1258 words - 6 pages

Case 3: Globalizing the Cost of Capital and Capital Budgeting at AES

Question 1

Explain and comment on the capital budgeting method used historically by AES. Is there a need for change? Explain.

Question 2

If Venerus implements the suggested methodology, what will be the adjusted discount rate for the Red Oak project (USA) and the Lal Plr project (Pakistan)?

Question 3

Calculate the effect that a revision of its cost of capital will have on the Lal Plr project’s NPV. Comment on the results.

Case 3: Globalizing the Cost of Capital and Capital Budgeting at AES

Q.1

At the AES corporation capital budgeting was historically a very simple method, that ...view middle of the document...

One such example is the Argentinean peso, when it lost 40% of its value on its first day of trading as a float.

With such enormous oversights by management, and dramatic realizations of differing risk levels across markets, it’s quite apparent AES must make a change to its capital budgeting structure, if it is to survive.

Q.2

If Venerus and AES implement the suggested methodology, the projects would change drastically due to a change in WACC. To find WACC we must first calculate the leveraged betas for each the US Red Oak and Lal Plr Pakistan projects, the equation unleveled beta/1-(debt to capital) will be used. The unleveled beta can be found in exhibit 7b, and is .25 for both projects. The debt to capital ratios can be found in exhibit 7a, for the U.S. it is 39.5%, and for Pakistan it is 35.1%. By plugging the numbers into the equation a leveraged beta can be found for the U.S. it is .41, and for Pakistan it is .3852.

The next step would be to find the cost of capital which is ultimately different for each country, but uses the U.S. risk free and risk premium rates, because all debt is financed in USD. The cost of capital is equal to U.S. T-bill+ leveraged beta (U.S. risk premium). For the U.S. project it is 4.5%+.41(7%) which is equal to 7.37%. For the Pakistan project it is 4.5%+.3852(7%) which is equal to 7.2%.

Now the cost of debt must be found, by using the formula U.S. t-bill+ default spread. Both the U.S. and Pakistan projects have equal spreads of 3.47%, therefore both yield the same cost of debt. Plugging in the numbers you have, 4.5%+3.47% which is equal to 8.07%. This clearly does not make sense given the vast differences in the markets structure of each country, the political risk involved.

To adjust for these factors the sovereign risk must be taken into account, which can be found in exhibit 7a. The sovereign risk for the U.S. is as expected 0%, but for Pakistan is a staggering 9.9%. To reevaluate the cost of capital and cost of debt the sovereign risk is added to them. This results in the U.S.’s being constant and Pakistan’s cost of capital rising to 17.1% and its cost of debt rising to 17.97%.

Finally with everything else calculated it’s possible to calculate the WACC, using the formula given on page 7. It consists of leveraged beta (cost of capital) + Debt to capital (cost of debt) (1-tax rate). For the U.S. WACC= 6.48%, and for Pakistan WACC=...

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