More on British Petroleum and the Cost of Capital

Just an Update on our previous blog about the market's estimate of the economic damage resulting from the Gulf of Mexico oil spill. Today, shares of BP closed below 300 pence in London representing a drop in market value of over $100 billion since the Deepwater Horizon sank on April 22nd. Click here to see the story from the Financial Times.

Earlier this week BP indicated that they would be raising $10 billion in the bond market to help fund a $20 billion escrow account that they had agreed to with the United States government. In addition BP has suspended their quarterly dividend to conserve cash. A June 8th article in the New York Times suggests that the cost of the oil spill may one day lead to the bankruptcy of British Petroleum in much the same way that Texaco was forced to file for bankruptcy protection in 1987. Bond markets appear to be pricing in the probability of bankruptcy as the yield spread is now 539 basis points above the benchmark. Before the Gulf crisis BPs bonds yielded 41 basis points above the benchmark. (The benchmark is the yield on British government bonds, and a basis point is 1/100 of 1%). A Bloomberg Businessweek article explains the effect of the higher interest rate on British Petroleum.

As the risk of default rises, bond prices fall and yields rise. To put the probability of bankruptcy into perspective, Greek 10 year bonds are trading today at 779 basis points over the benchmark German bonds. The market is suggesting that Greece is more likely to default than British Petroleum.

When a company such as British Petroleum needs to raise capital, for either investment purposes or contingency funds as in this case, they have several options. They could sell new common or preferred shares or use their retained earnings, all of which are forms of equity. The other option is to borrow the money. They can do this using lines of credit, issuing bonds, or debentures which are forms of debt. The choice between debt and equity depends on the relative costs of the two forms of capital. Firms attempt to minimize the cost of their capital by choosing appropriate weights for equity and debt. As the level of debt increases, the riskiness of the firm increases and interest rates on their debt rise. Increased levels of debt do however increase the yields on equity, so there is a trade-off between the higher levels of debt and high levels of equity. It is estimated that the yield on BPs $10 billion debt show will be in the 8 to 10% range. The last dividend payment in May represented a 6.75% yield on its equity. With the drop in BPs share price the cost of equity capital is now much larger, on an after-tax basis, then the cost of debt even with other risk premiums of over 500 basis points.

We will continue to follow this story and bring you updates when the bonds go to market.

For more on the cost of capital in the capital structure decision see:
Fundamentals of Corporate Finance; Richard A Brealey, Stewart C. Myers et al., McGraw-Hill Ryerson, Chapters 11 and 15