Globalization of cost of capital and capital budgeting Case Solution
If Venerus implemented the suggested methodology, what would be the range of discount rates that AES would use around the world?
First of all, the equity beta unleveraged is identified for all business projects in different countries of the world and after that beta leveraged is calculated from the different capital structure of the different business projects. Cost of equity is determined through Capital asset pricing model by using the beta equity leveraged and risk free and risk premium rates. Cost of debts is calculated on the basis of different spread of different countries.
Thus, through the above calculation, theweighted average cost of capital for worldwide business is calculated as shown in the excel file. This methodology is appropriate for the AES Corporation asit considers better domestic inputs into calculations and the results are more effective for future years as it provides better valuation for assets.It also provides better decision making process and better strategy for the domestic level investment and capital monitoring.
Does this make sense as a way to do capital budgeting?
The weighted average cost of capital for different countries specifically is more appropriate for capital budgeting as it shows true and fair cash flows and present values. Thus, it will assist in better decision making and more effective use of finance in these circumstances where capital rationing is necessary because of financial stress. Better comparability among different projects can be possible through this way.
By proceeding higher net present value projects with lower initial investments, the financial position can be improved. AES should seek for capital investment monitoring systems which will help in the completion of project by setting targets and improving with the new arising risks. AES can select the projects among those which have low risk association, as a result better risk management can be possible.
What is the value of the Pakistan project using the cost of capital derived from the new methodology? If the project was located in U.S what would its value be?
Free cash flow methodology is used to calculate the value of the Pakistan project. The calculation shows that if the cost of capital considered is appropriate for Pakistan, then the value of the project would $853 million which is good for the company. Moreover, if the US cost of capital is used, then the project value would decline by $7 million and stand at $846 million approximately. The cost of capital appropriate for Pakistan is suitable for AES as it gives higher value but also better justification.
How does the adjusted cost of capital for the Pakistan project reflect the probabilities of real events? What does the discount rate adjustment imply about expectation for the project because it is located in Pakistan and not the U.S?
The adjusted cost of capital for Pakistan project reflects the probabilities of real events because in the calculation of cost of capital, relevant country credit and default spread areused. Pakistan’s economy is a developing economy and in a developing country,there are fluctuations in economic indicators as compared to US’ stable economy. However, in this case, the cost of capital in Pakistan is lower as compared to the United States, which indicates that there is economic and political stability in the country. Equity beta has two risks, which are namely business risk and financial risk. Pakistan has lower beta equity than US, which indicates that the project has fewer chances to have losses as well as less chance of default……………….
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