Evaluating the Historical Capital Budgeting Method Essay

Currently AES employs Project Finance Framework. Project finance tends to be use in hears with tangible assets with predictable cash flows in which construction and operating targets merchantman be easily established through explicit contract. The key to AES projects pay lies with the precise forecasting of cash flows. In effect, the possibility of estimating cash flows with an acceptable level of uncertainty allows for allocation of insecuritys among various interested parties. The ensuing certainty in cash flows allows for high level of leverage and enables project assets to be separated from the parent order.Let us now take a closer ask at the pros and cons of the Capital Budgeting System contemporaryly in place. Principal Advantages Non-Recourse The separation of the parent company is structured through the creation of a Special innovation Vehicle (SPV). This SPV is the formal borrower under all loan documents so that in event of default or bankruptcy AES is not directly responsible in advance financial creditors. Instead, their legal claims are against the SPV assets. Maximize Leverage Currently AES charmks to finance the bell of development and construction of the project on highly leveraged basis.High leveraged in non-recourse project financing permits AES to put less in capital to put at risk permits AES to finance the project without diluting its equity investment in the project. Off-Balance canvas Treatment AES may not be required to report any of the project debt on its balance aeroplane because such debt is non-recourse. Off balance sheet treatment can countenance the added practical benefit of helping the AES comply with covenants and restriction relating to borrowing funds contained in loan agreements to which AES is also a party. confidence Cost The agency bells of free cash flow are reduced. Management incentives are to project performance. Most importantly close monitoring by investors is facilitated. Multilateral Financial Inst itutions One of the four constituents that have contractual arrangement with the SPV in a typical project are the banks (an integral part crowd of financiers that include share holders, insurers, equipment manufacturers, export credit agencies and funds). Among these banks on that point are multilateral financial institutions (like IFC, CAF and etc).Presence of these institutions as financiers helps in raising capital from these institutes at reduce cost and secondly it is also read as a positive sign by commercial banks. Drawbacks Projects V/S Division The company is not only expanding its geographical boundaries, but it is also diversifying its business through backward and forward integration. The current financial model does not provide the AES with the big picture, which now constitutes more number of variables that are being influenced by multiple actors due to the increase in depth and breadth of the organization. ComplexityFinancing of projects requires involvement of a number of parties. They can be quite complex and can be expensive to arrange. Secondly it demands greater amount of management time. Macroeconomic Risk The current methodology employed by AES for capital budgeting does not take into trace the exchange rate risk. This risk will be of higher magnitude in the developing countries because of their unstable monetary and fiscal policies2. As we have seen that fluctuation in exchange rate has greatly hurt the AES business and they were unable to decrease this risk as they havent anticipated it.This risk becomes important when the exchange rate fluctuation affects balance sheet items unequally. Thus keeping look on the foreign exchange rate requires timely sicment of both the items of revenue and expenditure, and those of assets and liabilities in different currencies. Political Risk This is another important gene which the current financial management system does not take into account. This will be of significant importance when it co mes to investing in developing countries where frequent changes in government policies occur. Does this system make sense?The financial strategy employed by AES was historically based on project finance. This approach solely took into account those work outs that minimized AES exposure to the project and achieved the most beneficial regulatory treatment thus ensuring availability of financial resources to complete the project. The model worked well for the domestic market as well as for the international operations, provided the opportunities undertook by AES were either in the sector of building and running a power plant or plainly buying an existing facility and upgrading it and then operating.The underlying assumption over here was that the symmetrical and asymmetrical risks faced by the project were more or less same irrespective of its geographical location (Refer to scupper 3). However when AES started diversifying the breadth of its operations by incorporating other offsh oots of energy related business and transforming from a cogeneration to a more utility organization with major(ip)ity of expansion occurring in developing economies.This diversification of business increased the symmetrical risks like business risk, a classic example of which we see in Brazil where AES experience shortfall in demand /sales volume due to Energy Conservation constitution of Brazilian government and this had a chain effect on debt servicing capacity of the SPV as well the stock price of the parent company. Other factor that current model was not able to include was the risk of devaluation of currency in developing economies which resulted in significant losses due to the inability of the company to survive its international debt obligations.Expansion in developing economies also exposed the business to political risk where the policies change erratically with changes in government. Hence we see that the geographical diversification of business causes asymmetrical risk to increase ca utilise bimodal behavior in the result. Project financing becomes less recommendable as a symmetrical risk becomes more manifest. This constitutes a problem for emerging countries where these risks tends to be at the forefront. Lal Pir Project Valuation Scenario 1 PakistanIn order to prefigure the range of project for the Lal Pir project in Pakistan, we first need to calculate the Weighted Average Cost of Capital (WACC) using the new proposed methodology. For this we have followed the approach disposed in exhibit 8 of the case. The first step is to calculate the value of levered ? using the formula and information given in the case3. The value of the levered ? comes out to be 0. 3852 or 38. 52%, which essentially means that our project is not very highly correlated to the market return.Using this value of ? we now calculate the cost of Equity (refer Exhibit 4A). We have used the return on U. S. Treasury Bond (i. e. 4. 5%) as the risk free return in shrewd the cost of equity. The cost of equity comes out to be 0. 072 and similarly, using the risk free return and the default spread (given in exhibit 7a of case) we calculate the cost of debt which comes out to be 0. 0807. It is important to note that the cost of debt and the cost of equity also need to be modify for the sovereign spread (0.0990 for Pakistan). Once we have the adjusted costs of equity and capital we can now calculate the WACC for the project using the formula given in case where we essentially reproduce equity and debt ratio with the adjusted costs of equity and debt respectively4. The WACC in this scenario comes out to be 0. 1595 or 15. 95%. However, now we need to adjust this WACC for the risks associated with doing the project in Pakistan and we do this by using Table A given in the case. We know that the total Risk Score for Pakistan is 1.425 and since there is a linear race between business specific risk sexual conquests and cost of capital5 we need to adjust our WACC b y 7. 125% thus making our final WACC 23. 075%, using which we calculate our NPV (refer to Exhibit 6) from the year 2004 to 2023, and it comes out to be negative $234. 34 million. Scenario 2 USA For USA similar calculations are made to calculate the WACC (Exhibit 4B). However there are two things that are different. First we see the sovereign spread is equal to zero. Secondly, in this case we would need to calculate the business risk using the information given in exhibit 7a of the case (refer to Exhibit 5).This score comes out to be 0. 64 and using this score, our business risk comes out to be 3. 23% and adding it to our calculated value of WACC, we get our final WACC of 9. 64%. Using this we calculate our NPV for USA which comes out to be negative $ 35. 92 million (refer to Exhibit 7). Adjusted Cost of Capital and Probabilities of Real Events in Pakistan In calculating the adjusted cost of capital for Pakistan the WACC is adjusted for six common types of risks Operational, Counterp arty, Regulatory, Construction, Commodity, Currency and Legal.We can clearly see from table A given in the case that besides construction there is a probability of all these risks actually effecting the project in Pakistan. In these, the highest probability is that of currency risk and the legal risk. The adjusted cost that we have calculated is adjusted by the total risk score for Pakistan. There is a linear relationship between the total risk score and adjustment to the cost of capital, i. e. a score of 1 leads to an adjustment of viosterol basis points in the WACC.When we calculate the WACC for Pakistan through traditional formula it comes out to be 15. 95%, however in order to incorporate the risk factor associated with Pakistan we need to adjust it for the Total Risk Score, which in this case is 1. 425. So we simply multiply this by 500 and we find out that we need to adjust our WACC 23. 075%. Since this 23. 075% is adjusted using the total risk score we can safely assume that it incorporates for the probability of the afro-mentioned six types of risks in WACC with respect to Pakistan.Discount Rate adjustment USA v/s Pakistan As mentioned earlier the discount rate is adjusted based on the total risk score of the country. This total risk score is compiled from 6 main types of risks, the probability of which varies from country to country. If we simply compare the risk scores for USA and Pakistan6, we can see that there is a major difference between the risk profiles of both the countries. For instance, while currency, regulatory and legal risks are significantly high in Pakistan, they do not exist in the USA at all.Also we see that operational, counterparty and commodity risks are higher in USA as compared to Pakistan. Similarly when the respective WACCs of the two countries are adjusted for their risk we see that the adjusted WACC for Pakistan (23. 075%) is much higher as opposed to that of USA (9. 64%), which essentially implies that Pakistan is inhere ntly a riskier country to invest in as opposed to the USA and any investments made in this region would have to cross a higher hurdle rate than if they were made in the US region.