International Finance and Accounting Handbook

ILLUSTRATION4:ESTIMATING A BOTTOM-UP BETA FOR TITAN CEMENTS—JANUARY2000.

To estimate a cost of capital for Embraer, we again draw on the estimates of cost of
equity and cost of debt we obtained in prior illustrations. The cost of capital will be
estimated using net debt all the way through (for the levered betas, interest coverage
ratios and debt ratios) and in U.S. dollars:

• Cost of equity = 18.86%


• After-tax cost of debt = 7.45%


• Market value of debt = 1,328 million BR


• Cash and marketable securities = 1,105 million BR


• Market value of equity = 9,084 million BR

The cost of capital for Embraer is estimated below:

To convert this into a nominal real cost of capital, we would apply the differential in-
flation rates (10% in Brazil and 2% in the United States):

9.3 ESTIMATING CASH FLOWS. To estimate cash flows for a firm, we usually
begin with its accounting earnings and adjust their earnings for noncash charges and
reinvestment needs. While the equation for computing free cash flows to the firm may
be identical for emerging market and developed companies, there are a few more
roadblocks that we run into when we look at emerging market companies.

(a) Earnings. The income statement for a firm provides measures of both the oper-
ating and equity income of the firm in the form of the earnings before interest and
taxes (EBIT) and net income. When valuing firms, there are two important consider-
ations in using this measure. One is to obtain as updated an estimate as possible,
given how much these firms change over time. The second is that reported earnings
at these firms may bear little resemblance to true earnings because of limitations in
accounting rules and the firms’ own actions. On both measures, you may have spe-
cial problems when valuing emerging market firms.

(i) Importance of Updating Earnings. Firms reveal their earnings in their financial
statements and annual reports to stockholders. Annual reports are released only at the
end of a firm’s financial year, but you are often required to value firms all through the
year. Consequently, the last annual report that is available for a firm being valued can
contain information that is sometimes six or nine months old. In the case of firms that

 1 1.18592a

1.10

1.02

b 1 
27.89%

Cost of capitalNominal BR
 11 Cost of Capital$2a

Inflation rateBrazil

Inflation rateU.S.

b 1

Cost of Capital
18.86%a

9084

9084  223

b7.45%a

223

9084  223

b
18.59%

Net Debt
1,328 million1,105 million
223 million

9.3 ESTIMATING CASH FLOWS 9 • 31