Petrobras and cost of capital Essay Example | Topics and Well Written Essays - 3000 words

Petrobras and cost of capital - Essay Example Petrobras 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.... erations 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 â€Å"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