Aswath Damodaran 351
Modifying the Cost of Capital Approach for Aracruz
! The operating income at Aracruz is a function of the price of paper and pulp in global markets. While 2003 was a very
good year for the company, its income history over the last decade reflects the volatility created by pulp prices. We
computed Aracruz’s average pre-tax operating margin over the last 10 years to be 25. 99 %. Applying this lower average
margin to 2003 revenues generates a normalized operating income of 796. 71 million BR.
! Aracruz’s synthetic rating of BBB, based upon the interest coverage ratio, is much higher than its actual rating of B- and
attributed the difference to Aracruz being a Brazilian company, exposed to country risk. Since we compute the cost of
debt at each level of debt using synthetic ratings, we run to risk of understating the cost of debt. The difference in interest
rates between the synthetic and actual ratings is 1. 75 % and we add this to the cost of debt estimated at each debt ratio
from 0 % to 90 %.
! We used the interest coverage ratio/ rating relationship for smaller companies to estimate synthetic ratings at each level
of debt.
Commodity companies tend to have volatile operating income. If you use the
current year’s income and it happens to reflect a really good or bad year for
commodity prices, you will overstate or understate the optimal debt ratio.
We are assuming that 1995 earnings were normal. There are alternative ways of
estimating normalized operating income:
Look at the average operating income over time. (If you have a cyclical
firm, you might want to look at the average over the entire economic
cycle). This is especially true if the entire sector is earning abrnormally
high or low earnings.
Look at the typical margins or returns on capital earned by firms in the
sector. Then estimate the normalized operating income for your firm (by
multiplying the industry margin by the firm’s revenues, or return on
capital by the firm’s capital). This is the approach to use if your firm has
abnormally low or high earnings in a sector that is not affected by the
same factors.
