BUS322 TMA TMB TMD 2014 TUT09 CH14

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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.

PetrobrsLukoilCapital Cost Components(Brazil)(Russia)Risk Free Rate4.800%4.800%Sovereign Risk7.000%3.000%Equity Risk Premium4.500%5.700% Market Cost of Equity16.300%13.500%

Beta (relevered)0.871.04 Cost of equity18.981%18.840%

Cost of Debt8.400%6.800%Tax rate28.000%28.000% Cost of debt, after-tax 6.048%4.896%

Debt/Capital ratio33.300%47.000%Equity/Capital ratio66.700%53.000%

WACC (calculated)14.674%12.286%

WACC (I-Bank report)14.700%12.300%

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.

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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 Components2004Risk Free Rate4.500%Levered Beta0.99Risk Premium6.000%Country Risk Premium5.500% Cost of equity (US$)15.940%

Exchange Rate 2.000% Cost of equity (R$)18.259%

Cost of Debt8.600%Tax rate34.000% Cost of debt, after-tax (R$)5.676%

Debt/Capital ratio40.000%Equity/Capital ratio60.000%

WACC (R$) calculated13.23%

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.

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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.

July 28, 2005March 8, 2005July 28, 2005Capital Cost Components2003A2004E2003A2004ERisk free rate9.400%9.400%9.000%9.000%Levered Beta1.071.091.081.10Risk Premium5.500%5.500%5.500%5.500% Cost of equity15.285%15.395%14.940%15.050%

Cost of debt8.400%8.400%9.000%9.000%Tax rate28.500%27.100%28.500%27.100% Cost of debt, after-tax6.006%6.124%6.435%6.561%

Debt/capital ratio32.700%32.400%32.700%32.400%Equity/capital ratio67.300%67.600%67.300%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 risk-free rate, which is difficult to understand or rationalize.

Source: "Petrobras," Citigroup SmithBarney, March 8, 2005, and July 28, 2005.

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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 EquityJune 2003Risk-free rate (Brazilian C-Bond)9.90%Petrobras levered beta ()1.40Market risk premium 5.50% Cost of equity 17.60%

Petrobras Cost of DebtPetrobras cost of debt 10.00%Brazilian corporate tax rate 34.00% Cost of debt, after-tax 6.60%

WACC Calculation (in R$)Petrobras cost of debt, after-tax 6.60%Long-term debt ratio (% of capital)50.60%Petrobras cost of equity17.60%Long-term equity ratio (% of capital)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.

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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 Component2003 Estimate2004 EstimateUS 10-year risk-free rate (in US$)4.10%4.40%Country risk premium (in US$)6.00%4.00%Petrobras premium "adjustment" 1-1.00%-1.00% Petrobras risk-free rate (in US$)9.10%7.40%

Petrobras Cost of EquityPetrobras risk-free rate (in US$)9.10%7.40%Petrobras beta ()0.800.80Market risk premium (in US$)6.00%6.00% Cost of equity (in US$) 213.90%12.20%Projected 10-year currency devaluation2.50%2.00% Cost of equity (in R$) 316.75%14.44%

Petrobras Cost of DebtPetrobras cost of debt (in R$)8.50%8.50%Brazilian corporate tax rate 35.00%35.00% Cost of debt, after-tax (in US$)5.53%5.53%

WACC Calculation (in R$)Petrobras cost of debt, after-tax 5.53%5.53%Long-term debt ratio (% of capital)31.00%28.00%Petrobras cost of equity16.75%14.44%Long-term equity ratio (% of capital)69.00%72.00%

WACC (calculated)13.27%11.95%

WACC (I-Bank report)13.30%12.00%

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.

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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.

U.S. dollar WACCsBrazilian reais WACCsJPMorganCitigroup ($)UNIBANCOCitigroup (R$)BBVACapital Cost Components(June 18, 2004)(March 8, 2005)(Aug 12, 2004)(June 17, 2003)(Dec 20, 2004)Risk Free Rate4.800%9.400%4.500%9.900%4.400%Sovereign/Country Risk Premium7.000%0.000%5.500%0.000%4.000%Petrobras Company Premium0.000%0.000%0.000%0.000%-1.000% "Adjusted" Risk Free Rate11.800%9.400%10.000%9.900%7.400%Levered Beta0.871.090.991.400.80Market/Equity Risk Premium4.500%5.500%6.000%5.500%6.000% Cost of equity (US$)18.981%15.395%15.940%17.600%12.200%

Exchange Rate 2.000%0.000%2.000% Cost of equity (R$)18.259%17.600%14.444%

Cost of Debt8.400%8.400%8.600%10.000%8.500%Tax rate28.000%27.100%34.000%34.000%35.000% Cost of debt, after-tax 6.048%6.124%5.676%6.600%5.525%

Debt/Capital ratio33.300%32.400%40.000%50.600%28.000%Equity/Capital ratio66.700%67.600%60.000%49.400%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%

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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?

Assumptionsa) Depreciating b) Appreciating Principal borrowed (British pounds)5,000,0005,000,000Pound interest rate, one year (percent per annum)7.375%7.375%Beginning of year spot rate, $/2.02602.0260End of year spot rate, $/1.94602.1640

Calculation of Principal and InterestPound-denominated debt, in pounds sterling: Principal5,000,000.005,000,000.00 Interest368,750.00368,750.00 Principal and interest due at end of year5,368,750.005,368,750.00

Cost of funds if pound depreciates versus dollarRepayment cost of pounds, in US dollars (ending spot rate)$10,447,587.50$11,617,975.00Divided by the US dollar value of initial pound debt proceeds$10,130,000.00$10,130,000.00 (at beginning of period spot rate)Equals1.031351.14689Minus 11.000001.00000Equals the implied US dollar cost of pound-denominated debt0.031350.14689

US dollar cost of pound () debt3.135%14.689%

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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?

AssumptionsValuePrincipal borrowed for three years, in euros 80,000,000Interest rate on loan, percent per annum6.250%Beginning spot rate, $/euro1.3460Expected % change in the euro versus the dollar-3.000%

Calculation of the dollar cost of euro debtYear 0Year 1Year 2Year 3

Proceeds from borrowing euros 80,000,000Interest payment due, in euros- 5,000,000- 5,000,000- 5,000,000Repayment of principal in year 3- 80,000,000 Total cash flows of euro-denominated debt 80,000,000- 5,000,000- 5,000,000- 85,000,000

Note: One way to check this calculaton is to find theinternal rate of return, IRR of this cash flow stream:6.250%This shows it is truly a 6.0% loan.

Expected exchange rate, $/euro$1.3460$1.3056$1.2665$1.2285 (spot rate x (1 - .03))

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 NPVof the cash flow stream of exactly zero.

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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?

AssumptionValueTax rate30.00%10-year euro bonds (euros) 6,000,00020-year yen bonds (yen)750,000,000Spot rate ($/euro)1.2400Spot rate ($/pound)1.8600Spot rate (yen/$)109.00

WeightedUS DollarPre-taxPost-taxComponentComponentAmountProportionCost (%)Cost (%)Cost (%)25 year US dollar bonds$10,000,00012.77%6.000%4.200%0.5363%5 year US dollar euronotes4,000,0005.11%4.000%2.800%0.1430%10 year euro bonds7,440,0009.50%5.000%3.500%0.3325%20 year yen bonds6,880,7348.79%2.000%1.400%0.1230%Shareholders' equity50,000,00063.84%20.000%20.000%12.7680%Total$78,320,734100.00%WACC =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).

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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?

JapaneseeuroUS dollarAlternativesyen bondsbondsbondsCoupon rate3.000%7.000%5.000%Current spot rate, yen/$106.00$1.1960Expected change in the value of the foreign currency2.000%-2.000%0.000%Principal needed by Grupo Modelo$100,000,000

Calculation of the dollar cost debt alternativesYear 0Year 1Year 2Year 3Year 4

Japanese yen bonds: Proceeds and principal and interest payments10,600,000,000(318,000,000)(318,000,000)(318,000,000)(10,918,000,000) Expected exchange rate (yen/$)106.00103.92101.8899.8997.93 US dollar equivalent in expected cash flows$100,000,000$(3,060,000)$(3,121,200)$(3,183,624)$(111,490,512) IRR of US$ cash flow stream (cost of funds)5.060%

euro-denominated bonds: Proceeds and principal and interest payments 83,612,040- 5,852,843- 5,852,843- 5,852,843- 89,464,883 Expected exchange rate (yen/$)1.19601.17211.14861.12571.1032 US dollar equivalent in expected cash flows$100,000,000$(6,860,000)$(6,722,800)$(6,588,344)$(98,693,393) IRR of US$ cash flow stream (cost of funds)4.860%

US dollar bonds: Proceeds and principal and interest payments$100,000,000$(5,000,000)$(5,000,000)$(5,000,000)$(105,000,000) IRR of US$ cash flow stream (cost of funds)5.000%

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.)

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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 IssuanceValuePrincipal borrowed for six years, in US$$650,000,000Issuance fees1.20%

Interest CostsFirst 6-months2nd 6-monthsLIBOR8.000%7.000%Spread over LIBOR0.800%0.800%Total interest cost8.800%7.800%

Calculation of the effective cost of fundsIssuanceFirst 6-months2nd 6-monthsFace value of syndicated loan$650,000,000less fees for issuance(7,800,000)Net proceeds of syndicated loan$642,200,000

Interest payment due at end of 6-month period$(28,600,000)$(25,350,000) (annual rate divided by 2 for 6-month period)Total interest payments in first year of loan$(53,950,000)

Effective interest cost (interest payment/proceeds)8.401%

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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?

AssumptionsValueA-Malaysia (in ringgits): Long-term debt11,400,000 Shareholders' equity15,200,000A-Mexico (in pesos): Long-term debt20,000,000 Shareholders' equity60,000,000

Adamantine Architectonics (non-consolidated) Investment in subsidiaries (US dollars): in A-Malaysia$4,000,000 in A-Mexico$6,000,000 Parent long-term debt$12,000,000 Common stock$5,000,000 Retained earnings$20,000,000Current exchange rates: Malaysian ringgit per dollar (RM/$)3.80 Mexican pesos per dollar (Ps/$)10.00

Consolidated Balance Sheet (US$)ValuePercentDebt: Malaysian ringgit debt (RM converted to US$)$3,000,000 Mexican peso debt (Ps converted to US$)2,000,000 Parent company debt12,000,000 Consolidated long-term debt$17,000,00040.48%

Shareholders' equity (common + retained)$25,000,00059.52%

Total capital$42,000,000100.00%

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.

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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 annumb. 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?

AssumptionsValueWorking capital debt needed for one year$5,000,000Borrowing US dollars in London: Interest rate, percent per annum7.250% Principal borrowed$5,000,000Borrow Hong Kong dollars in Hong Kong Interest rate, percent per annum7.000% Initial spot rate, HK$/US$7.8000 Principal borrowed39,000,000

Calculation of the breakeven exchange rate

Cost of repaying the Hong Kong dollar loan in HK$41,730,000Cost of repaying the US dollar loan in US$$5,362,500 Breakeven exchange rate (HK$ cost/US$ cost)7.7818

Breakeven is the equivalent of "indifferent."

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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 31Date of issuance: February 28, 2011Maturity: August 31, 2013

Coupon rate: 8.00% payable semiannually on June 30 and December 31Date of issuance: February 28, 2011Maturity: August 31, 2013

AssumptionsValueFace value of each note sold$1,000.00Annual coupon8.00%Semi-annual coupon 4.00% (paid June 30th and December 31st)Date of issuanceFebruary 28, 2011MaturityAugust 31, 2013

Cash FlowsDiscount Factor CalculationDiscountedDays SinceCumultive Days(par x coupon xCompound FactorDiscount FactorCash FlowsCash payment (payment date)Previous DateFrom Startdays/180)(cum days/180)(1.04) compounded(US dollars)

First coupon (30 June 2011)122122$27.110.67781.0269$26.40Second coupon (31 December 2011)180302$40.001.67781.0680$37.45Third coupon (30 June 2012)180482$40.002.67781.1107$36.01Fourth coupon (31 December 2012)180662$40.003.67781.1552$34.63Fifth coupon (30 June 2013)180842$40.004.67781.2014$33.30Sixth and final coupon (31 August 2013)62904$13.785.02221.2177$11.31 Principal repayment904$1,000.005.02221.2177$821.21$1,000.31

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.

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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?

AssumptionsValuePrincipal of Euro Commercial Paper issuance$2,000,000Maturity (days)60Yield to maturity at issuance6.000%

Proceeds of issuanceValue

Face value$2,000,000.00Discount rate (1 + ((days/360) x (ytm)))1.01000 Proceeds equal (Face value / Discount rate)$1,980,198.02