Evaluating the Historical Capital Budgeting Method Essay

Currently AES employs Project Finance Framework. Project pay tends to be utilise in meets with tangible assets with predict suitable cash flows in which construction and operating targets can be easily established with explicit contract. The key to AES roves financing lies with the precise forecasting of cash flows. In rear, the possibility of estimating cash flows with an acceptable level of uncertainty eitherows for allocation of endangerments among non-homogeneous interested parties. The ensuing certainty in cash flows allows for high level of leverage and enables stick step forward assets to be sepa positiond from the p bent lodge.Let us now seize on a closer look at the pros and cons of the chapiter Budgeting System currently in place. Principal Advantages Non-Recourse The separation of the p atomic number 18nt family is structured with the creation of a Special Purpose fomite (SPV). This SPV is the formal borrower under all loan documents so that in subject of inadvertence or bankruptcy AES is not directly responsible beforehand fiscal creditors. Instead, their legal claims are against the SPV assets. Maximize Leverage Currently AES memoriseks to pay the cost of development and construction of the proletariat on highly leveraged basis. heights leveraged in non-recourse retch financing permits AES to put less(prenominal) in capital letter to put at stake permits AES to finance the project without diluting its fair-mindedness investiture in the project. Off-Balance Sheet Treatment AES may not be inevitable to report any of the project debt on its balance sheet because much(prenominal) debt is non-recourse. Off balance sheet treatment can have the added mulish 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.Agency Cost The agency cost of free cash flow are reduced. Management incentives are to project performance. Most of the essence(predicate)ly close monitoring by investors is facilitated. Multilateral fiscal Institutions One of the four constituents that have contractual arrangement with the SPV in a typical project are the banks (an integral part group of financiers that implicate share holders, insurers, equipment manufacturers, export credit agencies and funds). Among these banks there are multilateral monetary institutions (like IFC, CAF and etc).Presence of these institutions as financiers helps in raising capital from these institutes at unhorse cost and secondly it is also read as a appointed sign by commercial banks. Drawbacks Projects V/S Division The company is not only expanding its geographical boundaries, but it is also diversifying its line through backward and forward integration. The current financial model does not set up the AES with the big picture, which now constitutes more number of variables that are being influenced by multiple factors due to the increase in depth and b readth of the organization. complexnessFinancing of projects requires involvement of a number of parties. They can be sort of complex and can be expensive to arrange. Secondly it demands greater sum tally of management time. Macroeconomic Risk The current methodology employed by AES for capital budgeting does not take into account the deputize rate venture. This essay of infection will be of higher magnitude in the exploitation countries because of their temporary monetary and fiscal policies2. As we have seen that fluctuation in transform rate has greatly hurt the AES business and they were unable to mitigate this risk as they havent anticipated it.This risk becomes important when the exchange rate fluctuation affects balance sheet items unequally. Thus keeping keep back on the foreign exchange rate requires timely coiffurement of twain the items of revenue and expenditure, and those of assets and liabilities in different currencies. Political Risk This is another impo rtant factor which the current financial management system does not take into account. This will be of fundamental importance when it comes 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 get down solely took into account those factors that minimized AES exposure to the project and achieved the more or less beneficial regulatory treatment thus ensuring availability of financial resources to boom 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 runnel a power plant or manifestly buying an active facility and upgrading it and then operating.The underlying assumption over here was that the isobilateral and a rhombohedral risks faced by the project were more or less same irrespective of its geographical location (Refer to stage 3). However when AES started diversifying the breadth of its operations by incorporating other offshoots of energy related business and transforming from a cogeneration to a more utility organization with majority of expansion occurring in developing economies.This variegation of business increased the symmetrical risks like business risk, a classic example of which we see in Brazil where AES nonplus shortfall in demand /sales volume due to cipher Conservation Policy of Brazilian government and this had a chain effect on debt servicing capacity of the SPV as well the stock legal injury 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. intricacy in developing economies also exposed the business to political risk where the polici es change erratically with changes in government. Hence we see that the geographical diversification of business causes asymmetrical risk to increase causing bimodal mien 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 reason the esteem of project for the Lal Pir project in Pakistan, we first strike to write in code the weight Average Cost of Capital (WACC) using the new proposed methodology. For this we have followed the approach precondition in exhibit 8 of the grammatical case. The first step is to get the respect of levered ? using the formula and information given in the case3. The protect of the levered ? comes out to be 0. 3852 or 38. 52%, which basically means that our project is not very highly correlated to the market return.Using this value of ? we no w 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 scheming 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 correct for the sovereign spread (0.0990 for Pakistan). Once we have the familiarized costs of equity and capital we can now calculate the WACC for the project using the formula given in case where we essentially manifold equity and debt ratio with the adjust 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 alliance between business specific risk pull ahead and cost of capital5 we need to adjust our WACC by 7. 125% thus reservation 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 Proba bilities 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, Counterparty, Regulatory, Construction, Commodity, property 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 500 basis points in the WACC.When we calculate the WACC for Pakistan through traditional formula it comes out to be 15. 95%, further 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 cy pher 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 occupy that it incorporates for the probability of the afro-mentioned six types of risks in WACC with respect to Pakistan.Discount Rate appointment 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, epoch 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 th eir risk we see that the adjusted WACC for Pakistan (23. 075%) is much higher as irrelevant to that of USA (9. 64%), which essentially implies that Pakistan is inherently a riskier country to invest in as opposed to the USA and any investments made in this region would have to dun a higher hurdle rate than if they were made in the US region.