Equity Sourcing Strategy. Why does the strategic path to sourcing equity start with debt?

409Raising Equity and Debt Globally CHAPTER 14

The national oil company of Brazil, Petrobrás, suffered from an ailment common in emerging markets—a high and uncompetitive cost of capital. Despite being widely considered the global leader in deepwater technology (the ability to drill and develop oil and gas fields more than a mile below the ocean’s surface), unless it could devise a strategy to lower its cost of capital, it would be unable to exploit its true organizational competitive advantage.

Many market analysts argued that the Brazilian com- pany should follow the strategy employed by a number of Mexican companies and buy its way out of its dilemma. If Petrobrás were to acquire one of the many indepen- dent North American oil and gas companies, it might transform itself from being wholly “Brazilian” to partially “American” in the eyes of capital markets, and possibly lower its weighted average cost of capital (WACC) to between 6% and 8%.

Petróleo Brasileiro S.A. (Petrobrás) was an integrated oil and gas company founded in 1954 by the Brazilian government as the national oil company of Brazil. The company was listed publicly in São Paulo in 1997 and on the New York Stock Exchange (NYSE: PBR) in 2000. Despite the equity listings, the Brazilian government con- tinued to be the controlling shareholder, with 33% of the total capital and 55% of the voting shares. As the national oil company of Brazil, the company’s singular purpose was the reduction of Brazil’s dependency on imported oil. A side effect of this focus, however, had been a lack of international diversification. Many of the company’s critics argued that being both Brazilian and undiversi- fied internationally resulted in an uncompetitive cost of capital.

need for Diversification Petrobrás in 2002 was the largest company in Brazil, and the largest publicly traded oil company in Latin America. It was not, however, international in its operations. This inherent lack of international diversification was apparent

to international investors, who assigned the company the same country risk factors and premiums they did to all other Brazilian companies. The result was a cost of capital in 2002, as seen in Exhibit A, that was 6% higher than the other firms shown.

Petrobrás embarked on a globalization strategy, with several major transactions heading up the process. In December 2001, Repsol-YPF of Argentina and Petrobrás concluded an exchange of operating assets valued at $500 million. In the exchange, Petrobrás received 99% interest in the Eg3 S.A. service station chain, while Repsol-YPF gained a 30% stake in a refinery, a 10% stake in an offshore oil field, and a fuel resale right to 230 service stations in Brazil. The agreement included an eight-year guarantee against currency risks.

In October 2002, Petrobrás purchased Perez Companc (Pecom) of Argentina. Pecom had quickly come into play following the Argentine financial crisis in January 2002. Although Pecom had significant international reserves and production capability, the combined forces of a deval- ued Argentine peso, a largely dollar-denominated debt portfolio, and a multitude of Argentine government regu- lations that hindered its ability to hold and leverage hard currency resources, the company had moved quickly to find a buyer to refund its financial structure. Petrobrás took advantage of the opportunity. Pecom’s ownership had been split between its original controlling family owners and their foundation, 58.6%, and public flotation of the remaining 41.4%. Petrobrás had purchased the controlling interest, the full 58.6% interest, outright from the family.

Over the next three years, Petrobrás focused on restructuring much of its debt (and the debt it had acquired via the Pecom acquisition) and investing in its own growth. But progress toward revitalizing its financial structure came slowly, and by 2005 there was renewed discussion of a new equity issuance to increase the firm’s equity capital.7 But at what cost? What was the company’s cost of capital?

7By 2005, the company’s financial strategy was showing significant diversification. Total corporate funding was well-balanced: bonds, $4 billion; BNDES (bonds issued under the auspices of a Brazilian economic development agency), $3 billion; project finance, $5  billion; other, $4 billion.

petrobrás of Brazil and the Cost of Capital6

6Copyright © 2008 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only and not to indicate either effective or ineffective management.


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410 CHAPTER 14 Raising Equity and Debt Globally

Country Risk Exhibit A presented the cost of capital of a number of major oil and gas companies across the world, including Petrobrás in 2002. This comparison could occur only if all capital costs were calculated in a common currency, in this case, the U.S. dollar. The global oil and gas markets had long been considered “dollar-denominated,” and any company operating in these markets, regardless of where it actually operated in the world, was considered to have the dollar as its functional currency. Once that company listed its shares in a U.S. equity market, the dollarization of its capital costs became even more accepted.

But what was the cost of capital—in dollar terms— for a Brazilian business? Brazil has a long history of bouts with high inflation, economic instability, and cur- rency devaluations and depreciations (depending on the regime de jure). One of the leading indicators of the global market’s opinion of Brazilian country risk was the sovereign spread, the additional yield or cost of dollar funds that the Brazilian government had to pay on global markets over and above that which the U.S. Treasury paid to borrow dollar funds. As illustrated in Exhibit B, the Brazilian sovereign spread had been both

high and volatile over the past decade.8 The spread was sometimes as low as 400 basis points (4.0%), as in recent years, or as high as 2,400 basis points (24%), during the 2002 financial crisis in which the real was first devalued then floated. And that was merely the cost of debt for the government of Brazil. How was this sovereign spread reflected in the cost of debt and equity for a Brazilian company like Petrobrás?

One approach to the estimation of Petrobrás’ cost of debt in U.S. dollar terms (kd $) was to build it up: the govern- ment of Brazil’s cost of dollar funds adjusted for a private corporate credit spread.

kd $ = U.S. Treasury + Brazilian + Petrobrás

risk@free rate sovereign credit spread spread

kd $ = 4.000% + 4.000% + 1.000% = 9.000%

If the U.S. Treasury risk-free rate was estimated using the Treasury 10-year bond rate (yield), a base rate in August 2005 could be 4.0%. The Brazilian sovereign spread, as seen in Exhibit B, appeared to be 400 basis points, or an additional 4.0%. Even if Petrobrás’ credit spread was only


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Source: MorganStanley Research, January 18, 2002, p. 5.

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exhibit a petrobrás’ Uncompetitive Cost of Capital

8 The measure of sovereign spread presented in Exhibit B is that calculated by JPMorgan in its Emerging Market Bond Index Plus (EMBI+) index. This is the most widely used measure of country risk by practitioners.

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411Raising Equity and Debt Globally CHAPTER 14

1.0%, the company’s current cost of dollar debt would be 9%. This cost was clearly higher than the cost of debt for most of the world’s oil majors who were probably paying only 5% on average for debt in late 2005.

Petrobrás’ cost of equity would be similarly affected by the country risk-adjusted risk-free rate of interest. Using a simple expression of the Capital Asset Pricing Model (CAPM) to estimate the company’s cost of equity capital in dollar terms (ke


k e $ = risk@free rate

+(bPetrobrás * market risk premium) = 8.000% +(1.10 * 5.500%) = 14.05%

This calculation assumed the same risk-free rate as used in the cost of debt previously, with a beta (NYSE basis) of 1.10 and a market risk premium of 5.500%. Even with these relatively conservative assumptions (many would argue that the company’s beta was actually higher or lower, and that the market risk premium was 6.0% or higher), the company’s cost of equity was 14%.

WACC = (debt/capital * kd $ * (1 – tax rate)) +(equity/capital * ke $)

Assuming a long-term target capital structure of one-third debt and two-thirds equity, and an effective corporate tax rate of 28% (after special tax concessions, surcharges, and incentives for the Brazilian oil and gas industry), Petrobrás’ WACC was estimated at a little over 11.5%:

WACC = (0.333 * 9.000% * 0.72) +(0.667 * 14.050%) = 11.529%.

So, after all of the efforts to internationally diversify the firm and internationalize its cost of capital, why was Petrobrás’ cost of capital still so much higher than its global counterparts? Not only was the company’s weighted aver- age cost of capital high compared to other major global players, this was the same high cost of capital used as the basic discount rate in evaluating many potential invest- ments and acquisitions.

A number of the investment banking firms that covered Petrobrás noted that the company’s share price had shown a very high correlation with the EMBI+ sovereign spread for Brazil (shown in Exhibit B), hovering around 0.84 for a number of years. Similarly, Petrobrás’ share price was also historically correlated—inversely—with the Brazilian reais/ U.S. dollar exchange rate. This correlation had averaged

Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04











Basis Point Spread over United States



Global Brazil

Source: JPMorgan’s EMBI+ Spread, as quoted by Latin Focus, www.latin-focus.com/latinfocus/countries/brazilbisprd.htm, August 2005.

exhibit b the Brazilian Sovereign Spread

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-0.88 over the 2000–2004 period. Finally, the question of whether Petrobrás was considered an oil company or a Bra- zilian company was also somewhat in question:

Petrobrás’ stock performance appears more highly cor- related 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 com- pany. If the historical trend were to hold, an improve- ment in Brazilian risk perception should provide a fillip to Petrobrás’ share price performance.

—“Petrobrás: A Diamond in the Rough,” JPMorgan Latin American Equity Research,

June 18, 2004, pp. 26–27.

Mini-Case Questions 1. Why do you think Petrobrás’ 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 inves- tors 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 Petro- brás? Does the corporate cost of capital really affect competitiveness?

412 CHAPTER 14 Raising Equity and Debt Globally

QUEStIOnS These questions are available in MyFinanceLab.

1. Equity Sourcing Strategy. Why does the strategic path to sourcing equity start with debt?

2. Optimal Financial Structure. If the cost of debt is less than the cost of equity, why doesn’t the firm’s cost of capital continue to decrease with the use of more and more debt?

3. Multinationals and Cash Flow Diversification. How does the multinational’s ability to diversify its cash flows alter its ability to use greater amounts of debt?

4. Foreign Currency-Denominated Debt. How does bor- rowing in a foreign currency change the risk associated with debt?

5. Three Keys to Global Equity. What are the three key elements related to raising equity capital in the global marketplace?

6. Global Equity Alternatives. What are the alternative structures available for raising equity capital on the global market?

7. Directed Public Issues. What is a directed public issue? What is the purpose of this kind of international equity issuance?

8. Depositary Receipts. What is a depositary receipt? Give examples of equity shares listed and issued in foreign equity markets in this form?

9. GDRs, ADRs, and GRSs. What is the difference between a GDR, ADR, and GRS? How are these dif- ferences significant?

10. Sponsored and Unsponsored. ADRs and GDRs can be sponsored or unsponsored. What does this mean and will it matter to investors purchasing the shares?

11. ADR Levels. Distinguish between the three levels of commitment for ADRs traded in the United States.

12. IPOs and FOs. What is the significance of IPOs versus FOs?

13. Foreign Equity Listing and Issuance. Give five reasons why a firm might cross-list and sell its shares on a very liquid stock exchange.

14. Cross-Listing Abroad. What are the main reasons for firms to cross-list abroad?

15. Barriers to Cross-Listing. What are the main barriers to cross-listing abroad?

16. Private Placement. What is a private placement? What are the comparative pros and cons of private place- ment versus a pubic issue?

17. Private Equity. What is private equity and how do private equity funds differ from traditional venture capital firms?

18. Bank Loans versus Securitized Debt. For multina- tional corporations, what is the advantage of securi- tized debt instruments sold on a market versus bank borrowing?

19. International Debt Instruments. What are the primary alternative instruments available for raising debt on the international marketplace?

20. Eurobond versus Foreign Bonds. What is the difference between a eurobond and a foreign bond and why do two types of international bonds exist?

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