Globalizing the Cost of Capital and Capital Budgeting at AES- tutorial 1 solutions PDF

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How would you evaluate the capital budgeting method used historically by AES? What’s good and bad about it? At AES, capital budgeting was used for all projects under consideration, regardless of venue. All recourse debt was deemed fine, the economics of a given project were measured at an equity discount rate for the dividends from the project, all dividend flows were considered similarly risky, and a 12 percent discount rate was used for all projects, according to this process. When this technique was used in the United States, it worked well, but when it was applied to foreign ventures, it gave the organization an unrealistic NPV. Though there was some doubt, they decided to use the original approach because they had no other choice. The company-built projects that quickly started to fail because it failed to account for increased WACC, currency risk, political risk, and sovereign risk. ADVANTAGES Currently, AES is attempting to fund the project's production and construction costs using heavily leveraged debt. High leverage in non-recourse project financing allows AES to place less money at risk, allowing the company to fund the project without diluting its equity stake. Since the project debt is non-recourse, AES will not be obliged to disclose any of it on its balance sheet. Off-balance sheet treatment can also help AES comply with covenants and restrictions relating to borrowing funds found in loan agreements to which AES is also a party. Free cash flow agency expenses are lowered. Project success is the focus of management incentives. Most significantly, investors should keep a close eye on the situation. DISADVANTAGES Plan financing necessitates the participation of a variety of parties. They can be very complicated and costly to put together. Second, it necessitates a higher level of management time. The exchange rate risk is not taken into account by AES's existing capital budgeting approach. Because of their insecure monetary and fiscal policies, this danger would be greater in developing countries. As we can see, exchange rate fluctuations have harmed the AES company significantly, and they were unable to minimize this danger because they had not expected it. When exchange rate fluctuations impact balance sheet products unequally, this risk becomes important. Keeping track of the foreign exchange rate necessitates prompt adjustments to all revenue and expenditure products, as well as assets and liabilities in various currencies.

If Venerus implements the suggested methodology, what would the range of discount rates that AES would use around the world? The projects would change dramatically if Venerus and AES implemented the suggested approach due to a change in WACC. To calculate WACC, we must first calculate leveraged betas for each of the US Red Oak and Lal Plr Pakistan ventures, using the formula unleveled beta/1(debt to capital). The unleveled beta for both projects is.25, as shown in exhibit 7b. In exhibit 7a, the debt to capital ratios for the United States and Pakistan are 39.5 percent and 35.1 percent, respectively. Plugging the numbers into the equation yields a leveraged beta of.41 for the United States and.3852 for Pakistan. The next step is to determine the cost of capital, which varies by country but is based on the risk free and risk premium rates in the United States since all debt is funded in USD. The cost of capital is equivalent to the yield on a US Treasury bill plus leveraged beta (U.S. risk premium). For the US project, the formula is 4.5 percent +.41(7%), which equals 7.37 percent. It is 4.5 percent +.3852(7%) for the Pakistan project, which is equivalent to 7.2% The cost of debt must now be calculated using the U.S. t-bill+ default spread model. Both the US and Pakistani projects have the same spread of 3.47 percent, resulting in the same debt cost. By plugging in the numbers, you get 4.5 percent + 3.47 percent, or 8.07 percent. Given the large variations in each country's market structure and the political risk involved, this makes little sense. To account for these variables, the sovereign risk, as shown in exhibit 7a, must be considered. The sovereign risk for the United States is 0%, as predicted, but it is staggeringly high at 9.9% for Pakistan. The sovereign risk is applied to the cost of capital and cost of debt in order to reevaluate them. As a result, the United States' cost of capital remains stable, while Pakistan's cost of debt rises to 17.97 percent. Finally, after all else has been measured, the WACC can be calculated using the formula given. Leveraged beta (cost of capital) + Debt to capital (cost of debt) are the components (1-tax rate). WACC is 6.48 percent in the United States and 15.93 percent in Pakistan. The final move is to fine-tune the WACC based on its risk score once more. Taking the number of the scores and multiplying it by the provided weight Since it is in USD and the U.S. projects WACC already accounts for risk, the U.S. risk score is presumed to be 0. With each point equaling 500 basis points, the Pakistan risk premium is measured as 1.425*500= 705bp= 7.05 percent. This figure is added to the current Pakistan WACC to arrive at 15.96 percent +7.05 percent = 23 percent, which is the final WACC figure for the project.

Does this make sense as a way to do capital budgeting? AES's financial policy has traditionally been focused on project financing. This strategy focused solely on factors that reduced AES exposure to the project and resulted in the most favorable regulatory treatment, ensuring the project's financial viability. The model was successful both in the domestic market and in foreign operations. The model performed well in both the domestic and foreign markets, as long as the opportunities AES pursued were either in the area of constructing and operating a power plant or simply purchasing an existing facility, updating it, and then operating it. The underlying premise was that the project's symmetrical and asymmetrical risks were more or less the same regardless of its geographical position. However, when AES began diversifying its activities by adding other energy-related businesses and transitioning from a cogeneration to a utility company, the bulk of its growth took place. This diversification of business increased symmetrical risks such as business risk, as seen in Brazil, where AES experienced a shortfall in demand/sales volume due to the Brazilian government's Energy Conservation Policy, which had a chain effect on the SPV's debt servicing ability as well as the parent company's stock price. Another factor that the new model failed to account for was the possibility of currency depreciation in emerging economies, which resulted in substantial losses due to the company's failure to meet its foreign debt obligations. Expansion in emerging economies often exposed businesses to political danger, as policies change frequently as governments change. As a consequence, we can see that geographical diversification of business increases asymmetrical risk, resulting in bimodal action. As a symmetrical risk becomes more apparent, project funding becomes less desirable. This is a challenge for developing countries, where these threats are often present.

What is the value of the Pakistan project using the cost of capital derived from the new methodology? If this project was located in the US, what would its value be? To determine the project value for Pakistan's Lal Pir project, we must first measure the Weighted Average Cost of Capital (WACC) using the current proposed methodology. For this, we used the method outlined in the case's exhibit 8. The first step is to use the formula and details provided in the case to determine the value of levered. The value of the levered is 0.3852, or 38.52 percent, implying that our project is not quite correlated to market returns. We now measure the cost of equity using this value of (refer Exhibit 4A). In estimating the cost of equity, we used the risk-free return on U.S. Treasury bonds (i.e. 4.5 percent). The cost of equity is 0.072, and the cost of debt is 0.0807. We measure the cost of debt using the risk free rate and the default spread (as seen in exhibit 7a of the case). It's important to remember that the sovereign spread affects both the cost of debt and the cost of equity (0.0990 for Pakistan). Once we have the adjusted costs of equity and capital, we can measure the WACC for the project using the formula given in case, which basically involves multiplying the equity and debt ratios by the adjusted costs of equity and debt. In this case, the WACC is 0.1595 percent, or 15.95 percent. However, we must now change this WACC to account for the risks associated with completing the project in Pakistan, which we do by referring to Table A in the case. We know that Pakistan's overall risk

score is 1.425, and since there is a linear association between business specific risk scores and cost of capital, we need to change our WACC by 7.125 percent, resulting in a final WACC of 23.075 percent, which we use to measure our NPV (see Exhibit 6) from 2004 to 2023, which is negative $234.34 million. Similar equations are used to measure the WACC in the United States (Exhibit 4B). There are two aspects, however, that are distinct. First, we note that the sovereign spread is zero. Second, we will need to quantify the business risk of this case using the data in exhibit 7a of the case (refer to Exhibit 5). This score is 0.64, and using this score, our business risk is 3.23 percent, which we multiply by our measured WACC value to get a final WACC of 9.64 percent. We measure our NPV for the United States, which is negative $ 35.92 million (refer to Exhibit 7)....