fault spread for AAA rated bonds in the United States was only 0.75%, there is the
added consideration that Embraer is a Brazilian firm. Since the Brazilian government
bond traded at a spread of 5.37% at the time of the analysis, you could argue that
every Brazilian company should pay this premium, in addition to its own default
spread. With this reasoning, the pretax cost of debt for Embraer in U.S. dollars (as-
suming a Treasury bond rate is 5%) can be calculated:
Cost of Debt Risk-free rate + Default spread for country + Default spread for firm
5% + 5.37% + 0.75%11.12%Using a marginal tax rate of 33%, we can estimate an after-tax cost of debt for Em-
braer:
With this approach, the cost of debt for a firm can never be lower than the cost of debt
for the country in which it operates. Note, though, that Embraer gets a significant por-
tion of its revenues in dollars from contracts with non-Brazilian airlines. Conse-
quently, it could reasonably argue that it is less exposed to risk than the Brazilian
government and should therefore command a lower cost of debt.
(ii) Calculating the Weights of Debt and Equity Components. The final step in com-
puting a cost of capital is to compute the weights of debt and equity components in
a firm’s capital. Before we discuss how best to estimate weights, we define what we
include in debt. We then make the argument that weights used should be based upon
market value and not book value. This is so because the cost of capital measures the
cost of issuing securities—stocks as well as bonds—to finance firms and these secu-
rities are issued at market value, not at book value.
(iii) What is debt? The answer to this question may seem obvious since the balance
sheet for a firm shows the outstanding liabilities of a firm. There are, however, limi-
tations with using these liabilities as debt in the cost of capital computation. The first
is that some of the liabilities on a firm’s balance sheet, such as accounts payable and
supplier credit, are not interest bearing. Consequently, applying an after-tax cost of
debt to these items can provide a misleading view of the true cost of capital for a firm.
The second is that there are items off the balance sheet that create fixed commitments
for the firm and provide the same tax deductions that interest payments on debt do.
The most prominent of these off-balance-sheet items are rental and lease commit-
ments. In most emerging markets, leases are treated as operating expenses rather than
financing expenses. Consider, though, what an operating lease involves. A retail firm
leases a store space for 12 years and enters into a lease agreement with the owner of
the space agreeing to pay a fixed amount each year for that period. We do not see
much difference between this commitment and borrowing money from a bank and
agreeing to pay off the bank loan over 12 years in equal annual installments.
There are therefore two adjustments we will make when we estimate how much
debt a firm has outstanding:
1.We will consider only interest bearing debt rather than all liabilities. We will in-
clude both short term and long term borrowings in debt.After-tax cost of debt11.12% 11 .33 2 7.45%9 • 28 VALUATION IN EMERGING MARKETS