparable companies to produce a single discount rate. This is despite of the fact that an industry average WACC is the most appropriate for Petrobras on a long-term basis. Suppose there exists any short-term differences between the industry WACC and Petrobras's WACC, then it goes that Petrobras will be more likely to go back to the industry WACC on a long-term basis. The company’s WACC calculation uses Petrobras's highest risk free rate, because no investment can have a cost of capital that is better than risk free. This situation may occur if the beta is negative and Petrobras uses a significant proportion of equity capital. While the company had decided to implement an internationalization expansion strategy, it was limited largely to expansion in the South American region. Given the similarities between these regional markets and the Brazilian market, this did not mean that there was going to be some reduced cost of capital at par with the ones of the other oil producing companies in the market. The reason being that risks would have remained the same as those associated with the Brazilian market. The South American markets, therefore, did not provide cheaper sources of capital as evident in the case and hence as a result did not ensure that there was 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. Nonetheless, with the inherent risk faced by Brazil, there is surely no better means of calculation as all investors have the information about Brazil’s political history and sovereign risk which then requires higher rates of return on investment to be able to compensate for the risk to be taken. However, if Petrobras can sell some of the shares held by government and embark on an expansion on a stronger international market like the North American one, then risk diversification can be achieved. As a result, investors would require relatively low returns and consequently a lower WACC for Petrobras. Other methods of calculating WACC There are two other methods of determining WACC apart from the method discussed above. First, there is this method that does not necessarily evaluate or assign value or estimates to the costs of equity and debt (Armitage 2005). The other method only employs the cost of equity and, therefore, does not use estimates for the cost of debt in calculation of the WACC. It is important to note that WACC should be discounted so that the real objective of evaluation is achieved. Q2. Sovereign Spread and Country Risk The sovereign spread is in essence the global debt markets’ view of the ability to source for credit by the government of Brazil when being lend by U.S. dollar-crowded debt. That, therefore, should have never been equated to the currency risk. However, it is important to note that in practical terms, this theoretical perspective may not be applicable in the case. Sovereign spread is given by the difference in returns or extra revenue received from a government bond issued by Brazil and the extra revenue resulting from a similar bond issued by the United States government. The difference results from the better sovereign rating of the US and, therefore, an equally better creditworthiness as opposed to the Brazilian government. In this case, it is also important to note the fact that the US dollar has been identified as the benchmark currency. Brazil’s creditworthiness is influenced by conditions such as the levels of external debt, economic growth rate and political stability as some of the main factors. In addition, currency risk is not the same as sovereign spread. In this instance, currency risk represents the possibility that the worthiness of Brazil's currency will fluctuate more than the value of the US dollar. In the case of Petrobras, its share price is at a high relative relation with the EMBI SP (sovereign spread) carried by Brazil. Investors will use this to assess the Petrobras’ WACC. In this case, therefore, it would appear that it also mirrors the risk of fluctuations in the exchange rate (the country’s currency risk). Therefore, while they are different in the context of this case study; the sovereign spread actually compensates for the currency risk. In general terms, there are three major factors that influence WACC that include interest rates, market risk premium and the tax rates (Chandra 2008). If the interest rates increase, it further causes a rise in the cost of debt and vice versa. An increase in corporate tax, for instance, will result in reduction of gains from investment, which has a direct bearing on equity. Lastly, the market risk premium influences the riskiness of investment in certain equity and, therefore, influences the Kd and E in substitution mechanism. Q3. Brazil's Market Perception and Calculation of the firm's Capital Costs Petrobras is essentially a Brazilian company and this seems to override the fact that it is an oil company, according to the views expressed. Suppose investors intent to invest on this type of organization, their expectations are bound to be that of a skeptical nature in order that they scrutinize the Brazilian capital market on its potential returns so that risks taken are realistic. WACC, which is often used as a benchmark rate is a point of reference that points to the presence or absence of access to the Return on Invested Capital (ROIC). This is done to be able to appropriately value the potential investment venture in terms of the risks and returns associated with it so that decision is made on an informed basis. It is, therefore, important that potential investors apply this method in relation to the equity market unpredictability in the country in which Petrobras has centralized its operations. In terms of calculation, WACC = (Debt/capital) x Kd x (1 – Tax rate) + (Equity/capital x Ke) Where; Kd is the cost of debt and Ke is the cost of equity It is important that we weigh the cost of debt and that of equity for the intended company’s capital structure (Hunt 2009). The cost of equity from Petrobras in this case is influenced by the country risk that has been derived from the risk free interest rate. The evaluated cost of equity of Petrobras is able to be derived by means of the Capital Asset Pricing Model (CAPM) formula: Ke = risk-free rate + (? Petrobras x market risk premium) Basically, the Brazilian portfolio will result in an increase in ? Petrobras, which leads to a rise in the cost of equity (Ke) that in effect increases the WACC. Suppose an investor uses the global portfolio for instance that of the NYSE in the US, Petrobras WACC will even be far much higher. This can be overcome by listing its shares in international markets like the proposed NYSE listing. This can benefit the company in various ways that may include extension of potential investor base for the company, which may help increase the share prices and in turn reduce its cost of capital. Secondly, international listing helps to expand the markets for the company’s shares that might help it add on its capital resource base. Consequently, this method helps the company to increase its liquidation in terms of the shares held by investors. Lastly, it can also lead to a brand positioning in international front that has a positive impact on sales and acceptance globally (Eun 2009). However, despite of the advantages of cross listing, the company must be aware of such issues such as international takeover by foreign buyers, stock volatility influenced by economic conditions of the markets and the extra costs associated with setting up and legalities. As a conclusion the benefits of internationalization still outweighs its disadvantages and hence a corporate like Petrobas should not be against this strategy to help it increase its cost of capital and hence handle the competition experienced in the sector. Another issue on internationalization is the diversification. The main concept of diversification was introduced in 1952 by proponents such as Harry Markowitz. It presupposes that diversification helps to reduce the uncertainties equated to the various asset portfolios. It has been therefore correctly established that internationalization of a company’s equity will definitely reduce the risks it is likely to face in its market. Currently, there are two competing views on the value of international diversification. However, there are still conflicting views regarding the extent to which risks are reduced due to international diversification of equity. The first view is of the opinion that international diversification reduces risk. The second view agrees that diversification is of massive benefit, but the additional risks faced by a company investing in foreign equities outweigh its potential benefits. Companies typically raise capital for business expansion through public offerings. During a bull market, such offerings are especially attractive to businesses because it is argued that they can price these offerings above the intrinsic value of the shares because investors believe that the impact of speculative flows on share prices will outweigh the Premia on the intrinsic value that they pay. This essentially translates to cheaper funding. Conversely, the argument goes, companies in a bear market may have to price their offerings at or below the intrinsic value which effectively raises their cost of funding. In the case of an under-subscription, the company's reputation may fall with the effect that future cost of capital for that company may increase. Sharp declines in the stock market, therefore, serve only to dampen sentiment and increase the cost of funding for companies. This hinders capital formation and ultimately translates to a slowdown in business expansion and investment. Q4. Relevance of Capital Cost In the Area of Competition and Strategy of A Company and How Corporate Costs Affect Competitiveness As is the tradition, cost of capital is an important factor that needs to be taken into account when evaluating an organization’s competitiveness. For an aspiring multinational oil company like Petrobras, the cost of capital is very critical to the success of its operations since it operates in an industry that require massive capital investments to be able to achieve substantial revenue. The company is looking at future prospects of exploiting underwater fuel in the forms of oil and gas that requires heavy investment for an operation that may take several years before any meaningful gains are achieved hence it cannot fail to check on the cost of capital. In Theory, the company will likely to invest in new ventures, which should exhibit the characteristic of having a higher return on investment. However in cases of high capital cost, little of the investment will be likely because of lesser potential in available capital ventures which might be having higher risks and vice versa. The cost of capital is for sure an important factor to take into account when developing a competitive strategy for a company or an investment portfolio that wants return on their investment in the end. This is because it is a very important determinant for the hurdle rate that investment opportunities must exceed in order to be considered viable. The larger the expenses incurred in acquiring capital the more superior the required rate of return on potential investments and, consequently, the fewer project can be undertaken. However, it must be noted that the CA solely is not the only factor but 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 (Phadtare 2011). 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 Petrobras, which operates in the highly capital intensive petroleum and gas sector, 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. A firm that can be able to reduce its cost of capital will also be able to add on its profitable capital expenses the firm can venture on and this goes a long way in raising the value of shares held by investors in the company (Eun 2009). Another way of reducing risks is through diversification of costs. The key difficulty associated with international expansion by a corporate are currency risk, impediments or barriers to the free flow of equity, legal risk, information costs and country risk. The currency risk can influence both the total return and the volatility of the investment like futures or forward currency contracts, buying put currency options, or by borrowing foreign currency to finance the investment. Summary Petrobas, as from the case, was suffering from volatility of the economic market it was operating on. The government of Brazil – its major shareholder - had a good initiative of reducing imports of oil and thereby eliminating reliance of international companies that were bound to hurt the economy of the country. However, Petrobas was being faced by an unfair rate in the CA since it was focused on being a local producer competing with multinationals. This contributed a lot in creating investor fear and speculation. The company followed the way of diversifying its markets but still did not make the right choice. By expanding its markets through ventures in the South American market, the real benefit of diversification was not going to be realized. This is because those markets had the same matters of economic instability that were being experienced at the company’s domestic market and hence the cost of capital could not be raised or increased according to the company’s expectations. It is therefore inherent that it goes further by investing in markets like the United States, which can provide a good benchmark internationally. The government should also give up some of the shares through offers in international stock exchange like the proposed NYSE listing so that the benefits of cross listing mentioned earlier in this essay may be derived. While embarking on a diversification strategy, the company should also take into account the issues that may arise from globalization like foreign takeover that may reverse the main objective of establishing the company in the first place. Another issue the company must look into is that of corporate cost of capital and the company’s competitive advantage in international market. The government should ensure that the local economy is stabilized in terms of more predictable inflationary and interest rates that is able to lower the cost of capital. In this way, investors will derive a better WACC for the company and that will enable it compete fairly both locally and internationally with other industry players. The future will be bright for the company if it implements the measures above. Bibliography Armitage, S 2005, The Cost of Capital: Intermediate Theory, Cambridge university press, Cambridge. Chandra, C 2008, Financial Management, McGraw-Hill Education, Irwin. Eun, C et al 2009, International Financial Management 5th Edn, McGraw-Hill Publishers, Irwin. Hunt, P. et al 2009, Structuring Mergers and Acquisitions: a Guide to Creating Shareholder Value, Apsen Publishers, London. Phadtare, M 2011, Strategic Management Concepts and Cases, New Delhi, PHI learning Pvt. Ltd. Read More