Petrobrás of Brazil

and the Cost of Capital

How do you estimate the cost of capital for a multinational
enterprise in a global industry – in this case oil – which is based
in an emerging market?

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Petrobrás of Brazil and the Cost
of Capital
• Petróleo Brasileiro S.A. (Petrobrás) was the national oil company of Brazil
• Petrobrás was an integrated oil and gas producer which was publicly traded but 33% of its
ownership shares were still owned by the Brazilian government
• The company was not internationally diversified in its operations, as all of its current oil and
gas operations were Brazilian when it went public in 2000
• As a result of its lack of diversification, and being considered relatively risky as a result of
Brazil’s economic history, Petrobrás has a significantly higher cost of capital than most
other major oil and gas companies all over the world
• Petrobrás’s cost of capital
• Oil and gas are priced and traded globally in U.S. dollars
• Most major multinational oil and gas producers as of January 2002 all had a cost of capital
which was between 7.6% and 9.0% -- but Petrobrás’s was 15.0%
• One of the major determinants of the company’s higher cost of capital was Brazil’s high
sovereign risk
• Sovereign risk
• Sovereign risk is the market’s assessment of the risk associated with the government’s
willingness and ability to repay U.S. dollar-denominated debt
• Brazil’s sovereign risk had been as high as 24% and as low as 0.4% over the past decade

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Petrobrás’ WACC:
Case Questions
1. Why do you think Petrobrás’s cost of capital is so high? Are there
better ways, or other ways, of calculating its weighted average cost of
capital?
2. Does this method of using the sovereign spread also compensate for
currency risk?
3. The final quote on “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?
4. Is the cost of capital really a relevant factor in the competitiveness and
strategy of a company like Petrobrás? Does the corporate cost of capital
really affect competitiveness?

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Exhibit 1 Petrobrás Suffers an
Uncompetitive Cost of Capital

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Exhibit 2 The Brazilian Sovereign
Spread (December 1997–August 2005)

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 Petrobrás’ WACC:
Case Questions
1. Why do you think Petrobrás’s cost of capital is so high? Are there
better ways, or other ways, of calculating its weighted average cost of
capital?
• Most of the major multinational oil firms are treated equally, with comparable
costs of capital and assessments of their earning potential.
• Petrobrás, however, was a Brazilian oil company which was distinctly domestic in
its activities. Even major oil companies like PDVSA, a Venezuelan oil company
(not discussed in the case), were considered of lower relative risk and possessed a
lower relative cost of capital because of the magnitude of their export sales.
Petrobrás was a Brazilian oil company producing for Brazilian markets.
• There is good argument that the company‟s cost of capital should not be
“burdened” by the additional charges of the Brazilian sovereign spread when
calculating its cost of debt and equity. It is operating in a global industry which has
a global price, in U.S. dollars, and a global market, which could potentially be
accessed for sales if the company wished.
• There are obviously a multitude of different ways to calculate the company‟s cost
of capital, but most methods would require some additional risk premium being
added to in some way compensate investors for the perceived risk of Brazilian
political or country risks (not particularly currency risks).
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Petrobrás’ WACC:
Case Questions

2. Does this method of using the sovereign spread also

compensate for currency risk?
• The sovereign spread is technically the international debt markets‟ opinion
of the creditworthiness of the Brazilian government when borrowing U.S.
dollar-denominated debt. This is not the same thing as currency risk.
• The credit analysis would in principle reflect the market‟s opinion of the
Brazilian government‟s capability to earn or generate U.S. dollar hard-
currency earnings in order to repay the debt, which may or may not be
directly related to changes in the value of the Brazilian reais itself.
• The fact that Petrobrás‟ share price had shown a high correlation with the
EMBI+ sovereign spread for Brazil, is however, a very interesting factor.
• As long the spread is used by investors in calculating the company‟s cost
of capital, it would seem to be reflecting changes in the exchange rate,
regardless of its theoretical validity.

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Petrobrás’ WACC:
Case Questions

3. Is the cost of capital really a relevant factor in the

competitiveness and strategy of a company like Petrobrás?
Does the corporate cost of capital really affect
competitiveness?

• This argument is consistent with the market‟s opinion that Petrobrás is a

Brazilian company first and an oil company second.
• If investors wish to invest in a firm of its character they must therefore
have bullish expectations on the potential of the Brazilian equity market
more than a positive opinion on the possibilities of the global or even
Brazilian oil markets.

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 Petrobrás’ WACC:
Case Questions
4. Is the cost of capital really a relevant factor in the competitiveness and
strategy of a company like Petrobrás? Does the corporate cost of
capital really affect competitiveness?
• The cost of capital is always a factor in considering a company‟s competitiveness.
For a company like Petrobrás, operating in one of the world‟ most capital-intensive
industries, the cost of capital is considered critically important.
• Theoretically, the company will only undertake new investments which are
expected to possess rates of return which exceed the cost of capital; the higher the
cost of capital, the fewer potential investments which can be considered and the
fewer potential investments likely to be undertaken.
• A final note. Although students of finance are clearly and consistently taught that
the cost of capital, specifically the cost of equity, is important to the ability of a
company to compete, there are also those who argue (convincingly sometimes) that
the cost of equity is a „paper-cost‟, and therefore is not as material as the cost of
debt which is an actual cash outflow which must be paid on a regular basis. Equity
cost is largely that calculated through methods like CAPM, where the cost is
actually and expected return, not a contractual cash flow commitment.

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 Petrobrás of Brazil and the Cost
of Capital

Petrobrás’s stock performance appears more highly correlated

to the Brazilian equity market and credit spreads based on
historical trading patterns, suggesting that one’s view on the
direction of the broad Brazilian market is important in
making an investment decision on the company. If the
historical trend were to hold, an improvement in Brazilian
risk perception should provide a fillip to Petrobrás’s share
price performance.
“Petrobras: A Diamond in the Rough,” JPMorgan
Latin American Equity Research, June 18, 2004, p. 26-27.

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Exhibit 1 (Mini Case Appendix) The
Brazilian Reais/U.S. Dollar Spot Rate,
1998–2005

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