GLOBALIZING THE COST OF CAPITAL & CAPITAL BUDGETING AT AES Case Solution

Political Risk

            The current financial project framework does not take into account the political risk associated with the other countries where AES is expanding. This is going to be highly important now and it needs to be taken into consideration as the businesses of the company have expanded in the developing countries of the world where there is frequent change in the policies of the government.

Question 2

If Venerus implements the suggested methodology, what would be the range of discount rates that AES would use around the world?

If Venerus implements the suggested methodology as shown in exhibit 8, then the detailed calculations would have to be performed to compute the discount rates within the different countries around the world. In order to overhaul the capital budgeting process at AES and evaluate each of the distinct investment opportunities with unique risks, separate cost of capital has been calculated for each of the 15 representative projects shown in exhibit 7a of the case.

The financial data in exhibit 7b has been used to calculate the weighted average cost of capital for the company for each of the 15 diverse businesses. The new proposed methodology has been used to compute the weighted average cost of capital for all the 15 projects. The levered beta has been calculated first of all, using the formula provided in the case and exhibit 7b. The return on US Treasury bond of 4.5% has been used as the risk free rate and a market risk premium of US has been used. The CAPM formula has been used to calculate the cost of equity and the after tax cost of debt has been calculated by first adding risk free rate in the default spreads and then subtracting the tax rate.

In addition to this, the cost of debt and the cost of equity have been adjusted for the sovereign spread. After this, we have used the WACC formula provided in the case to compute the cost of capital for all the 15 projects without the business specific risk. Therefore, the information given in Table A in the case has been used to adjust the WACC for the business specific risk. Since there is a linear relationship between the business specific risks and cost of capital therefore, we have adjusted (added) the basis points for the business specific risk in the cost of capital we have computed before.

Question 3

Does this make sense as a way to do capital budgeting?

            The new methodology for capital budgeting makes sense as it incorporates the individual rationale for each risk measure for each of the businesses. Accounting for the sovereign and the default risk spreads makes an intuitive sense for AES as these are the most obvious risks, which are faced by the company in the various countries around the world. A good attempt has been made by Venerus to calculate the probability weighted business risk as the projection and estimation of the project specific cash flows and the need to account for the unsystematic risk within the projects is quite difficult. Provided the weightings are accurate and the risks identified are collectively exhaustive then this method is an effective way to compute the business risk premium. However, if some of the risk factors have been omitted or some of the risk factors are given a higher or a lower weight age, then this might make the whole method ineffective and lead towards ineffective decisions by the management of AES. Therefore, there are two additional points which need to be addressed by the management of AES.

  • Previously, the company had taken a non recourse debt, which means that if one project failed, then it would not affect AES however, during the downturn it became known that this did not happen and each project exposure has an impact on the health of the parent company therefore, a weighting of the risk exposure with regard to the other projects also needs to be taken into account.
  • The sustainability for maintaining the probabilities and risk rank matrix is also not clear. Although the method makes sense however, it needs to be ensured that whether the management is successfully measuring the risks or it is trying too hard to capture all the business risks. It needs to be ensured that whether AES intends to update the risk ranking regularly as the probability matrix depends on the changing business and economic conditions.

Question 4

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 U.S., what would its value be?

            In order to calculate the value of the Lal Pir Plant project in Pakistan, we need to calculate the WACC for Pakistan based on the new methodology. We have already calculated this WACC in Q2 and we again briefly defined the calculations for this specific project. The levered beta has been calculated first of all, which is calculated to be 0.3852, using the formula provided in the case and exhibit 7b. The return on US Treasury bond of 4.5% has been used as the risk free rate and a market risk premium of 7% of US has been used. The CAPM formula has been used to calculate the cost of equity of 7.2% and the after tax cost of debt has been calculated by first adding risk free rate of 4.5% in the default spread of 3.57% and then subtracting the tax rate of 23%.

In addition, the cost of debt and the cost of equity have been adjusted for the sovereign spread of 9.9%. After this, we have used the WACC formula provided in the case to compute the cost of capital for this project without the business specific risk. Therefore, the information given in Table A in the case has been used to adjust the WACC for the business specific risk. Since there is a linear relationship between the business specific risks and cost of capital therefore, we have adjusted (added) the basis points for the business specific risk by adding 7.125% in the cost of capital we have computed before. The final cost of capital for Pakistan project is 23.08%. After this, by using the unlevered cash flows with TV from 2004 to 2023, the NPV for the Lal Pir Project has been calculated to be negative $327.74 million.

Similarly, the calculations of WACC have been performed for the USA WACC which is represented by the Red Oak project. However, there are two things which are different. First, the sovereign spread in the US is 0% and the business risks core for US is 0.64 therefore, 3.23% of business risk premium has been added to get a WACC of 9.64% for US. After this, by using the unlevered cash flows with TV from 2004 to 2023, the NPV for the Lal Pir Project in the US has been calculated to be negative $30.06 million.

Question 5

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 expectations for the project because it is located in Pakistan and not the U.S.?

            By calculating the adjusted cost of capital for the Pakistan project, the weighted average cost of capital has been adjusted for 6 different types of the risks, which are legal, currency, commodity, construction, regulatory, counter party and the operational risk. Therefore, from Table A of the case we can see that except the construction risk, all the other types of the risks have a higher probability of affecting the Lal Pir plant project in Pakistan. The highest probability is for the legal and the currency risk. The adjusted cost of capital which has been calculated is adjusted with the total risk score for Pakistan………………….

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