Globalizing the Cost of Capital and Capital Budgeting at AES Case Solution
Venerus, then suggested that for each country, a selected beta would then be compared and calculated by the marginal tax and debt to capital ratio of each of the selected project of the county in order to know how much the cost of equity each country would generate. After a critical evaluation to determine the equity portion, the company would also consider the importance of the cost of debt and shows that this would vary according to the current demand of each country, especially for developing nations. Therefore, Venerus estimated that this would be calculated through adding a risk free rate with the default spread that each country would possess. Therefore, this modified value would be considered as the net value of cost of debt under each scenario.
After determining the cost of equity and debt, it is concluded that WACC would show different results for each country due to different values generated under equity and debt portion. Therefore, a determined WACC under each scenario would then be adjusted through additional ratio of sovereign spread, which is the difference between a local government dollar and the US treasury’s notes. It is thus identified that a net value would represent a rate, which includes all the risks that each country would bear. These approaches to determine the cost of capital under each country might be favorable for the company due to its nature of reducing the risk and adverse impact of the economy.
Reason to use capital budgeting
After the critical evaluation of using the new way to determine the capital budgeting process as well as cost of capital for each project under different countries, it shows that these predetermined results would be helpful to analyze the country’s specific risks as well as assume an initial cost of capital for each project. The main reason to use this strategy was to reduce the expected risk that might hurt the operations and subject the company to bankruptcy due to the current results of AES. If the company would focus on the traditional way to determine the capital budgeting process, then it would suffer a huge loss due to the market fluctuations caused by the economic crisis. Therefore, a new method was important in order to maintain the position and for successful implementation of the projects in order to receive high cash flows.
Impact of adjusted cost of capital over the value of the project
While with the use of capital budgeting process of each country, it shows that different value would be generated under different project due to the relationship with the country’s specific risk and the default spread of the debt of each project. Therefore, it is identified that a net amount of WACC would be different under each case because of fluctuated economic results of developing countries where the project was in process.
Thus, various cost of capitals would also affect the value of the project for host country because these values would vary according to the currency exchanges as well as demand of the economy. For example, if there is less power supply in a selected country, then the demand would be high and would generate more profits as compared to all the other projects. Thus, it shows that a more accurate picture of developing countries would increase the cash flows for AES and minimize the level of risk in future.
Value of Pakistan project using cost of capital under new method
By calculating the capital budgeting process, it is determined that the value of the Pakistan project is three times greater than the US project because the country had a shortage in electricity supply and it therefore required a huge level of development in order to solve the problem of load shedding………………..
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